Banks and other lenders providing capital to businesses have a vested interest in mitigating the risk of their loans and ensuring proper collateralization. Among the many regulatory guidelines that must be met for business loans, including SBA loans, is the requirement of a certified appraisal for loans above various threshold amounts. Appraisers used by lenders include real estate appraisers, equipment appraisers and business appraisers, among others. Each of these disciplines has its own set of professional standards, designations and licensure.
When lending to an operating company, lenders may seek out the services of a business appraiser with the expectation that their service offering is most closely aligned with the needs of the loan. Though this may be the case in limited instances, loans to operating companies will have varying collateralization thresholds and interest rates depending upon the composition of assets within the organization, and as such, the need for appraisals from multiple disciplines is likely required. Failure to understand these nuances may lead to an under- collateralized loan, added risk to the lending institution, as well as possible regulatory violations.
To avoid these missteps, it is important to engage a valuation firm with competencies in multiple disciplines, or engage the services of two or more firms to ensure proper application of valuation principles. Regrettably, many business appraisal firms do not call attention to the inadequacy of their analysis, which may not fully address the underlying assets of the business. Professional appraisal standards require the use of three approaches: the income, market data and asset approaches.
The income approach derives value as a function of the expected future economic benefits, typically free cash flow, discounted at a risk-adjusted required rate of return. The market data approach relies on either comparable publicly-traded companies or transactional data reported for comparable privately-held companies to derive valuation multiples that can be applied to the subject entity. Lastly, the cost or asset approach considers what it would cost to replicate the assets of a subject business using pricing data for assets of similar age, physical condition and utility. For business appraisers, the cost approach is often ignored or misapplied due to budgetary or time constraints imposed by lenders, scope limitations, lack of expertise and/ or a lack of information. Though lenders must be mindful of the cost and turnaround time of appraisals, reliance on an inadequately prepared appraisal may lead to under-collateralized loans that jeopardize the financial health of the institution.
The asset approach requires the appraiser to adjust all assets and liabilities to their respective fair market values (FMV). The indicated equity value of the subject company is thus the difference between the FMV of assets and the FMV of liabilities, followed by any applicable discounts such as lack of control or lack of marketability, among others. The proper adjustments to fair market value require the expertise of a certified machinery/equipment appraiser, and because many business valuation firms do not have a certified equipment appraiser on-staff, these firms often dismiss the approach altogether. When the cost approach is implemented, business appraisers may opt to use the stated book values of all assets and liabilities from the financial statements to determine the value of the company. Book values often represent management choices regarding capitalization thresholds and depreciation methodologies, and there is often a wide variance between stated book value and actual fair market value.
For example, let’s look at a hypothetical company, ABC Corporation, and how book value and fair market value can lead to divergent indications of value when using the cost approach.
We will present two scenarios. Scenario 1 will reflect ABC Corporation’s asset side of the balance sheet as reflected on their financial statements at book value, including the impact of an accelerated depreciation method. Scenario 2 will demonstrate what the company’s asset side of the balance sheet would look like following an appropriate adjustment of fixed assets to fair market value.
|Scenario 1- Book Value:||Scenario 2- FMV Adjustment:|
|Less Acc. Dep.||($500,000)||$0|
|Net Fixed Assets||$0||$375,000|
In the previous illustration, it is apparent that the book value of assets in Scenario 1 of $170,000 is considerably lower than the hypothetical adjustment to fair market value of $525,000 in Scenario 2. As mentioned, many factors can lead to this divergence, including, but not limited to, the use of accelerated depreciation methods, supply and demand as it relates to the particular industry or assets, various impacts of economic and functional obsolescence, etc. The hidden value might actually mean the difference between making a properly secured loan and not making a loan at all.
Making proper adjustments to the balance sheet is critical for a reliable opinion of value from a valuation firm. Without knowing the true value of the assets, the valuation adjustments cannot be properly reflected. It is, therefore, most important to have access to a certified machinery/equipment appraisal as part of the due diligence process.
Knowing the fair market value of the machinery and equipment is critically important to determining the true value of a business and the proper collateralization of the loan. It makes sense to use a valuation firm that has staff with equipment appraisal expertise or make sure your valuation firm has access to a certified equipment appraisal from a third party. As described above, lenders can benefit greatly by requesting appraisals from multiple disciplines when lending to operating companies.