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 ‘!

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 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.