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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.

Is a Dropship Business Worth It?

I’ve heard a lot of horror stories about dropshipping and it made me do more research about it. You see, the most common reason why people fail in this kind of business is that they fail to prepare on one of the important aspects of it. As with any business, preparation is critical and making sure that even those simple steps are taken cared of will mean the success of your business.

I visited a forum the other day and there was one guy who said his dropship business failed and he is not recommending the business model ever. He said it’s a bad business to get in to and you’ll lose money on it, no questions asked.

So I sent him a message asking him about what happened and how a supposedly good business model failed him. It turned out that he was partnered with a lousy dropshipper and he was not prepared enough to answer customer service questions. You see, with a dropship business, you still have to take care of your customers, it’s not a set and forget thing that will make you money even while you sleep.

Dropshipping is a real business with real customer interaction and real hands on experience. Of course, minus the inventory and physical stuff but all the other business aspects are still there.

During our conversation I was leading him to think about what happened and to re-assess everything and think who really is to blame about his failure. In the end, he said, you’re probably right, the business model was not the problem, I’ve always thought a dropship business would make rich, and it was me who screwed up. I’m not sure but after our conversation, I’m thinking he’s out there setting up a dropship business all over again.

So in my opinion, any business, be it a dropship business, an affiliate marketing business, or even a good old brick and mortar business is well worth it if you prepare well and you’re ready to take on the challenge. Go for it full blast, with all your heart and all your might and I’m sure everything will be perfect.

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.