What is My Business Worth?

Syracuse, NY – March 17, 2006 – Small-business owners want and need to know what their business is worth.

The short answer is it depends. It depends on the purpose of the valuation, the standard of value, majority or minority interest, going concern or liquidation. There are many factors that affect value, and experts differ in their analysis. In addition, the IRS will often be looking at the valuation results, and these results can generate significantly different values for the same entity. The outcome often leads to business owners scratching their head in confusion.

The more common purposes for valuation are estate and gift taxes; buy-sell agreements; divorce; buying or selling a business; dissenting stockholder actions; and Employee Stock Ownership Plans (ESOPs), according to “Valuing a Business” by Shannon Pratt, etal.. The standard of value used depends on the purpose of the valuation.

Standards of Value

Fair market value (FMV), the most commonly known standard of value, is the amount at which a property would change hands between a willing buyer and seller, where neither party has a compulsion to buy or sell, and both possess knowledge of the relevant facts. FMV will typically include discounts for minority interests and lack of marketability. It is the standard of value for estate and gift tax valuations and ESOPs, among others. ESOP valuations also have to comply with Department of Labor ERISA regulations.

In cases of divorce or dissenting stockholder actions, Fair Value typically applies. Fair Value differs from FMV in that it is defined by state laws and its definition varies from state to state.

Investment value or strategic value is the value determined in the eye of the beholder. In this instance, the buyer or seller has an individual preference or strategic reason for the transaction. Investment Value is most relevant for purchase and sale transactions, and is typically higher than FMV.

In buy-sell agreements, the parties usually negotiate the standard of value and can use any of the value standards stated above. However, the buy-sell price can be challenged in situations of divorce, dissenting stockholder or estate and gift transactions, etc., if it does not conform to the standard of value applicable to the circumstances.

Practical Application

Let’s consider the situation of setting a price to sell the business. The standard of value in this instance is typically investment value because the prospective buyer will have a specific purchase motivation, e.g. a job, elimination of a competitor or perhaps expansion in an industry. Sellers generally sell on past performance; buyers buy on the future performance.

What approach or method can be used to calculate value?

There are three – asset-based approach, income approach and market approach. The asset-based approach uses the fair market value of the NET assets of the business, and is relevant for companies that have significant capital investments and modest profit performance. The downside is that it can understate goodwill the owner has generated in his or her company.

The income approach derives company value using a multiple of company earnings/cash flows. It is relevant for service companies, among others, and reflects the company’s unique performance results.

The market approach is similar to determining the value of your house to sell or challenging a property assessment. The business is compared to other comparable privately-held businesses and/or public companies, and the value is extrapolated from those comparisons. The difficulty using this approach is finding truly comparable data for private companies (e.g. my insurance agency is worth the same as an agency in Peoria, which sold in 1999?) or using public company stock prices as a proxy for small business (e.g. if Google is worth 80 times earnings, so am I).
Finally, there are “rules of thumb” for many industries that may ignore the unique value items about your specific company, but can be a handy sanity check.

For this example, the income approach is useful because it takes into account the unique performance characteristics and operating results of the company, plus the actual reported data is available from financials and tax returns. The valuator typically analyzes the previous five years of profit/cash flows performance and adjusts for unusual, excessive or non-recurring revenues and expenses to determine the prospective future earnings/cash flows.

The future earnings/cash flows is then converted into an estimate of present value using a capitalization rate or multiple. Investment in small privately-held companies is risky and requires a greater return, which reduces the multiple (the higher the multiple, the higher the value). Using a broad generalization regarding multiples, we’ll say the small business owner can estimate his or her value using a multiple of between 3 to 8 times the earnings/cash flows, depending on the company’s management, performance and industry. The higher multiple is more appropriate for extremely well-run companies in growth industries.

In cases where an owner intends to gift, rather than sell the business, he or she can take the value above (investment value) and apply discounts for lack of marketability, minority interest, key man, etc., which results in the fair market value. If this was a case of divorce, statutory adjustments would be made to determine a fair value standard.

The previous information is a very simplified and generalized example of what would be done in a valuation. Calculating value is not a static, uniform process. It requires small business owners to remain active and informed when deciding with their financial advisor/valuator what approach or method best suits them, considering they know their business operations better than anyone. The best way to determine value weighs on the owners ability to understand and take part in the process. The results depend on it.

How Much is Small Software Business Worth?

One colleague of mine asked me a question – “I have a selling software product. How much is this software business worth?” I think I can give an advice.

A small software business can be owned and operated by one person: a developer, salesman, manager, and holder – all in one. This business could be run at home or in a small office. It does not require massive investments to grow up – only a computer, Internet connection, web site, and lots of hard work. Well, you have run it, you are working hard, designing your product, promoting your site, attracting customers – and one day you feel you are rich and tired. You wish to load off your mind and sell your business with potential to grow.

How much does it cost?

Let’s say, for simplicity – you have designed the software title; possess a well-known web site; have a stable income and no registered legal entity, patens, or licenses. You are not selling your permanent assets – computers, developments tools, telecommunications, and the like. You have no other staff but yourself.

Here is a simple estimation formula:

Business costs = (Month net income * Forecasting period) – Holder changing expenses

Month net income = Income – Tax rate – Overhead expenses – Development costs

For example:

You are selling the software for $4000 per month.
You are paying the 20% taxes.

Expenses are $250 per month for hosting, advertising, etc.

You are planning – your software will be selling for the next 3 months without additional design and development. So the development costs = $0, Forecasting period = 3 months.

If you do not have a registered trademark, patens, LLC – your Holder changing expenses and registration fees = $0. So, the buyer spends nothing for registration.

Let us strike a balance:

Month net income = ($4000 income – 20% tax rate – $250 month expenses – $0) = $2950 per month

Business cost = ($2950 * 3 planning months) – $0 = $8850.00

Now, you have the justification for your price.

However, you need a strong argument – why do you want to sell your small gold-mine?

Good luck!

Funding For Your Business – Worth More Than Money!

Cultivate relationships with established early stage financing sources, through Angel Investors, Capital Finders, or Venture Capitalist. Even if you never raise a dime from any of these sources, as an emerging entrepreneur they are worth to you their weight in gold. In fact, they have something more valuable to you than mere capital. It’s their deal inventory. So what’s valuable about deal inventory?

What’s it worth to you to have first knowledge of the newest and soon to be hottest applications in your field? Could that knowledge give you a huge jump on your competition? Could some new technology enable you to do something no other competitor can now do? Could access to this technology enable you to introduce a new product or service within a time window before anyone else can do it?

I take time every few months to talk with those individuals that I have come to know over the years who have been prolific at either financing or finding financing for companies pioneering new technologies. For the price of a phone call and 30 minutes or so of mutual updating on our current projects, I am consistently introduced to young companies that have developed a technology that can enable me to eclipse my competition.

This past week, I was introduced to a new company with a revolutionary way to digitally color and pattern fabric. They have one name brand account for whom they produce in volume and are hungry for more business. Because of the way they imprint the fabric and fuse dye with material, a clothing designer can economically create clothing designs that would be utterly cost prohibitive under any other existing method.

Imagine the reception by buyers for major department stores when I show them at the next trade show a clothing line priced 40% less than what comparable style and quality would normally cost. What an opportunity to introduce a new line of clothing from a new designer!

And, what if we’re too successful? How do we finance production? We take orders at the trade show for delivery several months later. We’ve lined up the manufacturer ahead of time as well as the lender, a factor and even some small investors. Once we have the orders in hand, everyone is happy and ready to play their part with minimum if any risk.