You have several ways to value your business. There’s the old “talking it over with a friend” method. Most buyers, however, are not going to put much credibility in your friend’s numbers.
Another likely source for a business owner to derive the value of his or her business is a personal accountant. Tax returns, financial statements, depreciation schedules and other pertinent financial data will provide important information. You may want to retain your CPA to prepare a formal business evaluation.
When an M&A advisor is involved, buyers know the seller is serious about selling the business
There are also numerous proverbial “rules of thumb.” You’ve probably heard of many of them. However, they rarely answer the kinds of questions a buyer will ask, such as: “How many years will it take me to achieve my investment goals? And how many years will it take me to get a return of and on my investment?”
Let’s debunk the myth now: There is no secret formula that determines the value of your company. There are so many variables that a magic formula would be impossible to create.
In short, there are as many ways to value businesses as there are people to value them. An M&A advisor will value a business with an in-depth analysis of the practical part of the business that buyers want: They want to buy your assets and revenues.
Business valuation is based on the history of the business. Everything you do in preparation for selling your business directly impacts the value of it, such as those explained in the previous chapter.
You get one good opportunity to market your business and achieve the highest price for it; rarely does a second chance present itself
Establishing a reasonable value for your business is critical. An unreasonably high valuation will raise serious questions in the minds of the buyers about the credibility of the sale and ultimately chase them away. You get one good opportunity to market your business and achieve the highest price for it; rarely does a second chance present itself. Professional buyers know the industry and common valuations; they know what’s reasonable and what’s not.
Conversely, offering a business at a low valuation prohibits raising the price at a later date. The result is receiving less money than what the business is actually worth.
The best course of action determines a reasonable price justified by assets being sold and the profitability of the business. And then, build in a premium to allow for the negotiating process. This strategy will help you reach the best possible purchase price.
So, what is your business worth? And how do you go about determining the business valuation?
Looking at your business valuation critically may be difficult. Emotionally, most business owners believe their businesses are worth more than they are. This is one example of how selling a business is an emotional experience. You must come to terms with the fair market value of your business.
Your M&A advisor can facilitate the valuation process. Many variables, both quantifiable and intangible, are considered. Of all the possible variables, your business valuation should consider the following:
- Multiple of earnings value, including an indication of the owner’s discretionary cash flow
- Asset valuation, including real estate, tangible and intangible assets
- A comparison of value to other businesses in the industry
A buyer will want to know how much money a business makes after the expenses of operating the business. In order to communicate this on a universally accepted basis, most accountants refer to the EBITDA number as a good measure of the profitability of the business. EBITDA means earnings before interest, taxes, depreciation and amortization.
This number can be calculated from your income and expense statement by adding up:
- Net income after taxes
- + Interest expense
- + Income taxes
- + Depreciation
- + Amortization
Your M&A advisor will start with the EBITDA calculation and add to it any expenses of a discretionary nature to come up with what is commonly referred to as the owner’s discretionary cash flow. This represents the cash the business produces that is available to an owner (seller or buyer) to use at their discretion, including the payment of: debt service, owner’s salary, company vehicle, insurance, or any other expenses at the owner’s choice.
M&A advisors may use owner’s discretionary cash flow to help substantiate the best possible value of the business. This is the number that may then be used to calculate the approximate value of your business after factoring in suitable multiples for your industry.
Another approach commonly used to value your business is the asset valuation method. In order to use this method you would review your balance sheet and place a fair market value on all of the assets used in the operation of your company. You would assign these values to your furniture, fixtures, equipment, inventory, investments, real estate, intangible assets and any other assets owned by the business. Intangible assets would include any trademarks, patents and the value of goodwill.
Whether you own or lease, you must deal with real estate. You will need to establish the value of owned land and buildings. In the end, you may or may not include real estate in the sale, but for purposes of valuation, you need to provide the buyer with a complete physical and financial understanding of your business. That includes real estate.
Typically, whether or not real estate is included in the sale depends on the tax implications and financial planning strategies. It may be to your advantage to sell the real estate outright along with your business, or you may be better off leasing it now and selling later. An analysis of the tax implications with your advisors will help establish your goals.
Remember, the buyer’s interest may conflict with your interest regarding the sale or retention of real estate. Remaining open to other possibilities will help facilitate the closing of a deal that is good for you and the buyer.
Furniture, Fixtures, Equipment and Inventory
Equipment is most valuable as it relates to the income stream it produces for a growing business. In other words, while these assets are important, their importance is relative to the income they help to generate. As such, their value to your business is not necessarily based on their cost (as accounted for in depreciation schedules). Rather, their value is confirmed by their function in a profitable business operation.
Because accounting for such assets depends on the structure of the deal and the allocation of the purchase price, which are decisions generated by you and your CPA, we will return to assets in Chapter Eight: Your Accountant.
That said, your business owns things such as computers, desks, chairs and other equipment. Your business valuation must include such items. A complete listing of them and their approximate value will be important to the buyer.
Only assets that allow you to produce income are important to the buyer
Goodwill or Intangible Asset Values
The final part of the valuation is the goodwill or intangible asset value. This value can best be explained by asking the following questions:
- How much is the relationship you personally have with your largest customer worth?
- How much is your brand worth?
- How much are your intangible assets, such as patents and copyrights, worth?
- How valuable is your growth potential?
These are difficult questions to answer. Take a famous brand such as Coca Cola as an example. How much is the Coke brand worth? How do you quantify it?
Goodwill is the non-asset, profit-making infrastructure that you, as owner, created. It includes: reputation, relationships, service, customer lists and telephone numbers, among others. It’s the premium that’s paid for the business. For example:
If you have $7 million in assets, and sell the business for $8 million, the difference is the goodwill value.
There is no objective measure by which to value intangible assets. It is the job of the M&A advisor to facilitate your assessment of goodwill values in such a way that it won’t chase away would-be buyers.
Nobody knows your business as intimately as you do. So, ask yourself this question: “How much would I pay for my business?” The difference in the price and the asset value is a good starting point in assessing goodwill value.
If this is only a starting point in assessing goodwill value, then what are some of the other aspects of the assessment?
One aspect of the assessment is the buyer’s investment timeline. The buyer will assess a goodwill value relative to the number of years it takes to get the investment returned and make money on it. If the buyer’s investment timeline is 5 to 7 years, and the seller’s goodwill value places the total cost of the business within the timeline, then the buyer may accept the value. The timeline will differ with each buyer.
Another aspect is terms. If as a part of the purchase price you are willing to participate in the profits going forward (via an earn-out), then that may allow a buyer to pay more and allocate the premium to goodwill.
If available, the price for which a comparable business in your industry sold will help establish the value of your business. Remember, every business is unique and your business will not sell for the exact price as one similar to it. However, it may give you an idea of your industry’s typical multiplier for use in the multiple of earnings method of valuation explained earlier in this chapter.
Any doubts in the buyer’s mind lowers the price he or she is willing to pay
To calculate a business’ value, we use a combination of three methods: multiple of earnings, asset value, and comparable value. The calculations will produce approximate valuations. An average of these three methods may produce the best indication of value for your business.
To put that range in context, we can evaluate it by answering three questions. Given the valuation, if the business continues to operate the way it is currently:
- How many years will it take the buyer to get a return of the investment (down payment)?
- How many years will it take the buyer to get a return on the investment (ROI)?
- How many years will it take the buyer to repay the balance of the acquisition debt?
If the answers come out to be between five and seven years (the typical buyer’s expectation for a return on investment), then the valuation range may be one to take to the market. If done right, you will have multiple buyers with competing prices within the range.
Remember from the beginning of this chapter, the goal is to calculate a fair market value. Valuations that are too high will not attract serious buyers; valuations that are too low will not provide you with enough money for your business. Bringing an appropriate valuation to the market is the most accurate and effective way to fairly present your business.
Contact Faelon Partners to learn more about Business Valuations.