Business valuation is tricky even under the best circumstances. And the probate process adds a few more twists.
The first twist is that you are probably not selling a turn-key business. Some people come to us with valuation approaches such as 1) Comparables (what similar businesses have sold for in the area) and 2) Discretionary income (meaning, what sort of income does this business throws off, multiplied by the number of years you expect to earn that).
Both approaches assume the business is fully operational, which isn’t always the case when the owner has passed away. You can’t use the grocery store where the owner is alive and running it as a comparable to the store in the midst of chaos since the owner passed.
In probate, the business often stops upon owner’s death. Even if the business doesn’t stop, the quality of the business tends to head downhill. People usually notice when the business isn’t run by the owner anymore. It’s kind of like an “inmates running the asylum” type of situation… Not great for business, and therefore not great for the valuation of the business.
Buyers typically want to step into a seamless, ongoing operation. With a probate business, the buyer is not purchasing an ongoing business, but rather has to re-jumpstart a business that may have been temporarily closed for months. The buyer can’t walk into the restaurant and be open for business the next day with the menu ready to go.
Without a keyman, the business doesn’t work. The keyman is so crucial to a business that you can buy “keyman insurance” in case he passes away. When a small business loses its keyman, it loses a lot.
First, there is no transfer of knowledge. If you buy a business from a living owner/operator, he can tell you the tips and tricks of the business. These tips are unlikely documented anywhere, just things that the owner knows.
Second, there are no relationships with customers. Without the owner, maybe some of the best customers don’t come anymore. There are no relationships with vendors who give the business a good deal. They may want to reset their prices and not give the new owner a grandfathered-in deal. Additionally, if the owner/operator doesn’t own the property, the quality of the relationship with the landlord is huge for determining the value of the business. Without a lease, there is no business. Also, since the landlord doesn’t know the new owner, he may want to renegotiate the lease.
Lastly, the keyman is important because valuation is sometimes based on discretionary income (the amount of income the business throws off). Small businesses don’t necessarily report on paper all that they earn. How can the seller convey to the buyer what the business is actually worth – the real income? That conversation between seller and buyer often happens when no brokers or lawyers are present. If the owner passed away, there is no side discussion of actual discretionary income. Without that conversation, is almost impossible to value the business based on discretionary income.
Rapidly declining value
In probate, a non-operational business rapidly declines in value.
First, inventory may be expiring and rotting with every passing day. This is assuming that in the absence of the owner, the business ceases to function or functions poorly.
If the business closes for a couple weeks or months, that may not feel like a long time to an heir who has never run a business. But that is enough time for its most loyal customers to find a new favorite store. Not only that, but closed businesses attract theft and vandalism. A closed business is an easy target for a crime of opportunity.
Lastly, even while the business is non-operational, it is still bleeding expenses (rent, security, taxes, utilities) while no revenue is coming in.
For those reasons, the faster you sell in probate, the better in order to keep the value from falling farther. The longer the business sits, the more money it loses. We have experience in this area and have seen these scenarios first-hand.
If you want to learn more about how probate works, please check out my book, “How Probate Works,” available on Amazon. If you are dealing with a situation like this, please feel free to reach out to me.
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