Another Business Valuation Disaster
Let me be clear. This was a very experienced realtor; very experienced at selling houses. But like what seems to be the case with many realtors, she felt she could sell a business just as easily – especially given that it included some real estate, an asset category with which she claimed some familiarity. Unfortunately, she did not pause to consider the fact that residential real estate is to commercial real estate what a flu shot is to a heart transplant. Just because you understand one doesn’t mean you’re proficient in the other.
But much of the blame for this debacle attaches to the business owners. They made three mistakes, albeit it all with good intentions, if not well thought-out. Here’s the background.
Bad Decisions From the Get-Go
The business in question is not complex; a restaurant with sales of $1.2 million. Simple. Easy peasy from a valuation standpoint. But in the manner of using a piece of artillery to take out a wayward rabbit in the backyard, the owners hired a regional CPA firm with no fewer than eight partners, 15 support staff, three offices and operations in several U.S. states to establish the value of the restaurant business. A professional business broker, one with a CBI certification, could have done the job for 1/10th the cost.
Though this was only a pocketbook mistake – and, in the overall scheme of things, a minor one at that – it was mistake number 1.
For mistake number 2, they hired, independently of the CPA firm, a real estate appraiser to appraise the real estate. But, apparently, they failed to tell him the true purpose of the appraisal. As a result, the appraiser appraised the building as if it housed a fictional tenant, not with a restaurant operating in it for the past 10 years. That is, he appraised it as if the tenant – the restaurant – was paying market rent. It wasn’t. (Oh, oh…)
The third mistake was, of course, hiring a realtor to handle the marketing, the negotiating and the sale.
Business Valuations Mistake Number 1
Business Valuations Mistake Number 2
The second mistake was hiring a real estate appraiser without giving him the reason for the appraisal, which was to establish the current value of the real estate with the current business – the restaurant – as the tenant. The business was, after all, going to stay put. This mistake resulted in an appraisal that was completely inaccurate.
Why? Well, as it happened, the real estate was owned by an entity that was, in turn, owned by the same people who owned the restaurant. Such an arrangement made it possible to give the restaurant a sweet deal on the rent, a fact that the appraiser apparently was not aware of but one that would have significantly impacted his conclusions, as I explain in a moment.
I have waxed philosophical on these pages repeatedly – here, here and here, for example – over the last few years about how owners of a business that also own the real estate in which the business operates should hold both assets separately. There are two reasons for doing this (and they are explained at length here) and these owners had set their holdings up correctly. But from a valuation standpoint, all the FACTS must be consider by whoever’s driving the train.
Business Valuations Mistake Number 3
The third mistake – and this arguably was the big one – was hiring a real estate agent to sell the business, particularly as the owners wanted to sell both the business and the real estate as a package.
The first problem that surfaced was that, as I surmised above, the appraiser was apparently unaware that the appraisal was intended to support the sale of the business which was operating in the real estate he was to appraise. He used customary appraisal data for his calculations including determining what per-foot rental rates were being paid for similar properties in the subject business’ market area. He adjusted his numbers for differences between the subject property and the other properties in his data set and arrived at a rate that he believed would be the appropriate rental rate for the owners’ property in an open market. This method is, of course, the primary way investors look at real estate investment opportunities and it resulted in a valuation of $650,000.
Unfortunately for everyone involved, it was not based on the actual rent being paid by the business.
In fact, the business was not paying rent at anywhere near the market rate and nobody picked up on this because nobody knew what the hell they were doing. As it turns out, the business was paying a rental rate that was 40%(!) lower than what the appraiser used in his calculations.
The next problem was that the realtor, being completely untrained and inexperienced in both business brokerage and commercial real estate, did not know enough to examine either the business valuation or the real estate appraisal and simply added the two numbers together and said to the owners, “Here’s the value! Let’s list it for $1.25 million!” A couple of high-fives around the room and we’re off to the races!
The Rude Awakening
But hold on a minute there, Bucko! Something’s wrong, right? And probably more than one thing.
If the business is paying a rental rate that if 40% below the market rate – the one used by the appraiser – that tells us two things.
- The business is not making enough money to pay the full freight, and;
- The real estate is substantially overvalued – which, in turn, tells us that the listing price is WAY high (which, not coincidentally, explains why the business hasn’t sold).
Any issues that I would have raised about the business’ valuation would have been tantamount to picking nits; unless the business was valued using the real estate appraisal as guidance – using the market rental rate, rather than the actual rent paid – in which case the business would have been worth roughly $130,000 less.
But more dramatically, if the appraiser had used the actual rental rate being paid by the business rather then the composite rate he developed for the market, the real estate would have appraised out at roughly $370,000 – almost $300,000 lower than the sellers, the CPAs, the appraiser and, not least, the realtor believed.
What Does All This Mean to Business Owners?
Because there was no business broker anywhere near this fiasco, there was no one carrying the ball; no quarterback; no one making sure that all the parties involved were working toward the same goal – and advising the owners properly on how to reach that goal.
Nearly all of the upfront costs incurred by the owners – $10,000-$15,000 for a CPA firm to do a valuation on a small business, $3,500-$4,000 for a commercial real estate appraisal, a couple of years futilely hoping their business would sell – could have been saved if they had hired a professional, certified business broker.
Our course, The Basic “How-To” of Becoming a Business Broker”, teaches how to become a professional business broker.
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The Bottom Line
I have nothing against realtors. Like veterinarians, landscapers, plumbers and countless other professionals, most of them know their profession – how to sell real estate. But they don’t know how to splint a pony’s leg, choose the right foliage for the weather in Minnesota, Florence and Normandy or how to run a waste line in a 10 -story building. They also don’t know how to sell a business.
If you want a hip replaced, you don’t go to a gastroenterologist to get it done. Likewise, if you want to sell a business, you don’t go to a real estate agent to get it done.
If you have any questions, comments or feedback on this topic – or any topic related to business – I want to hear from you. Put them in the Comments box below. Start the conversation and I’ll get back to you with answers or my own comments. If I get enough on one topic, I’ll address them in a future post or podcast.
I’ll be back with you again next Monday. In the meantime, I hope you have a profitable week!
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