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business valuations
SBA Business Valuation Requirements: Explained
The SBA SOP outlines lending requirements across over 400 pages, in this article we aim to explain the basic requirements related to SBA business valuations.
"If the amount being financed (including any 7(a), 504, seller, or other financing) minus the appraised value of real estate and/or equipment is greater than $250,000 or if there is a close relationship between the buyer and seller (for example, transactions between existing owners or family members), the Lender must obtain an independent business valuation from a Qualified Source."
-SBA SOP 50 10 7.1
For more than a decade the SBA has required third party business valuations for most SBA 7(a) loans used for acquiring a small business. The SBA SOP outlines lending requires across over 400 pages, in this article we aim to explain the basic requirements related to SBA business valuations.
Q: What loans require a business valuation?
A: Most SBA 7(a) loans funding more than $250K for a small business acquisition will require a third-party business valuation. However, many lenders will still require the borrower to purchase a business valuation for smaller acquisitions.
Q: Who can prepare an SBA business valuation?
A: The business valuation must be prepared by a "qualified source" on behalf of the bank. The bank may not use a business valuation prepared for the seller, business broker, or any other party. The SBA SOP defines a Qualified Source as an appraiser with credentials such as Certified Valuation Analyst (CVA) from the National Association of Certified Valuation Analysts (NACVA). Every Value Buddy report is prepared by a Qualified Source with our valuation experts having nearly a decade of experience in preparing valuations for SBA lenders.
Q: How much does an SBA business valuation cost?
A: The cost of the business valuation will depend on the valuation firm that the SBA lender works with. Value Buddy offer market-leading pricing of $1,800, but most appraisers will charge between $2,500 and $3,000. In some cases the SBA lenders will allow the borrower to select an appraiser from a set list of firms that have been approved by the lender.
Q: What information is needed to prepare an SBA valuation?
A: The appraiser will need to understand the business' financials including historical tax returns, the deal terms via a purchase agreement / letter of intent, and qualitative factors regarding the industry, management team, etc.
Q: What factors should be considered when choosing a business appraiser?
A: Expertise, price, and turn times are typically the most important factors when choosing an appraiser. It is best to have an appraiser with significant experience valuing businesses in a similar industry. The valuation fees should not be exorbitant, and the report should not delay the loan origination process with slow turn times. Value Buddy pairs every business with an expert appraiser who has prepared valuations for businesses in that industry. Our $1,800 pricing and 3 business day turn times make Value Buddy the preferred appraiser of many top SBA lenders.
Q: What happens if the conclusion of value comes in below the purchase price?
A: The SBA-guarantee of the business acquisition cannot exceed the conclusion of value determined by the appraiser. If this happens the buyer and seller may renegotiate, the lender may offer non-SBA bridge financing, or the deal may be declined. It is important for the buyer to exercise caution with proceeding if their purchase price exceeds the fair market value of the business.
SBA-Compliant Business Valuations: What Every Lender Needs to Know
Learn everything SBA lenders need to know about SBA-compliant business valuations, including key methods, regulatory requirements, and the role of qualified appraisers.
Understanding Business Valuations for SBA Lending
When financing small business acquisitions, accurate and independent SBA business valuations are a cornerstone of the lending process. These valuations ensure compliance with SBA regulations, safeguard the lender’s interests, and support informed decision-making. Whether assessing a company’s tangible assets, intangible assets, or enterprise value, lenders must rely on detailed analyses conducted by qualified professionals. This guide delves into the specifics of SBA business valuations, offering clarity for lenders with foundational SBA knowledge.
Categories of Valuations
Valuations span several asset types critical to the transaction:
Real Estate Valuations for SBA Loans: Typically assessed by certified real property appraisers, real estate valuations are crucial for transactions involving owner-occupied premises.
Equipment Valuations: Often valued based on its current utility and market demand, especially for machinery-heavy businesses.
Business Valuations: Captures the overarching value of the company, considering both tangible and intangible elements.
Intangible Asset Valuations: Includes goodwill, trademarks, customer relationships, and proprietary technologies—key for businesses with strong brand recognition or innovative products.
SBA Requirements for Business ValuationsUnder the SBA SOP guidelines, the requirement for an independent valuation hinges on specific thresholds:
Loans Exceeding $250,000: Mandate an independent valuation to ensure accuracy and impartiality.
Transactions Involving Related Parties: Demand heightened scrutiny to avoid potential conflicts of interest.
These requirements are designed to mitigate risk for lenders and provide a clear understanding of the business’s fair market value. For loans under $250,000, while not mandated, lenders often seek valuations as part of prudent underwriting practices.
Qualifications of AppraisersNot all appraisers are created equal. The SBA stipulates that valuations must be conducted by professionals with credible certifications, such as:
Accredited in Business Valuation (ABV): Issued by the AICPA, emphasizing expertise in financial valuations.
Certified Valuation Analyst (CVA): From NACVA, focusing on a structured approach to business valuations.
Accredited Senior Appraiser (ASA): Offered by the American Society of Appraisers, recognized for rigorous standards.
These credentials signal an appraiser’s ability to deliver accurate, defensible valuations in alignment with SBA expectations. The SBA also emphasizes that appraisers must follow Uniform Standards of Professional Appraisal Practice (USPAP) guidelines.
Key Steps in the SBA Valuation ProcessThe valuation process involves several critical stages:
Engagement Letter: Defines the scope of work, timelines, and responsibilities between the appraiser and lender.
Information Request: Appraisers collect financial statements, tax returns, operational data, and other relevant documentation to gain a holistic view of the business.
Valuation Analysis: Combines quantitative and qualitative insights, leveraging multiple approaches to triangulate an accurate value.
Valuation Report Preparation: A comprehensive document outlining valuation methods, assumptions, and conclusions is delivered to the lender for review.
Common Valuation Methods
Valuations draw on established methodologies tailored to the business’s characteristics:
Income Approach for SBA Valuations: Centers on cash flow generation and profitability.
Capitalized Returns Method: Uses a multiple applied to adjusted earnings.
Discounted Cash Flow Method: Projects future earnings and discounts them to present value based on risk factors.
Market Approach: Benchmarks the subject business against comparable companies or transactions.
Asset-Based Approach: Evaluates the company’s net asset value, factoring in both tangible and intangible assets.Adjustments to Cash FlowCash flow adjustments are vital for reflecting a business’s true earnings capacity.
Key adjustments include:
Adding Back Non-Cash Expenses: Items like depreciation and amortization.
Normalizing Compensation: Adjusting owner salaries to reflect market rates.
Addressing Discretionary Expenses: Adjusting for personal or non-recurring costs that don’t impact future operations.
Considering Industry Benchmarks: Comparing financial performance against industry standards to identify anomalies.
Enterprise vs. Equity Value
Grasping the distinction between enterprise and equity value is essential:
Enterprise Value in SBA Lending: Represents the total value of the business, inclusive of debt but excluding cash.
Equity Value: Focuses on the residual value available to shareholders after settling liabilities.
This distinction is critical for structuring loans and assessing the overall financial health of a business. For example, lenders often focus on enterprise value to determine the borrowing base.
Reporting and Independence
SBA-compliant valuations require absolute independence. The appraiser must base conclusions on objective data, free from undue influence by the buyer or seller. The final report must:
Detail the valuation methodologies employed.
Provide transparent justifications for all assumptions.
Be defensible in the event of audits or disputes.
Lenders should also ensure that appraisers disclose potential conflicts of interest in their engagement letters.
Common Challenges in SBA Valuations
Limited Financial Records: Small businesses often lack robust financial documentation, making it challenging to perform accurate valuations.
Subjectivity in Intangible Assets: Valuing goodwill and other intangibles requires careful judgment and robust methodologies.
Economic Variability: Market conditions and regional factors can significantly impact valuations.
Why Accurate SBA Valuations Depend on the DCF Method
Value Buddy uses Discounted Cash Flow (DCF) valuations for SBA-backed acquisitions to align with bank underwriting, incorporate tailored growth forecasts, and deliver precise insights that capture a business' true value.
At Value Buddy, we specialize in SBA business valuations and have nearly a decade of experience working with top SBA lenders. In our SBA business valuation reports, we often utilize the Discounted Cash Flow (DCF) method to provide accurate, data-driven results. Our innovative approach combines machine learning and advanced analytics to capture each business’s unique potential, setting us apart from competitors who often rely on simpler Capitalization of Cash Flows (CCF) methods.
Comparing DCF and CCF: Which Method Delivers Better Results
Capitalization of Cash Flows (CCF) Method: The CCF method is a traditional approach that capitalizes a business's normalized earnings at a fixed rate tied to U.S. GDP growth. While this method works well for businesses with stable and predictable earnings, it assumes that future performance will closely mirror historical data. This limitation makes it less effective for businesses undergoing significant changes or growth.
Discounted Cash Flow (DCF) Method: The DCF method forecasts future cash flows and discounts them to present value using a discount rate. Unlike the CCF method, DCF provides tailored growth projections specific to the business, risk-adjusted insights into future cash flows, and a detailed understanding of operational performance and resale value. By accounting for company-specific growth rates and operational changes, the DCF method is ideal for businesses with evolving operations or significant growth potential.
Why Value Buddy Chooses the DCF Method for SBA Valuations
Advanced Data Analytics for Accurate Valuations
Value Buddy leverages machine learning to analyze hundreds of data points, incorporating FRED (Federal Reserve Economic Data) for macroeconomic indicators, RMA (Risk Management Association) for industry benchmarks, BVR (Business Valuation Resources) for comparable transaction data, and Comparable Companies for financial metrics and insights. This data-driven approach ensures precise, customized cash flow forecasts that reflect the unique characteristics of each business.
Alignment with Bank Underwriting Standards
We integrate the bank’s cash flow forecasts from their credit memos into our valuations. This ensures that our reports align with the financial assumptions banks use in underwriting, providing consistency and reliability for SBA lenders.
Accounting for Business-Specific Changes
The DCF method captures critical changes that impact valuations, such as launching new products or services, expanding into new markets, and securing significant client contracts. These dynamic factors are often overlooked in static CCF models, making the DCF method a superior choice for many businesses. However, it is important to note that SBA business valuations must not consider buyer-specific synergies given that the conclusion of value is based on what a hypothetical buyer would pay for the business.
Combining DCF with SDE Exit MultiplesTo deliver comprehensive valuations, we pair DCF with a Seller’s Discretionary Earnings (SDE) exit multiple. This hybrid approach captures expected cash flows during the forecast period, estimates the business’s resale value after the forecast period, and reduces uncertainty by avoiding perpetual cash flow projections.
Competitor Limitations: Why CCF Falls ShortCompetitors relying on CCF models face several constraints, including over-reliance on historical financial data, inability to reflect growth opportunities or operational risks, and simplistic perpetual growth assumptions that misrepresent a business’s true value. In contrast, Value Buddy’s data-rich, tailored approach provides accurate and actionable valuations that better serve the needs of SBA lenders and business buyers.
Key Benefits of Using DCF for SBA Valuations
Enhanced Precision: Tailored to each business’s unique financial scenarios.
Reduced Risk: Balances detailed cash flow forecasting with practical resale valuation.
Informed Decision-Making: Leverages comprehensive data for robust, reliable insights.
SBA-Compliant Business Valuations: Common Financial Adjustments Explained
Learn how financial adjustments like owner compensation, rent, and non-recurring expenses impact SBA business valuations. Discover the rigorous process Value Buddy uses to ensure accurate, SBA-compliant valuations for lenders and business brokers.
When evaluating small business valuations for SBA loans, lenders and business brokers often rely on financial statements as a starting point. However, these statements can misrepresent the true economic reality of a business. Adjustments—known as normalization adjustments—are critical in business valuations to present an accurate picture of cash flow and earnings. For SBA lenders and business brokers, understanding how these adjustments impact fair market value (FMV) is essential when assessing a business's worth.
At Value Buddy, we specialize in SBA-compliant business valuations, bringing expertise and a rigorous process to ensure every adjustment is well-supported and accurate. By focusing on realistic, defensible adjustments, we help SBA lenders and brokers make informed decisions.
Why Normalization Adjustments Are Crucial for SBA Business Valuations
Normalization adjustments align financial statements with what a hypothetical buyer would experience when operating the business. Without these adjustments, cash flow could be overstated or understated, resulting in an inaccurate FMV.In SBA loan valuations, adjustments ensure compliance with SBA Standard Operating Procedures (SOPs), which require valuations to reflect fair market conditions. Adjustments such as owner compensation, rent, and one-time expenses are common areas of focus. However, many adjustments proposed by sellers or buyers fail to meet the stringent standards required in SBA business valuations.
1. Adjustments to Owner CompensationOwner compensation often requires normalization because small business owners can set their own salaries, which may not reflect market rates.
How Value Buddy Normalizes Owner Compensation:
We analyze industry benchmarks, geographic norms, and job responsibilities to establish fair market compensation.Multiple owners are evaluated based on their contributions, with passive owners’ salaries typically removed from the valuation.
Why Scrutiny Matters:
Proposed adjustments must align with market data. For instance, if a seller claims their compensation was inflated by $30,000, we verify this claim against data from reliable sources like the Economic Research Institute (ERI) and PayScale.
2. Manager Salaries
For businesses with absentee owners, a manager may handle day-to-day operations. If a buyer intends to assume this role, the manager's salary can be added back to cash flow.
Our Expertise:
We validate manager salaries with W-2s or other wage documentation to ensure accuracy. Claims of excessive or unnecessary management costs are scrutinized to avoid inflated cash flow adjustments.
3. Family Member Compensation
Business owners often employ family members at non-market rates. For instance, a family member performing minimal work might receive a high salary, while others may be underpaid for their contributions.
How Value Buddy Handles This:
We adjust for fair market wages based on responsibilities, using supporting documentation such as job descriptions and W-2s.Unsupported claims of overcompensation or undercompensation are rejected.
4. Rent Adjustments
When business owners also own the property, rental agreements may not reflect market rates. Fair market rent adjustments ensure valuations align with what a hypothetical buyer would experience.
Our Process:
Value Buddy uses real estate appraisals, lease agreements, and market data to determine appropriate rent.Even when real estate is included in the transaction, a normalized rent expense is applied for consistent valuation practices.
5. Non-Recurring or One-Time Expenses
Sellers often claim that certain expenses, such as legal fees or equipment repairs, are one-time in nature. While these adjustments can be valid, they require strong documentation.
Value Buddy’s Approach:
Adjustments are only made if expenses are unlikely to recur and are unrelated to ongoing operations.Claims without invoices, contracts, or clear evidence are excluded to ensure accuracy.
6. Travel, Meals, and EntertainmentPersonal expenses, such as vacations or non-business meals, are often reported as business costs. These are common areas for proposed adjustments, but proof is critical.
Our Rigorous Review:
We reject adjustments without documentation that clearly separates personal and business expenses. For instance, claiming $12,000 in travel as personal requires detailed receipts and justifications.
7. Owner Benefits: Health Insurance and Retirement Contributions
Benefits such as health insurance premiums and retirement contributions are added back as discretionary expenses. However, these must be verified through payroll records or tax filings.
8. Non-Business-Related IncomeIncome from non-operating activities, such as grant funding or asset sales, is excluded if it cannot be expected to continue in the future.
Commonly Rejected Adjustments in Business Valuations
Not all proposed adjustments meet the rigorous standards required for SBA-compliant business valuations.
Advertising and Marketing:
Sellers may claim that cutting outdated marketing expenses will not impact revenue. Without evidence, these claims are typically rejected.
Industry Comparisons:
While industry averages (e.g., RMA benchmarks) are useful for context, they do not justify altering a business’s actual expenses.
Unverified Personal Expenses:
Personal expenses for items like family cell phones or meals are often proposed as adjustments. However, without clear documentation, these are excluded.
Impact of Normalization Adjustments on Fair Market Value
As Reported EBITDA: $225,000
Adjustments:
Officer Compensation: +$40,000
Payroll Taxes (7.65%): -$3,060
Rent: -$10,000
Repairs: +$7,500
Professional Fees: +$12,000
Travel/Entertainment: +$6,000
Total Adjustments: +$52,440
Normalized EBITDA: $277,440
FMV with 4.5x EBITDA Multiple: Increased from $1,012,500 (as reported) to $1,248,480 (normalized).
