Business Valuation 101

Obtaining the right valuation can either make or break a business sale. The task is particularly made difficult by sellers who have not only given birth to their company but put their heart and soul into building the business from a startup to a profitable enterprise. Subjective inputs and personal attachments can quickly skew the economic realities of what the business is actually worth in the marketplace.

The bottom line is that the value of your business is the amount someone is willing to pay for it in today’s marketplace. Personal feelings about your company’s value are far less important than sound valuation methodologies as well as other intangible factors that can influence value.

Common Valuation Methodologies
One of the reasons business valuation is such a complicated issue is because there are many acceptable valuation methods. Rather than using a “one-size-fits-all” valuation approach, sellers need to decide which method is right for their business based on industry, size and the circumstances of the sale. Among the more popular valuation methodologies are the following:

  1. Asset Based Valuation
    Asset based valuation is used when a company is asset-intensive. Retail businesses and manufacturing companies typically fall into this category. This process takes into account the following figures, the sum of which determines the market value:

    • Fair market value of fixed assets and equipment – This is the price you would pay on the open market to purchase the assets or equipment.
    • Leasehold improvements – These are the changes to the physical property that would be considered part of the property if you were to sell it or not renew a lease.
    • Owner benefit – This is the seller’s discretionary cash for one year; you can get this from the adjusted income statement.
    • Inventory – Wholesale value of inventory, including raw materials, work-in-progress, and finished goods or products.

     

  2. Multiplier of Earnings Valuation
    This is often the best way to assign value to a healthy business that will be listed on the open marketplace. By basing price or value on some multiple of the business’s earnings potential, prospective buyers gain the ability to translate the purchase into earnings and an informed return on investment (ROI) estimate. This also provides a more tangible and simpler basis by which to compare different businesses in different industries or locations.
    However, even the earnings multiplier valuation method presents challenges. Although earnings data is based on the business’s historical financial performance, the calculation requires earnings to be precisely defined and agreed upon by both parties. Likewise, you will need to select the right multiplier to apply to defined earnings. There can be a large variance in multipliers (e.g. 1, 3, 5, 10 or more) since the valuation reflects business risk and industry standards. With that being said, a simple way to get to a proper multiple is to work with a business broker who can share recently sold business comparables (commonly known as “comps”), so that you can see what multiples businesses in your industry and location have historically or recently sold for. Prior to working with a broker, you can visit business for sale websites like BizBuySell.com or BizQuest.com to see what prices and multiples of cash flow or revenue current businesses are listed for and have sold for.Here are a few industry multiplier examples, as mentioned in “The Complete Guide to Buying a Business” by Richard Snowden (Amazon, 1994):

    • Travel agencies – .05 to .1 X annual gross sales
    • Ad agencies – .75 X annual gross sales
    • Retail businesses – .75 to 1.5 X annual net profit + inventory + equipment

     

    To find the right multiplier for your industry, you can try contacting your trade association. Another option is to utilize the services of a broker or appraiser who specializes in businesses such as yours.

  3. Capitalization of Earnings Valuation
    This method, which is best used for non-asset intensive businesses like service related businesses, places no value on fixed assets such as equipment and takes into account a greater number of intangibles.In Richard Snowden’s aforementioned book, he cites a dozen areas that should be considered when using Capitalization of Earnings Valuation. He recommends giving each factor a rating of 0-5, with 5 being the most positive score. The average of these factors will be the “capitalization rate” which is multiplied by the buyer’s discretionary cash to determine the market value of the business. The factors are:

    • The owner’s reason for selling
    • Length of time the company has been in business
    • Length of time that the current owner has owned the business
    • Degree of risk
    • Profitability
    • Location
    • Growth history of the company
    • Competition
    • Barriers to entry
    • Future potential for the industry
    • Customer base
    • Technology

     

    Add up the total ratings and divide by 12 to come up with an average value to use as the capitalization rate. You next have to come up with a figure for “buyer’s discretionary cash” which is 75% of owner benefit (seller’s discretionary cash for one year as stated on the income statement). You then multiply the two figures to determine the market value.

  4. Owner Benefit Valuation
    This formula focuses on the seller’s discretionary cash flow and is used typically for valuing businesses whose value comes from the ability to generate cash flow and profit. It uses a fairly simple formula — you multiply the owner benefit times 2.2727 to get the market value. The multiplier takes into account standard figures such as a 10% return on investment, a living wage equal to 30% of owner benefit, and debt service of 25%.

How to Improve Your Business Value
Business brokers, accountants and business valuation experts typically find that sellers are surprised to discover that the valuation they had for their business was lower than their anticipated asking price for their business. The good news is that should such be the case, there are steps you can take to increase the value prior to a sale. It is important to start immediately as many of these techniques takes months, if not years, to implement.
From a buyer’s perspective, proven profitability and future earnings potential are the most attractive qualities in a potential business acquisition. By documenting a multi-year solid track record of profits and positive cash flow, you can drive up the value of your company, particularly if you choose to use the earnings multiplier valuation method.

Another strategy for improving business value is basic organization. Carefully maintained financial records, corporate/LLC record books, detailed minutes of meeting held, documented employee policies all count when it comes to the amount buyers are willing to pay for your business. The easier it is for buyers to understand your business and envision themselves at the helm, the more likely it is that your business will sell for its full value.

Seller financing also plays an important role in improving your business valuation. While seller offered financing is not an option for every seller, buyers are willing to pay more for businesses that include some level of seller financing, particularly in tight credit markets. In today’s tight lending environment, we have seen seller financing become an essential tool to completing transactions. Business owners who advertise their willingness to finance part of the deal should expect a significant increase in the number of offers they receive.

Lastly, most sellers ultimately realize that they need to the assistance of a qualified third party business appraiser or broker to accurately value their companies. A good appraiser or broker, with a proven track record of assisting businesses in your industry, can significantly shorten the sale process by ensuring that your business is priced to move in today’s current market.

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