How Much is Your Business Worth?

There are 3 basic approaches to value your business: the Asset Approach, the Income Approach and the Market Approach.

The Asset Approach is based on the principle of substitution. Meaning, it assumes that no prudent buyer / investor would pay more for a particular business than the cost to reproduce it right across the street. The main flaw with the Asset Approach is that it does not do a good job of capturing intangible value (goodwill). How you (and your employees) treat your customers and the reputation you hold in the marketplace is not something easily duplicated (and therefore valued with the Asset Approach). So, beware of the limitations of this approach. Understand that although an Asset Approach provides a relative indication of value for highly asset intensive companies, it may serve merely as a liquidation value for your service oriented company. The Income Approach and Market Approach do a much better job of fairly capturing the value of your company’s goodwill or intangible value.

The Income Approach operates under the assumption that a buyer will pay for the cash flow that your business is set up to produce going forward as of the date of sale. Buyers buy cash flow. How much they are willing to pay for access to your cash flow depends on the risk associated with the buyer actually receiving it once you exit the business. If your company shows a consistent history of steady cash flow and/or growth a buyer is likely to pay more for your cash flow stream (less risk) than for the cash flow stream of a similar company with unstable cash that cannot reasonably be assumed to reoccur in future periods (more risk).

By valuing the cash flow of your company you are inherently valuing EVERYTHING that your company does. If your company did something different (made different decisions or operated under a different philosophy) your cash flow would look different and the value of your business would be different. Your cash flow reflects all the decisions you make within your company. So, I challenge you with this question, if the decisions you are making don’t increase your cash flow (and buyers will pay you only for your cash flow) why are you engaging in those activities that don’t result in increased cash flow? They are not adding value to your company.

The third approach to value is the Market Approach. If you own a home or have rented an apartment, you’ve done a form of the Market Approach. When you compare and contrast similar properties and then use the comparative data to value your property, you are doing a Market Approach. In residential real estate you may compare things like price/sq.ft. or price/bedroom and price/bathroom. Once you obtain these ratios from similar properties you multiply the ratio by the square footage, the number of bathrooms, or the number of bedrooms in your home to get to a value for your property.

You can do the same thing with businesses. However, as you may have guessed, the value of your business is not driven by its square footage and its bathrooms. It is driven by other metrics such as revenue, assets, growth, leverage, turnover, liquidity, etc. Publicly traded companies and transactions involving other private industry participants provide an understanding of how price relates to the various financial metrics of these companies. Then, just like we did in valuing your property, we apply these market ratios to the metrics of your business to determine its market value.

Valuation is a complex matter with many intricacies that are not discussed here. The purpose of this article is to familiarize you with the basic valuation approaches employed. I don’t recommend that you attempt to value your business without the help of a qualified expert. But, I do encourage you to gain an understanding of these approaches so you can better focus on building value within your business before it is time to sell.

How Much is My Business Worth If I Sold It?

Does a business owner know what his business is worth – we suspect he thinks what the firm is worth, but in fact does not know if that is what the market would call a ‘ fair ‘ price.

When a company is private and the business owner is contemplating selling there are essentially two methods that one focuses on:

1. The value of the hard assets

2. The value of the business as an ongoing concern

When we look at category #1 above the focus gets more specific. The owner should ask himself if the business were liquidated what would be the price of those assets. Asset valuators actually break that category down into two other areas – fair market value, forced value. By forced value we mean a third party usually coming in and selling assets immediately at best bid. As one can imagine that is never the optimal selling strategy!

When someone is considering buying a business they consider the ‘book value ‘of the assets – which is simply the value on the accounting books relative to any debt on those assets. That clearly is also not an optimal number for the owner, and even the buyer sometimes, as it focuses on accounting and deprecation issues, not the true value of the asset in today’s market.

Focusing on our item # 2- Going Concern – when a third party looks to purchase a business he views the asset in the context of using those assets to generate future profits.

This brings us into the main category in the Going concern valuation method, which is the earning capitalization. Buyers, ( and sellers obviously ) focus on looking at the earnings over the last number of years, placing a realistic value on those earnings, and then determining how many more times over that level of earnings the purchaser will pay.

Lets use a simple clean example – A company has earned 200,000$ net over the last 5 years. But 100,000 of that is owner’s salary. That 100,000 are deducted from earnings in the value calculation. So we are left with $ 100,000.00.

If a potential investor wants to earn an over all return of 10% on his money then he should be willing to pay 1 Million dollars for the business – the purchaser has ‘capitalized’ the investment at ten times the return.

Business owners should also know that each industry has its own capitalization rates, and the owner would do very well to investigate what capitalization rates firms in his industry are selling at. Naturally many of those numbers are smaller private deals that aren’t published, so the owner can do two things:

Research comparable public firms in his market space

Or

Used the services of a trusted third party advisor who knows his firms industry.

The general guidelines for determining the capitalization rate are:

– growth potential of the business

– the current economic environment

– the firms position in the marketplace

– overall financial structure and stability

– management

In summary, business owners should probably be investigating valuations of their business far before they actually entertain an offer. This will allow them to focus and negotiate with strength based on solid data typically used by third party purchasers – The Boy Scout motto works once again – ‘Be prepared ‘!

How Much Is My Business Worth?

Did you ever notice that the attitude of a seller of real estate is often substantially different than the attitude of a buyer? Sellers have been known to irrationally claim their property has more value than it does, despite evidence to the contrary.

The buyer often sneers at the seller’s price, and claims the property is hardly worth buying, that the seller is crazy, and that as long as the seller thinks he has such a treasure trove, he can keep it.

Now here’s where it really gets fascinating. All buyers eventually become sellers. Some well meaning folks will display both attitudes, first the buyer’s attitude when they purchase (This property is hardly worth buying.), and then years later when they are ready to sell, they display the seller’s attitude (This property is a hidden treasure worth far more than I paid for it, and any buyer would be lucky to have it.). I love to watch and learn about human behavior, and this behavior fascinates me.

Let me bring this home to roost where the most eggs are laid. Small business owners. Many small business owners drive a hard bargain when they purchase their business. During the years they run the business, many don’t show all the income on their tax return. For example, it is commonly known that coin operated businesses are ripe with opportunities to skim coins off the top without reporting that as income. Another approach, within legal limits, is to deduct the heck out of everything and show virtually zero net income. And the Trap . . .

Is that when it comes time to sell, they want more than they can justify, because they can’t prove to the buyer it really makes all that income.

Key Point. When you purchase a business, always operate the business as though you intend to sell it to get the highest possible FMV. If you can’t prove income, you won’t get your price.