The market value of any asset may obviously change over time. This includes the value of a business’s real estate and equipment, among other items. So why would you accept the value of assets your borrowers pledge as loan collateral as given — without further examination? It’s important to take a hard look at the current market value of these assets. One way to do so is to obtain a formal asset appraisal.
Taking the right approach
Whether an appraiser is valuing a building, trademark, artwork or investments in a subsidiary, the approaches used are essentially the same. Appraisal boils down to three primary techniques:
- Cost approach. The value of an asset can be determined by the cost to replace or reproduce it. Under this approach, appraisers factor in functional and operational obsolescence. When valuing investments in private company stock using this approach, an appraiser would subtract liabilities from the combined fair market values of the company’s assets.
- Market approach. An asset is worth as much as other assets with similar utility in the marketplace under this approach. With investments in private company stock, for example, an appraiser might look at recent transactions involving other companies in the same industry and compute pricing multiples from those comparables.
- Income approach. With this approach, investors pay for the expected cash they’ll receive every year from an asset and when the asset is eventually sold (or salvaged) in the future. Often, appraisers “discount” future earnings based on the asset’s risk, using a discounted cash flow analysis.
Appraisers always consider all three approaches, but one or two may be more relevant than the rest.
Determining the standard of value
There are several definitions — or standards — of value. One of the most commonly quoted definitions of fair market value comes from IRS Revenue Ruling 59-60: “the price at which the property would change hands between a willing buyer and a willing seller, when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.”
Although this standard of value doesn’t apply in every situation, it highlights key assumptions. Namely, both parties — the buyer and seller — are knowledgeable and not compelled to deal. These assumptions may not be valid if, say, a buyer of a business interest hasn’t performed adequate due diligence — or if a distressed company needs cash to make payroll.
In the latter situation, liquidation value may be more relevant to its creditors. Orderly liquidation assumes that assets are sold over a reasonable time period and sometimes bundled together to maximize the net sales proceeds. Conversely, forced liquidation assumes that assets are quickly sold, typically in an auction. In these dire situations, it’s common for the company to receive 50 cents (or less) for every dollar on its balance sheet.
Deciding when to obtain an appraisal
If a borrower plans to merge with or acquire another company, they often need bank financing. An appraisal can help demonstrate that the purchase price is reasonable. And if a company plans to grow using internal resources, it may need a line of credit to fund its incremental working capital requirements or a long-term loan for new property or equipment. Appraisers can value all kinds of assets — including used equipment, vacant land and patents — that may eventually become loan collateral.
In addition, a distressed borrower may attempt to turn its operations around by cutting costs and divesting unprofitable assets in a reorganization. An appraiser can help evaluate reorganization alternatives, including the long-term effects on future cash flow. Finally, appraisers can help lenders understand how much cash a borrower is likely to receive under various liquidation scenarios. They can also support decisions to reorganize or liquidate.
Some lenders recommend that borrowers obtain formal appraisals if their loans are denied, based on today’s stricter underwriting requirements. An appraisal may convince underwriters to make an exception to the bank’s strict rules. This may be true for growing companies with limited credit histories or established companies with appreciated assets on the balance sheet that are reported at their original cost from decades ago.
Relying on professional help
Determining asset value is a complex task with many factors to consider. Gaining a basic understanding of appraisal approaches is a first step. But nothing can replace the help of an appraisal professional when you need to determine the value of your borrowers’ loan collateral.