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What Is Your Business Worth?
Part l – General Discussion
Part 2 – Valuation Guidelines & Techniques
Part 1
Determining how much you should ask for your business is a complicated process that is
best done with the help of a business broker and an accountant. Establishing the value of
your business is done in negotiations with a serious potential buyer. Factors you consider
important may not appear so to the potential buyer and vice versa. But before you ever
sit down at the negotiating table, you have a lot of homework to do.
In preparing to sell a business, you first must gather documentation. Audited statements
prepared by a reputable accountant will help establish your business credentials. Tax
returns also offer proof of business performance. Generally, three years of financial
records will serve to establish where the business is going and its profitability. Among
the items you'll need to gather are:
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Income statements
Balance sheets and income tax returns from the last three to five years
Records of accounts receivable and payable
Copies of any notes or mortgages owed
Existing contracts with employees, customers or suppliers
Present lease
Corporate books (if incorporated) or partnership agreement (if partnership)
Any patents, trademarks or copyrights
There are various methods for valuing a business, each with its limitations. One method
involves calculating net worth by subtracting liabilities from assets. Fixed or tangible
assets can include everything from machinery and office equipment to inventory,
receivables (you may have to guarantee their collection) and prepaid expenses, such as
taxes and deposits. On the other side of the balance sheet are liabilities, items that may
reduce the selling price of your company. They include payables such as salaries, bills
and periodic expenses, short-term bank notes and/or long-term loans, as well as federal,
state and local taxes. (In figuring payables, don't include invoices for products or
materials you use in the course of producing your own products for resale. Those are
accounted for as cost-of-goods sold.) One key drawback to this valuation method is that it
does not take into account the profit or earning potential of the business.
Another method of valuing a business is based on its income or profits and the return on
investment that a buyer could reasonably expect. However, since small business owners
often write off everything they legally can in order to reduce taxes, their profit margin
may appear to be smaller than it really is. It behooves you, as a seller, to prepare an
itemized profit-and-loss statement that shows what excess cash your business generates,
not simply what your final profit was for tax purposes.
Be wary of trying to set a price on your business based on simplistic formulas or rules of
thumb, or on comparisons to the amount paid for similar businesses. Unlike home sales
in a particular real estate market, there are simply too many variables between businesses
to make truly useful comparisons for pricing purposes.
Valuing Goodwill
If establishing the net worth of your business is fairly straightforward, determining the
value of an entity created through your personal efforts is more subjective. As the seller,
you'll unconsciously factor in how difficult it was in the beginning and how much
sacrifice was necessary to weather leaner times. You must realize, however, that others
will evaluate your business from a much narrower point of view: its ability to return an
investment over a fixed period of time with an acceptable margin of risk.
This does not mean that a buyer will fail to appreciate your efforts in building the
business. But goodwill is the single most difficult portion of your business to value.
Your reputation and relationships with your customers, vendors and the community,
along with your participation in trade-related activities, all contribute to goodwill. In fact,
your customer list is probably among your business's most valuable assets. Sales of some
businesses are based on this alone. Accurate addresses, buying patterns and payment
history all are important information that should be available to potential buyers. Guard
this information, but be prepared to provide select references to substantiate its
credibility.
In the final analysis, your company is worth only what someone will pay for it.
Generally, a potential buyer's offer will be influenced by how soon he or she expects to
see a return on the initial investment. Five to six years is usually considered a reasonable
length of time to recoup the initial investment. Among the other factors that will
influence a buyer's offer are the age of your business, how easy or difficult the business is
to operate and the economic climate, both locally and nationally. Again, getting
professional help in setting a price and in negotiating the sale of your business can really
pay off in the long run.
Financing
How the sale of your business is financed may be driven by your personal financial needs
and lifestyle. Start by deciding whether you would like to remain involved with the
business or walk away from it entirely. This helps determine whether you will want to
participate in the financing or have the buyer obtain independent financing. The
following options illustrate the levels of financial involvement you might have in the sale
of your business.
Cash. Once a selling price is agreed upon, the buyer simply pays you that amount. You
have no involvement in the financing.
Seller financing. The buyer pays a portion of the agreed-upon selling price at the time of
sale. You provide financing for the balance. The portion of the sale price financed by
you, the seller, may be driven by the amount of goodwill factored into the total business
valuation. More specifically, sellers often finance that portion of the selling price
represented by goodwill because it is so hard to value.
Lease option. Your third option is to offer your buyer a lease with an option to purchase.
This gives a buyer without sufficient cash or financing resources an opportunity to
participate in the business and earn the necessary cash portion of the sale price. While
the business is being leased, you are still the owner.
Other Inducements
Finally, to sweeten the deal for a potential buyer, you may want to offer to serve as a
consultant or sign a non-compete agreement. Consulting is a good option if you're not
determined to separate yourself from the business. It gives the buyer the benefit of your
expertise and provides a smooth transfer of customer loyalty from the former owner
(you) to the new one. It also gives the buyer confidence that you do not intend to compete
under a new business name.
A non-compete agreement can be an added inducement to a sale, although you should
check with your attorney to find out your state's requirements. This agreement formally
assures the buyer that, for a set period of time, you don't intend to start up all over again
under a new name and lure away customers loyal to your former company.
Passing the Torch
Speak with a lawyer before selling your business to make sure you have complied with
relevant state and federal requirements. You don't want any unpleasant surprises after the
sale. If all goes smoothly, the transfer of a business can be an exciting and rewarding
time for buyer and seller alike. You get what you want-the chance to cash out-and the
buyer gets the business opportunity he or she is seeking. Be as smart in selling your
business as you were in running it, and you're sure to be happy with the outcome.
Part 2
Sample Valuation Guidelines
1. An extremely well-established and steady business with a rock-solid market
position, whose continued earnings will not be dependent upon a strong
management team.
A multiple of eight to ten times current profits
2. An established business with a good market position, with some competitive
pressures and some swings in earnings, requiring continual management attention.
A multiple of five to seven times current profits
3. An established business with no significant competitive advantages, stiff
competition, few hard assets, and heavy dependency upon management’s skills
for success.
A multiple of two to four times current profits
4. A small personal service business where the new owner will be the only, or one of
the only, professional service providers.
A multiple of one times current profits.
Valuation Techniques
If you are analyzing a privately owned company, there are often a number of items on the
financial statements that have to be adjusted or recast in order to understand the real
earning power of the company. Business owners are highly motivated to pay the least
amount of corporate taxes possible, and the extent to which they stretch to minimize tax
liability runs the gamut from legitimate to marginal to illegitimate. Legitimate deductions
include abnormally high salaries for the owners, above-market rent for buildings owned
by a related family-owned real estate trust, and company automobiles. Illegitimate
deductions include salaries for nonworking family members, pleasure trips charged as
business trips, and home maintenance expenses charged to the company.
In valuing the target company, a very basic initial query to the owner is the question:
What is for sale? The owner will generally prefer to sell stock, since such a transaction
results in a single capital gains tax. A stock sale, on the other hand, may be a
disadvantage to a buyer if there are depreciable assets on the balance sheet because he or
she cannot “step up” the value of the assets and increase depreciation charges. In
addition, the buyer will assume all liabilities resulting from previous infractions or
product malfunctions. For these reasons, buyers may well value a company lower when
they are required to purchase stock. Conversely, in an asset sale the seller will be taxed
twice: once at the corporate level and again when distributing the proceeds of the sale
out of the corporation. For the right to buy assets, therefore, the buyer may have to place
a higher valuation on the target company.
Whether you buy assets or stock is only part of the answer as to what is for sale. Other
considerations could include what assets, particularly real estate assets, are going to be
withdrawn prior to the purchase. And, are there any obligations of the seller, particularly
debt, to be assumed by the buyer?
Valuation Technique 1: Multiple of Earnings
For middle-market manufacturers, the multiple of earnings approach is the preferred
method of valuation. For such businesses, earnings before interest and taxes (EBIT) is the
standard earnings component to which multiples are applied in determining business sale
prices. If EBIT shows no earnings, a multiple is sometimes applied to cash flow and even
to gross margin.
Examples of what some M & A experts have said relative to the multiples to apply to
EBIT:
“Will pay 4 to 5 times EBIT if there are growth prospects and no requirements
for additional capital.”
“Will pay over 5 times EBIT if net worth is 60 percent or more of the selling
price.”
“Will pay 5 to 6 times EBIT for companies with a 15 to 20 percent return on
investment.”
“Will pay 5 to 6 times EBIT if there are consistent earnings, good
management, and market leadership.”
Mary Young of the Boston office of BankAmerica Business Credit Inc. reported that at
the 1994 Buy-Out Symposium in New York City sponsored by Venture Economics, the
following observations were made by various speakers:
1. The most common multiple of EBIT is 5 to 7 times for industrial
companies and 7 to 9 times for pricing initial public offerings. Thus there is
an enormous difference in pricing between private and public companies.
2. It is acceptable to pay up to 7 times EBIT for a stand-alone company but 4
to 5 times for add-on acquisitions.
3. Consumer product companies are selling for 8 to 10 times cash flow.
4. The less a buyer pays for a business, the more he or she can afford to
provide for management incentives.
Is the EBIT multiple an arbitrary number? A rule of thumb is that if you buy a new
machine for a factory, you should be able to pay for it in five years from the resulting
labor savings. Likewise, a business should be able to pay for itself in three to five years,
assuming that the earnings remain exactly the same for that period of time. To go one
step further, a prudent person might expect a 20 percent return on an investment in a
company with steady earnings. On that basis, the company could be paid for in five years
at the same earnings level.
Therefore, higher or lower multiples are affected by the corresponding difference in the
rate of return. Historically, however, a five-year payback has been a de facto standard.
According to Joseph Myss, an intermediary from Wayzata, Minnesota, “The multiplier
you select is market driven based on market conditions, comparables, and value in the
eye of the beholder. The value the buyer sees in the company affects the market
multiplier: Paying 10 times earnings for a company provides the buyer with a 10 percent
return on the invested capital based upon historical financial performance. Paying 5 times
earnings results in a 20 percent return on invested capital; 4 times earnings results in a 25
percent return.” Myss emphasizes that EBIT is most commonly used as the constant of
the multiplier. One needs, however, to separate the acquisition and financing features of
the deal. Buyers will use their own capital structure as a model to finance the acquisition
of the seller and will look at the company from that perspective.”
Valuation Technique 2: Book Value
Book value, a multiple of book value, or a premium to book value is also a method used
to value manufacturing or distribution companies. Book value, of course, is total assets
minus total liabilities and is commonly known as net worth.
The book valuation technique is usually used as a method of cross-testing the more
common technique of applying multiples to EBIT, cash flow, or net earnings. In the
following situations, however, the use of book value as the primary method of valuation
is prevalent:
1. When the company is losing money on an operating basis. In such cases,
there are no earnings on which to apply the multiples previously discussed.
Therefore, the reconstructed or fair market value of total assets less total
liabilities is used for the valuation.
2. For small distribution companies with sales of under $20 million.
Distributors of this size are usually successful because of the departing
owners’ many close relationships with the company’s suppliers and
customers. These relationships are tenuous because they are usually
noncontractual and nontransferable. Such companies usually sell at their
book value plus a modest premium.
Book value is very common as a method of testing valuations for nonservice businesses
for these reasons:
1. If the primary method of valuation is using a multiple of earnings, it is
helpful to take the industry average of the book value multiples of other
companies recently sold. Book value serves as a reference point. Some
buyers will raise or lower their EBIT multiple for valuation purposes based
on the relationship to the proposed selling price; some buyers will use only
multiples of 4.5 to 5 times EBIT. If book value is higher than half the selling
price, some buyers will use a 5 to 6 multiple.
2. By pegging the purchase price to a multiple of book value as of the date a
purchase and sale agreement has been signed, the buyer is protected against
a decline in the value of the business between the signing of the purchase
and sale agreement and the completion date of due diligence.
When the book value technique is used, there is an important variation that a seller will
probably want the buyer to consider. The assets may have a far greater value if the values
are recast to reflect fair market value for machinery, equipment, buildings, and land.
Also, the inventory might be adjusted to reflect current values and to pick up items that
have been written off in order to minimize taxes. The buyer must also determine that all
the assets are actually earning money for the business. If they are not, he or she should
request an adjustment in the purchase price to reflect this condition.
Valuation Technique 3: Discounted Cash Flow
Discounted cash flow is what someone is willing to pay today in order to receive the
anticipated cash flow in future years. It is the method most often used by large investment
banks and consulting and accounting firms. The discount rate is based on the level of risk
of the business and the opportunity cost of capital. In other words, it is the return you can
earn by investing your money elsewhere.
In his book Creating Shareholder Value, Alfred Rappaport states:
The appropriate rate for discounting the company’s cash flow stream is the weighted
average of the costs of debt and equity capital. For example, if a company’s after tax cost
of debt is 6% and its estimated cost of equity is 16% and it plans to raise capital 20% by
way of debt and 80% by way of equity, it computes the cost of capital at 14% as follows:
Weight
Cost
Debt
20%
Equity
80%
= Cost of Capital
*
Weighted
6%
16%
=
Cost
1.2%
12.8%
14.0%
Te use of discounted cash flow is a hotly debated subject among those in the mergers and
acquisitions business, particularly in the middle market. Its use is widely accepted with
larger companies because it provides a rational economic framework for valuing
acquisitions in that marketplace.
In the book Mergers & Acquisitions: A Valuation Handbook, Joseph H. Marren states,
One of the complexities with using the net present value method is that a target
company’s future cash flow depends on the method of acquisition and the purchase price.
How? A target company’s future cash flows are directly impacted by the taxes it will pay.
The taxes it will pay depend on the company’s taxable income. And the company’s
taxable income will depend, in part, on its taxable deductions for depreciation and the
amortization of intangible assets. Such deductions depend on the target’s tax basis for its
assets, which in turn depend directly on the purchase price paid for the business.
Other opponents of the discounted cash flow method do not believe in paying for
earnings that are not earned. Furthermore, the projections are speculative, and the
selection of the discount rate is somewhat subjective. Nevertheless, it is important to
mention this method, as it is one of the most popular methods for analyzing large
companies. Its use is more appropriate for determining shareholder value than for valuing
acquisitions.
Valuation Technique 4: Service Companies
The most important asset of a service company is its employees, from senior management
to the most recent hiree. An equally important asset is its customers. The third major
asset is the business system utilized by the company. This section focuses on middlemarket service companies with sales of from $2 to $150 million.
Such service companies are very difficult to value, since they are highly dependent on the
personal relationships of the management and its customers. In talking to the owner of a
very profitable public relations firm who wanted to sell her company, I was stunned to
hear that she not only got up for work every morning at 4:30 a.m. but was responsible for
securing every new account in the agency. Even though she would stay on for a period
after the business was sold, this superwoman was almost irreplaceable!
The company had $3 million of annual billings and reconstructed net before tax of about
$300,000. Is this business worth $1.5 million? Possibly, but more important is the payout
period and the extent to which the owner will remain in the business to retain the key
accounts and teach the new CEO how to run the business. The most critical issue is the
retention of the existing accounts, and for this reason the purchase agreement might be
constructed as follows:
Payment at closing
Payment in 1 year
$ 500,000
333,000
Payment in 2 years
333,000
Payment in 3 years
333,000
Total $1,500,000
Conditions:
1. Owner works for two years at base salary or for one year plus two years as a
consultant.
2. Any loss of an account existing at the time of closing will reduce payout by
50 percent of one year’s billing of that account.
3. A loss in the third year will reduce the payout by 25 percent of one year’s
billing.
Service businesses are varied, and for this reason it is very difficult to generalize
valuation techniques that will cover all situations. Glenn Desmond, in his book Handbook
of Small Business Valuations, (contact Business Brokerage Press, P.O. Box 247,
Concord, Mass. 01742) lists some of the advantages of using rules of thumb or formulas
for small service businesses:
1. They are market derived and provide market comparisons.
2. They provide a uniform guide and a range of values.
3. They are easy to use and can be used for preliminary value estimates.
The disadvantage of using rules of thumb is that they are general in nature and there is no
single, all-purpose formula.
Valuation Technique 5: Using Business Appraisers
Numerous buyers spend a large portion of their personal net worth to buy a company
without receiving expert opinion from professionals in the M & A field. Needless to say,
some of these businesses failed largely because the buyer overpaid when going into the
deal. One does not have to hire an appraiser to put together a $5,000 to $10,000
“bulletproof” document that is defensible in court. You can hire an appraiser for $150 to
$200 per hour to give you a verbal opinion. You might also want to consult on an hourly
basis with specialist appraisers who concentrate in providing values of machinery and
equipment, inventories, or real estate and buildings.
Advice:
1. Do not stray from the business field in which you have experience
2. Do not acquire a company if you will be undercapitalized at the beginning
of your ownership
3. Be sure you have highly competent people in the business.
4. Hire a business appraiser to assist you in determining how much you should
pay for the business.
Other Valuation Techniques
Edmund Sears, a corporate valuation expert from the Benchmark Consulting Group in
Boston, lists the major approaches to valuation as follows:
1. Cost-based approaches
A. Book value
B. Adjusted book value
C. Liquidation value
2. Market approaches using comparables
A. Price to earnings
B. Price to pretax earnings
C. Price to cash flow
D. Price to book value
3. Income approaches:
A. Capitalization of earnings
B. Excess earnings methods
C. Discounted future earnings
D. Discounted future cash flow
Sears states that appraisals must be done with full knowledge of the facts, circumstances,
and all relevant factors pertaining to the subject company. A particular valuation
technique that is appropriate for one company at one point in time may not be appropriate
for that company at another point of time or for another company at any time.