Business Valuation

Business Valuation

 

Aside from the sale of your business there may be a few other times in your business life that you need to put a fair market value to your business.  Here are a few of the reasons why you may need a Business Valuation:

1. When looking to sell your business
2. When looking to merge or acquire another company
3. When looking for business financing or investors
4. When establishing partner ownership percentages
5. When adding shareholders
6. For divorce proceedings
7. For dissolution of a Business Partnership
8. For certain tax purposes
9. For bragging rights… (Just kidding)

There are a large handful of ways to perform a Business Valuation, although several are more about determining the value of a publicly traded stock share.  So today we will focus on a few methods used for most small and medium size businesses for one or more of the purposes previously stated.

In all methods there is a certain amount of subjectivity.  The methods themselves are fairly straight forward but the subjectivity comes into play when determining “future potential”.  And this becomes the battlefield of the buyer and seller, as value is ultimately determined by the beholder.

 

Market Value Valuation Method

The Market Value method compares your business to similar businesses in your area that have sold.  Almost exactly how residential real estate is valued, but with a much smaller sample size.

I cannot recommend this method because even though the size, and gross revenue may roughly match, profitability rarely does.  Some business owners can squeeze more juice out their fruit than others, locations are not equal, and for a variety of other reasons it is difficult to get an apple-to-apple comparison with any other business.

I was recently involved with valuing a franchise operation where all the stores in the franchise were the same footprint.  Even in this case, their profitability on roughly the same volume of business ranged from 10% of revenue to 38% of revenue.  If the price for each were the same based on “Market Value”, which store would you prefer to buy?

This being said, because this small business valuation method is relatively imprecise, your business’s worth will ultimately be based on negotiation, especially if you’re selling your business or seeking an investor.

Nevertheless, this valuation method is a good preliminary approach to gain an understanding of what your business might be worth, but you’ll likely want to bring another, more calculated approach to the negotiation table.

 

Asset-Based Valuation Method

Asset-Based method is fairly straight forward.  As the name suggests, you look at your balance sheet and subtract Liabilities from Assets and the remainder is the value of the business.

This method fails to take future potential into the equation, and is therefore a method to use when the business makes little or no profit each year or for the purpose of liquidation.

It can be a good valuation to do along side the method we are about to discuss, as sometimes a business is asset rich even at a depreciated value and if the value is close to the number of the next method it is easier to justify to the buyer because it is less subjective.  Other times, this number might be considered the floor value of the business, or the least value the business should be worth.

 

Capitalization of Earnings Valuation Method

Capitalization of Earnings method, often called Cap Value, uses a method of future potential as its main driver.

In order to determine the Cap Value, one must first calculate the EBITDA, which is the annual earnings BEFORE Interest, Taxes, Depreciation, and Amortization.

EBITDA is the net profit a new owner could expect to earn if they simply maintain what you are doing presently.  It strips away the “funny money” from the equation like depreciation and amortization which are not hard expenses, and because the buyer’s tax rate and interest rates may be different than yours it removes them as well.

Once the EBITDA is determined we apply a Cap Rate multiplier.  The multiplier is stated as a percentage, for example a 25% Cap Rate is a 4X multiplier because 25 goes into 100, 4 times.  Therefore, the higher the percentage the lower the multiplier, i.e., a 50% Cap Rate would be a 2X multiplier.

Don’t worry to much about fractional math here, as most negotiations we talk about the multiplier not the Cap Rate.

There are two main subjective areas when doing this calculation or more precisely during the negotiation between the seller and buyer.

1. What the multiplier should be
2. The time period used in determining the EBITDA

Let’s address these by looking at both the Buyer’s and Seller’s perspective.

 

Buyer’s Point of View

When it comes to what multiplier should be used, let’s look at this from the buyer’s point of view.  If they have the money to invest in your business, could they get a better rate of return in a safe, relatively risk-free investment.  This is what Your Business is being compared against.

If they could double their investment in another place in 5 years, then why would they take the risk, responsibility, and work to give you 5 times EBITDA which equates to the same earnings?

They will be measuring risk and profit based on what You did with the business not on what improvements they think they can bring to the table.

If you have a business that has a lot of real estate, like a hotel/motel or a farm, this automatically reduces much of the risk or value or equity and those businesses then usually deserve higher multipliers as people are usually more patient about the return on their investment.  Conversely if you rent a location and have limited assets, then there is no fallback equity and those businesses have much smaller multipliers.

Each industry has a range of multipliers that work financially for those types of business, so I won’t get into typical multipliers in this article, suffice to say those multipliers must work for the buyer.

There can be mitigating factors however that might make a buyer willing to pay more than calculated value such as changing landscape of the area, elimination of competition, changing demand, a strategic reason, or even changing technology.

 

Seller’s Point of View

The Seller has put in a lot of work on building the business and perhaps experienced a recent downswing or upswing in both revenue and profit.

He or she might want to get paid for recent growth by prorating the last 3 months to 12 months rather than the last 12 moths of financial history.  Or if experiencing a downswing they might prefer to average the last 3 years of history to determine EBITDA.

If you want to play this game you best be prepared to convince the Buyer as to why you think this is the fair way to value the business.

At the end of the day, this business is NOT worth what you say or calculate, it is worth what someone is willing to pay for it.  If that is not enough, a Business Owner must be prepared to continue on and make their money over time rather than through the sale of their business.

Skip Williams

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