1399 Purpose Oriented Business Valuation for MSMEs ‘Character. Be more concemed with your character than with your reputation, Your character is what you really are while your reputation is merely what others think you are - John Wooden’ — A ~ Inthe wake of economic liberalisation, The goal of such an appraisal is companies ate relying more on essential to estimate a fair market the capital market, acquisitions value of a company. So, at the outser, ‘and restructuring are becoming we must claily what is meant by "fair commonplace, strategic alliances are market value" and what is meant gaining popularity, employee stock by “a company". The most widely plans are prolferating, and regulatory accepted definition of ‘fair market bodies are struggling with tatif value was laid down by the Internal determination. In these exercises a Revenue Service (RS) of the US. It CA. Hozefa Natalwala crucial issue is: How should the value defined fair market value as “the price (The authoris a member ofthe institute, of a company or a division thereof be at which the property would change He can be reached at eboard@icalorg ) hands between a wiling buyer and a {THE CHARTERED ACCOUNTANT /MARCH 2071/95| PO vaco i | wiling seller when the former Is not comments of TS. Tony Leung, GPA) Characteristics of SME under any compulsion to buy and the In pure sense, business valuation Some of the major characteristics latter is not under any compulsion to refers to estimation of business value. observed are as folows: sell, both parties having reasonable Although considerable time and A. Ownership knowledge of relevant facts." When the etfort is involved in preparing formal MSME_ businesses usually are asset being appraisedis ‘a company", business valuations, unfortunately the owned by individuals, family the property the buyer and seller are resulls may or may not reflect the “teal members, friends or relalives, and trading consists of the claims of all the world” value of a speciic company fit are likely to be highiy dependent investors ofthe company. This includes were formally offered forsale fon the ownerimanager, Small outstanding equity shares, preference To assume there is only one businesses often have 2 high shares, debentures and loans, “correct” estimate of values amistake, degree of rellance on one or more But note that, ‘Fair market value’ and "right" is a matter of opinion, key owmerimanagers. In extreme (FMV) Is not Gesigned with any cases, the business may rely on a particular individual in mind, nor the Business Valuation and single person for sales, technical real’ transaction for that matter. FMV ISIMES expertise, andlor personal contacts, is a hypothetical value for the ‘mode!’ In general, there cannot be any strict and may not be able to survive transaction. The governing conattions definition for a business to regard as without that person, inthis ideal concept are ful knowledge a small or medium or large or giant. B. Financial Records and freedom to act. But in eaity, these It is matter of debate to fix a basis Small businesses tend to have ideal conaitions are rarely present. for treatment of business as a small —__lower-quallty financial statements Emotional and subjective elements or large. The defintion of MSME that are less tkely to have been cften override rational considerations, varies trom country to county and prepared by a professional ‘and full knowiedge is something rarely from rind to mind. in our case, for accountant or qualified auditor. attained by the arm’s-ength potential business valuation, the important thing Their statements tend to be tax ‘buyer who previously has not been is to know whether the fundamentals oriented rather than oriented involved in the business, ff valuation changes when applied to. stockholder disclosure as. in The family-owned and/or closely for business unit which are relatively larger companies. Whereas large hold business is the more cificut tiger small in size. Answer is "No". The companies usually keep separate to tame, Publicly traded companies fundamentals ofvaluation like Promises records for the preparation of tax seek to show bottorviine profit to of value, Standards of value, valuation _—relums. and generally accepted satisty “public owners,” while closely approaches techniques remains accounting principles for financial held enterprises seek only to sat'sfy unchanged iespective of size and statements, private interests, before prof fals to identity. But yes, the dilicuties to be C, Access to Capital the bottom tine. Thus the “documents” faced and the considerations requre _-—_‘Smallbusinesses have lass accoss by which the psychology of ownershios by an appraiser changes due to some to capital than larger companies fare measured send out diferent inherent characteristics of relatively and atten must rely on capital messages in each, Since ownership small businesses. tincludes availabilty infusions from the owner family, and management of closely held and reliability of financial data and frends and/or owner employees. fontarprises are often one and the ther information, quantifying the size Access to debt capital is also same, financial records are massaged r'sk and business specific risk, size of _ more imted because of the higher for tax avoidance. In addition, private discount for lack of marketabllty and risk of smaller businesses, The ‘ownerships can, and sometimes do, lack of control, any, intluence of cient, cost of borrowing is higher, and play the game of chance by stretching ele. The businesses here considered _the owner usually must personally the “gray” areas in law beyond the are (1) which are relatively small and guarantee debt. Many smal limits. Al of this leads to difficult medium in size, in general and (2) businesses oporate with tle or no interpretations of what really goes functioning of which are controlled by debt, reflecting their limted access fon in these companies. Thus, the the owners, themselves (Referred as to debt capital and a frequent necessary conclusion is that few buy’ "MSME" businesses). Of course, the reluctance of owners to take on the soll transactions involving closely held need of valuation ditfers in case of _riskof substantial debt. Many small ‘small businesses are done at so-called MSMEs when compared to large of business owners minimise cebt fair market values, (Summarised from public Companies. to reduce risk during economic 96 /THECHARTERED ACCOUNTANT / MACH 201111 1401 downturns and to increase the probability of keeping the business in the family . Other Operational Characteristics Small businesses can lack diversity in products, markets, and ‘geographic location. They are very dependent on afew key customers and also on a key supplier. Small businesses. may have difficulty ‘competing for employees. In small companies, the portfalio of ‘operations or products frequently reflects the interests and contacts of a particular owner. Sometimes these operations or products have few synergies, and the portfolio. may have litle appeal to potential buyers The characteristics of small businesses tend normally to result in overall higher isk thanis found in|arger businesses. These characteristics tend to be extreme in the smallest of small businesses. So in general, it can be sald that "Risk tends to increase as size decreases’ ‘An Overview of the Task of Estimating Values in Small Companies Business value depends on the effective employment cf capital, manpower, machine, and material fo produce profs; therefore, “business” value depends on the skils that vary widely among indviduals. In cases of closely held businesses, the concept for values must be cartied out to include tangible assets, intangible assets, and perception. So, the conclusion is that perceptions of value in MSME are individually swayed and factualy weighted by productivity of assets employed. In other words, each componento‘businessvalue, including any reference to facts, might change through the personal perceptions of individual caling for valuation, Tris requies to examine the following: (a) general market conditions; (0) specific business conditions; and (c) individual perceptions, Professional service organisations, such as physicians, lawyers, accoun- tants, consuttants, and soon, are among the more diffu types of businesses to establish an intangible value. Pracitioner characterstics, per- sonaities, and reputation play heavily into the generation of cash streams, ‘Take the specific practioner out of the business, andthe cash streamwil quite often suffer considerably. Therefore, a fundamental question is: How much business value is directly attributable toa "prson,” and how much of that value will emain if he or she leaves? To the unwary, this can present the classic diemma of "getting lost in the numbers.” Subsequently, the purchase of a "sole practioner” business can 'be much more risky than the purchase of @ business with mutiple practi tioners who remain after he purchase, These “people” or ownerrestrictive clements can be present in all tyoes cof small businesses and, with safety in ming, cannot be overlooked. A ‘business continuation” risk tonds to decrease with increasing size of staff and, when the present owner is more separated from practice work, by the demands of administrative duty Unlike a publicly traded company that has a published market-driven share price, the value of privately ‘owned company must be calculated Using both qualitative and quanttative analysis. The biggest aiference between valuing business of the public Companies and nonpublic business is lack of information. The application of recognised valuation methodology and rigorous analysis of the closely hold entity provides the foundation for valuation of business. It may be necessary ta make certain adjustments toimprove comparability of the subject ‘company to industry norms, publicly traded companies, or companies involved in market transactions Ea considered in the valuation process ‘The aporaisal process is subjective, time consuming and requires highly specialised professional skis, Testing the Financials ‘A company’s historical financial statements generally provide the most rellableinformation for estimating future performance and isk assessment, Audited financial statements are preferred. However, since the financial Slatements of many MSME businesses are neither audited nor reviewed, the analyst may have to rely on compiled financial statements, which provide no level of assurance and may not contain footnote disclosure. In other ‘cases, the analyst may have to rely fon income tax retuns or internally generated financial statements, the Quality of which may be suspect for purposes of proper financial statement analysis. Ifthe historical information is unreliable, the special care should be taken to disclose the facts and degree of responsibilty assumed based on financial statements, ‘Some common practices which condense the straight reliabilty of financials of MSMES and require restructuring o financials are, + charging the salaries and ‘commission in name of owner or family membor + charging interest on loans trom family, relatives and friends at the rate signifeantly different from prevailing market rat, + missing to account the interest, commissions, remunerations etc foregone by owner or directors + withdrawing unreasonable rent for own premises for business utilisation, + treatment of personal expenses as business exenses, + unrecorded removal of goods for tax saving purposes, + withdrawal of goods for own usage without proper accounting, WE CHARTERED ACCOUNTANT MARCH 2011/97