Posts tagged with: business valuation
Business valuation goes beyond simple mathematics.
To get some idea of what your business might be worth, consider these three business valuation methods.
Your business is likely your largest asset so it’s normal to want to know what it is worth. The problem is: business valuation is a “subjective science.”
The Science Part
The science part is what people go to school to learn: you can get an MBA or a degree in finance, or you can learn the theory behind business valuation and earn professional credentials as a business valuation professional.
The Subjective Part
The subjective part is that every buyer’s circumstances are different, and therefore two buyers could see the same set of company financials and other value drivers and offer vastly different amounts to buy the same business.
Below we’ll look at the basic science and math behind the most common business valuation techniques. Keep in mind that there will always be exceptions, outliers that fall well outside of these frameworks. These are strategic sales, where a business is valued based on what it is worth in the acquirer’s hands. These strategic acquisitions, however, represent the minority of acquisitions, so use the three methods below to triangulate around a realistic value for your company:
Assets-based Valuation Method
The most basic way to value a business is to consider the value of its hard assets minus its debts. Imagine a landscaping company with trucks and gardening equipment. These hard assets have value, which can be calculated by estimating the resale value of your equipment.
This valuation method often renders the lowest value for your company because it assumes your company does not have any “Good Will.” In accountant speak, “Good Will” has nothing to do with how much people like your company; Good Will is defined as the difference between your company’s market value (what someone is willing to pay for it) and the value of your net assets (assets minus liabilities).
Typically, companies have at least some Good Will, so in most cases you get a higher valuation by using one of the other two methods.
Discounted Cash Flow Valuation Method
In this method, the acquirer is estimating what your future stream of cash flow is worth to them today. They start by trying to figure out how much profit you expect to make in the next few years. The more stable and predictable your cash flows, the more years of future cash they will consider.
Once the buyer has an estimate of how much profit you’re likely to make in the foreseeable future, and what your business will be worth when they want to sell it in the future, the buyer will apply a “discount rate” that takes into consideration the time value of money. The discount rate is determined by the acquirer’s cost of capital and how risky they perceive your business to be.
Rather than getting hung up on the math behind the discounted cash flow valuation technique, it’s better to understand the drivers of your value when you use this method. These value drivers are: 1) how much profit your business is expected to make in the future; and 2) how reliable those estimates are.
Note that business valuation techniques are either/or and not a combination. For example, if you are using Discounted Cash Flow, the hard assets of the company are assumed to be integral to the generation of the profit the acquirer is buying and therefore not included in the calculation of your company’s value.
A money-losing bed and breakfast sitting on a $2 million piece of land is going to be better off using the Asset-based valuation method; whereas a professional services firm that expects to earn $500,000 in profit next year, but has little in the way of hard assets, will garner a higher valuation using the Discounted Cash Flow method or the Comparables technique described below.
Comparables Valuation Method
Another common valuation technique is to look at the value of comparable companies that have sold recently or for whom their value is public. For example:
- Accounting firms typically trade at one times gross recurring fees.
- Home and office security companies trade at about two times monitoring revenue,
Most security company owners know the Comparables technique because they are often getting approached by private equity firms rolling up small security firms to sell theirs. Typically you can find out what companies in your industry are selling for by asking around at your annual industry conference.
The problem with using the Comparables methodology is that it often leads owners to make an apples-to-bananas comparison. For example, a small medical device manufacturer might think that, because GE is trading for 20 times last year’s earnings on the New York Stock Exchange, they too are worth 20 times last year’s profit. However, in one study of more than 13,000 businesses, it’s clear that a small medical device manufacturer is likely to trade closer to five times pre-tax profit, not 20 times.
Small companies are deeply discounted when compared to their Fortune 500 counterparts, so comparing your company with a Fortune 500 giant will typically lead to disappointment.
Finally, the worst part about selling your business is that you don’t get to decide which methodology the acquirer chooses. An acquirer will do the math on what your business is worth to them behind closed doors. They may decide your business is strategic, in which case back up the Brinks truck because you’re about to get handsomely rewarded for your company. But in most cases, an acquirer will use one of these three techniques to come up with an offer to buy your business.
Curious to see what your business might be worth? Get a free valuation here.
Valuation is important at every stage of your business lifecycle. Owners assume it’s implicit in their revenue goals, growth goals, hiring and expanding. Instead, a formal tangible valuation is essential all along the way to keep your company on course. These five reasons are tied to the lifecycle of every business.
Ideally, if you follow Stephen Covey’s advice to ‘begin with the end in mind,’ you will perform your first valuation before you open your doors. This will give you a baseline for everything else you do. It also starts the habit of focusing on value, not just revenues.
As you grow your business, periodic valuations are a measure of how the market would value every area of your business. A valuation report will help direct you to focus on certain value drivers to achieve your objectives.
Consistent periodic valuations will help you measure your position in the market, your competition, as well as timing the best opportunity for your sale or exit. Basing your exit timing on objective third party reporting will guide you to make strategic decisions that give you more leverage in negotiations before you get to a transaction.
If your business is in decline for any reason and you have been conducting periodic valuations along the way, you will see the symptoms of that decline earlier, be in a position to respond and correct the situation to mitigate risk and damage.
The valuation process owners are familiar with is the one initiated by the intended buyer or acquirer. This valuation on its own, late in the game, is a wildcard – you don’t know what their business appraiser will discover, focus on or be concerned by. Any questions or concerns they find will (intentionally) discount the offer price or possibly derail the whole thing. But if you have a history of three or more periodic valuations:
- You won’t be surprised by anything they find, anything they ask for
- You will be better prepared for the process
- You will have uncovered and resolved every concern they could raise, beforehand.
- You will have your documents complete, up to date, accessible, in a format they seek
- You will fare much better through the process because you are prepared to be so forthcoming
- You will be in a position to support and defend the value you expect to command in the marketplace.
There are many different ways a business appraiser can value your business. In addition, a wide range of objectives also affect how the calculations are done. Be sure your periodic valuations are consistent in formula and objectives.
I don’t perform valuations, but I do help you build, track and measure the value drivers that will enhance your market valuation. Call 508.820.3322 or email us to discuss your unique situation.
When you started your business, you were more likely paying attention to the value of your product and services to command a good price. At the same time, you probably were not focusing on what would add value to the business itself.
When it comes time to monetize your business, like when you want to sell off equity or find a buyer; that’s when value becomes a serious criteria in your decision process. That’s because value plays a big part in the price anyone will pay for an ownership position in your company. But as Chris Mellon of Delphi Valuations cautioned when I interviewed him on Exit This Way: “Business value does not equal price”.
Value is commonly discussed as if you’ll execute a cash transaction. But other options such as stock transfers, notes, or earn outs with contingencies, are often involved.
A business appraiser does not know the terms of the deal that will determine the price a buyer will pay for your business. Your valuation expert will look at the overall market assuming a cash transaction to come to a value or rather a range of values. It’s called a continuum of value. For example, a business may be worth somewhere between $7M and $13M and that range will vary for different purposes. Fair Market Value (Fair Value) is somewhere in between.
Why have your business valued?
Maybe you will get a business appraisal for compliance such as in financial reporting or litigation even in shareholder disputes or a divorce; or strategic planning, such as exit planning; or for an acquisition or sale.
Business and personal situations vary. You want to consider the value of your business in your overall decision making process, as a business owner but also in terms of its value in your portfolio.
Then there are also the tax implications for various decisions that can prompt getting a valuation of your business. Three common tax reasons that can drive a valuation are to: assess gift taxes, determine estate taxes, or when you convert a C corporation to an S corporation.
When should you have your business valued?
If you are starting your business on the fast-track to an exit (a targeted acquisition or an IPO), you will want to have a valuation performed early as a benchmark.
Beyond the startup phase, most businesses will benefit from having a valuation performed regularly, even yearly in the 3-5 years leading up to your exit transaction. The valuation exercise will reveal enhancements, improvements, growth, and metrics which will demonstrate a pattern of building business value. In turn that sequence of valuations will give a seller significant leverage in any negotiations in any 3rd party transaction. Businesses put themselves at a disadvantage if they pinch pennies and expect to only go through valuation once, when they are already talking to their prospective buyer.
Building business value goes hand in glove with exit planning to achieve your objectives in the business and beyond. Valuation is an exercise to measure the return on your efforts.
When you want to get out, do you look at past performance or the future potential of your business? Too often, business owners erroneously assume that a buyer will want to buy the business based on past performance. Buyers go through due diligence specifically because they want to know what the business can deliver moving forward after you get out.
To add perspective, let’s compare both scenarios:
Getting Paid for the PAST
There are three core elements to selling your business:
- When you sell your business
- How you structure the transaction
- The business valuation itself
You deserve to be paid for what you’ve built. You stand on your past performance. But that’s not the same as preparing the business to be buyer ready so they see the full value of the business as it stands now and what the future could hold. Only when you make the business self-sustaining without your personal operational control each day, can your buyer see what the business itself can do. Unfortunately, without that preparation, in many private company transactions, there are stories of 75% of sellers leaving up to 75% of value of the business on the table.
Getting paid for the FUTURE
Informed and interested buyers do exist at all levels. They actively seek out smaller companies for a range of reasons (e.g., to increase their earnings and competitive position within their marketplace), all based on the projected ROI. As the seller, it’s up to you to demonstrate your company can deliver that ROI looking ahead, not backwards.
Unfortunately, it’s far too common for inexperienced sellers to negotiate the sale of their company based on historical performance. While that historical performance is important, it is not the driving factor on which the buyer will base his decision. Rather, buyers are all about the future earnings and potential growth of the company. Their future ROI not your past success is most important to the buyer.
As a basis for business valuation discussions with any buyer, it is essential to use realistic future cash flows and earnings of the business. For buyers, the future potential of an acquisition is far more important than its past performance.
To be a successful seller, you must recognize that buyers will not pay a premium for past financial performance. Instead, they seek to maximize the value they can gain from your business in the future. That’s what you must sell them.
Selling to the Wrong Buyer
Often, private companies will sell to professional or personal acquaintances, including employees, family members or competitors. However, these sellers fail to recognize that buyers often come from unlikely sources, locations or industries.
Acquiring buyers do exist. They actively purchase companies to sustain earnings growth. Sellers who fail to retain an advisor often forego the opportunity to engage a selection of optimal buyers.
There are still other risks in selling your business:
1. Selling at the wrong time
Timing is everything when it comes to selling your business. Selling a business at an inopportune time is one reason too many sellers leave significant money on the table. Key factors when considering timing your exit include the economy, the market, interest rates, as well as the impact of tax and regulatory constraints.
2. Structuring the wrong deal
Inexperienced sellers easily become fixated only on the purchase price while neglecting the importance of overall deal structure and the full range elements and outcomes. Taking the time to creatively structure the deal around all your needs and preferences as the seller will expand options to generate the maximum value you while minimizing tax liabilities.
When you plan ahead and plan early, you can ensure that no money is left on the table when you sell your business.