Business
Valuation
by Michael Hoffman
What is a Business Valuation?
A business valuation determines the estimated market value
of a business entity. A valuation estimates the complex economic benefits that
arise from combining a group of physical assets with a group of intangible
assets of the business as a going concern. The valuation, which is part art and
part science, estimates the price that hypothetical informed buyers and sellers
would negotiate at arms length for an entire business or a partial equity
interest.
Valuation vs. Appraisal: How Do They
Differ?
Valuation and appraisals are similar, but they are not
interchangeable. Most people are familiar with appraisals in their personal
lives. Often times people will have appraisals
performed on a house, a car or a piece of jewelry. The key difference between a
valuation and an appraisal is that a valuation includes both tangible and
intangible assets, while an appraisal just includes tangible or physical
assets.
Business Valuation: Art or Science?
A business valuation combines quantitative financial
techniques with qualitative analysis of the business, the industry and the
economic conditions in general.
Why Do a Valuation?
Lack of an Efficient Market
Despite the commonly held belief that markets are efficient, an efficient
market does not exist for privately held businesses and certain fractional
equity interests. Unlike the NYSE or the NASDAQ there is no place to buy and
sell privately held businesses aside from the business brokerage community,
which is small in scope. As a result, it is very difficult to determine what a
privately held business is worth in the marketplace. This lack of an efficient
market presents a critical need for valuation services.
Exit Strategy
The business owner needs to develop a strategy to enable him or her to obtain
value from the company when he or she decides to sell. If a potential buyer is
able to invest fewer dollars on his or her own and duplicate the seller's
business the potential buyer would obviously be better off starting a new
business than buying an existing one.
Business Valuations are Usually
Performed for Five Primary Reasons
Establishing a Price for a Transaction
Valuations help business owners in the sale of a business by determining a
reasonable asking price. A valuation can also be used in a merger/acquisition
transaction as a due diligence consideration.
Business Planning
Often times a valuation can help business owners negotiate buy/sell agreements.
A sound valuation can become part of the actual buy/sell agreement. A valuation
that is prepared prior to the occurrence of a liquidation event can save both
time and money.
Business owners can also use a business valuation as one of
the cornerstones of a long-term financial plan to enhance the value of their
business. Business owners often use management consulting to improve strategies
and tactics through a particular function (e.g., marketing, operations.)
Business valuation consulting focuses on how strategies and tactics create
value for business owners.
Attract Capital
Valuations are often an important part of obtaining debt or equity financing.
Estate and Gift Planning
If an interest in a closely held company is material to a person's net worth a
valuation of that investment should be an integral part of the person's estate
planning. When a person dies a posthumous valuation of a closely held business
is often done as part of the estate's tax return. These valuations are
important because the IRS audits most estate tax returns even if the value of
the closely held business is of modest value.
Also, if an owner of a closely held business wants to make
a charitable gift of a business interest the IRS requires a valuation.
Governmental Requirements
The IRS requires a valuation for employee stock ownership plans (ESOP's) and in
conjunction with the conversion of a C corporation to an S corporation. Many
states also require valuations in divorce proceedings or minority shareholder
actions.
The Components of a Business Valuation
IRS Revenue Ruling 59-60 states that valuations should
address the following issues:
Historical Performance
The past and future earnings power of a business is often the single most
significant factor in the valuation of a business. The quality and completeness
of the company's accounting and financial records also have a significant
impact on the valuation. An incomplete set of financial records will cause the
valuator to have to make significant "normalized" adjustments to
reflect the true financial position of the company.
Company Management
The quality and depth of management is obviously a critical factor in the value
of a business.
Company Ownership
The size of the ownership interest being valued has a significant impact on the
valuation. A minority interest in a business might have to be adjusted for a
lack of control discount, while a controlling interest may be given a premium
for having control.
Conditions of Operations
The physical aspects of a business are important as well. A company with
current systems and new equipment will have a higher value than a company that
has deferred investment in infrastructure and equipment for several years.
Proprietary Products and Services
Proprietary products, services or processes add significant value to a
business. These legal rights can insulate a company from its competition and
allow it to charge higher prices in the market.
Industry
The macroeconomic condition of the company's industry is also an important
consideration in a business valuation. A company in a high growth industry will
have a higher value than a company in a mature industry.
Competition
As all business owners know, the company's position in the competitive
marketplace has a significant impact on the overall financial performance of
the business. Valuators put a great deal of stock in market share and on the
basis in which the company competes in the markets that it operates in.
Government Regulation
As laws change so do their effects on businesses. Unfortunately many laws and
regulations are designed for Fortune 1,000 companies. As an example, General
Electric may be able to easily comply with certain environmental laws, but
these same laws may be a significant burden to a small business. The valuation
must consider these regulatory roadblocks.
How is a Business Valuation Conducted?
The business valuation process can be broken down into four
components.
There are several issues that must be addressed at the
start of the business valuation process.
Research and Data Gathering
At this point the valuator will request certain information from the client.
This request may include the following.
While this information is being gathered the valuator will
be performing industry and comparable company research.
Analysis and Estimate of Value
During this phase the valuator puts together and analyzes all of the internal
company information in conjunction with the industry and comparable company
research. This analysis will then enable the valuator to synthesize an estimate
of value.
Reporting
In the reporting phase the valuator will issue his or her report. There are
three basic types of reports.
At the end of the valuation process the valuator will ask
the client to sign a client representation letter that states, in effect, that
everything that the client supplied to the valuator is true and accurate to the
best of the client's knowledge and abilities.
Role of the Valuator
Unlike legal counsel who is ethically obligated to be the
client's advocate, the valuator is independent. In the past valuators were
often hired by legal counsel to support a particular preconceived position.
Although this practice still exists it occurs less frequently today. In the
long run, the advocacy bias creates tension between parties trying to reach a
good faith agreement on the value of a business. Even if the valuator has to
provide expert testimony in a court proceeding the
valuator's ultimate responsibility is to document and support his or her
estimate of value. The IRS, AICPA, SEC and the DOL all have various rules
regarding independence and the advocacy position of the valuator.
As a general rule our firm will not accept a valuation
engagement, in which the valuation report will be used by a third party, or for
a client for whom we do audit or tax work.
Role of the Client
The key to a successful valuation is establishing a
relationship of mutual trust among the valuator, the client and the client's
professional advisors. It is in the client's best interest to be open and
forthcoming with the valuator in order to avoid errors and reduce costs.
What a Valuation is not
A valuation is not an audit or review. The valuator is not
providing any form of assurance, as defined by the AICPA, on his or her
estimate of value. The valuation is also not a strategic plan or a long-term
financial forecast.
What Affects the Price of a Valuation
The three biggest factors that affect the price of a
valuation are the type of report to be issued, the availability, completeness
and organization of the company's financial records and the purpose of the
valuation. As an example, a valuation prepared for estate planning purposes
with a limited scope report will cost significantly less than a valuation
prepared for a high net worth divorce case that requires a full scope report
and expert testimony in a court proceeding.
How to Reduce the Price of a Valuation
There are four key steps that a client can take to reduce
the cost of the valuation engagement. The two most important steps for the
client are to be open and honest with the valuator during the engagement and to
keep detailed and organized financial records. Clients should also consider
having valuations done on a periodic basis. This will significantly reduce the
time spent by the valuator in the research and data gathering phase. Finally,
like any other significant purchase, the client should do comparative shopping
and get at least two or three quotes for the assignment.
Business
Valuation
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Business valuation is a
mix of art and science. The bottom line is, of course, that a business is
worth what a buyer will pay for it. However, there are ways of estimating a
fair price. Several of those methods are described in this section. There are
variations of these and there are other methods that apply to specific
situations. It is not uncommon to value a business by a number of different
methods and use an average (or more likely a weighted average that gives more
weight to some methods than to others) of the various methods used. Note that there are a number of reasons for valuing a business, other than
buying or selling it. Businesses are valued for estate and tax purposes,
divorce settlements, and for raising capital. In keeping with the purpose of
this web site, all valuation discussion here will be limited to valuing for
buying and selling. Need help valuing your company? We offer business valuations for a very
reasonable price. Click here
for more information on our valuation services. |
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Table
of Contents: |
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A common method of valuing
a business is called the Capitalization of Earnings (or Capitalized
Earnings) method. Capitalization refers to the return on investment that
is expected by an investor. The logic is readily understandable to any
business person-- it's as simple as evaluating return on investment based on
the risk involved. As simple as it is, it provides a good understanding of
how a buyer may initially approach valuaing your business.
To demonstrate the capitalization method of valuation, let's look at a
mythical and highly oversimplified business. Pretend the business is simply a
post office box to which people send money. The magic post office box has
been collecting money at the rate of about $10,100 per year steadily for ten
years with very little variation. It is likely to continue to collect money
at this rate indefinitely. The only expense for this business is $100 per
year rent charged by the post office. So the business earns $10,000 per year
($10,100-$100). Because the PO box will continue to collect money
indefinitely at the same rate, it retains its full value. The buyer should be
able to sell it at any time and get his initial investment back. A buyer would look at this "minimum risk" business earning
$10,000 and compare it to other ways of investing his or her money to earn
$10,000 per year. Let's assume a near no risk investment like a savings
account or government treasury bills currently pays about 4% a year. At the
4% rate, for someone to earn the same $10,000 per year that the magic Now the real world of business has no magic |
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This method is similar to
the capitalization method described above. The difference is that it splits
off return on assets from other earning (the excess earnings). For
example, let's suppose Mr. Owner runs a business that manufactures novelty
products. His company has Tangible Assets of $900,000. Further let's suppose
that Mr. Owner pays himself a very reasonable market value salary-- the same
amount that he would have to pay a competent manager to do his job. After
paying the salary Mr. Owner's business has earnings of $360,000. The financially rational reason for owning business assets is to produce a
financial return. Let's say that a reasonable return on Mr. Owner's Tangible
Assets is 15% per year. A reasonable number here should be based on industry
averages for return on assets adjusted to current economic conditions. So $135,000 of Mr. Owner's profits are derived from the tangible assets of
the business ($900,000 x 15%= $135,000) The remaining $225,000 ($360,000 -
$135,000 = $225,000) in earnings are the excess earnings. This $225,000 excess earning number is typically multiplied by a factor of
2 to 5 based on such factors as the level of risk involved in the business,
the attractiveness of the business and the industry, competitiveness, and
growth potential. The higher the factor used, the higher the estimate of the
business will be. A typical multiplier number is 3 for a solid, but not
spectacular small business that is judged to be average in terms of the level
of risk involved, the attractiveness of the business, the industry,
competitiveness, and growth potential. The actual factor used is a mix of
opinion, comparison to others in the industry, and industry outlook. Let's suppose that Mr. Owner's business is a bit better than average in
these factors and assign a multiplier of 3.6. Therefore, the value of this
business can be determined as follows:
The capitalization methods work best for medium size businesses that have
substantial assets such as recievables, inventory,
and/or fixed assets. |
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Buyers often look at a
business and evaluate it by determining how much of a loan the cash flow will
support. That is, they will look at the profits and add back to profits any
expense for depreciation and amortization but also subtract from cash flow an
estimated annual amount for equipment replacement. They will also adjust
owner's salary to a fair salary or at least an acceptable salary for the new
owner. The adjusted cash flow number is used as a benchmark to measure the firm's
ability to service debt. If the adjusted cash flow is, for example, $300,000,
and prevailing interest rates for business loans are 8%, and the buyer wants
to amortize the loan over 5 years, the maximum this buyer would be willing to
pay for the firm would be about $1.2mm. This is the amount that $300,000 per
year would support over 5 years. Therefore, when using this method, the value
of a company changes with interest rate conditions. It also changes with the
terms a buyer can obtain on a business loan. From a buyer's perspective this
may make sense, but from a seller's perspective it introduces a sort of
arbitrariness into the process. |
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Tangible
Assets |
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(Balance
Sheet) Method |
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In some instances, a
business is worth no more than the value of its tangible assets. This would
be the case for some (not all) businesses that are losing money or paying the
owner(s) less in total than a fair market compensation. Selling such a
business is often a matter of getting the best possible price for the
equipment, inventory, and other assets of the business. It is generally best
to approach other firms in the same business that would have direct use for
such assets. Also, a company in the same business might be interested in
taking over your facility. This would mean your leasehold improvements
(modifications to space, etc.) would have value and the equipment would have
value as "in place" plant and equipment. In place value is higher
than the value on a piece by piece basis such as at a sale by auction. |
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Cost To
Create Approach |
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(Leap
Frog Start-Up) |
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Sometimes companies or
individuals will purchase a company just to avoid the difficulties of
starting from scratch. The buyer will calculate his or her start up needs in
terms of dollars and time. Next he or she will look at your business and
analyze what it has and what it may be missing relative to the buyer's start
up plan. The buyer will calculate value based on his or her projected costs
to organize personnel, obtain leases, obtain fixed assets, and cost to develop
intangibles such as licenses, copyrights, contracts, etc.). A reasonable premium of above the sum of projected start up costs may be
offered because of the effort and time being saved by the buyer. The more difficult, expensive, and/or time consuming
startup is likely to be, the higher the value would
be based upon this method. |
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One of the most common
approaches to small business valuation is the use of industry rules of thumb.
While most financial analysts cringe at the use of these approaches, they do
have their place, which we believe to be as adjuncts to other methods. One industry rule of thumb says a payroll service customer is worth 1.5 to
2 times its annual service fees. Another says that small weekly newspapers
are worth 100% of one year's gross income. The problem with these and all rule of thumb formulas is that they are
statistically derived from the sale of many businesses of each type. That is,
an organization might compile statistics on perhaps 100 small weekly
newspapers that were sold over a two year period. They will then average all
the selling prices and calculate that the average paper sold for 100% of one
year's gross income. The rule of thumb is thus created. However, some
newspapers may have sold for twice one year's gross while other may have sold
for half of one year's gross. The rule of thumb averages may be accurate for those businesses whose
performances are right about at the average. The business with expenses and
profits that are right on target with industry averages may well sell for a
price in line with the rule of thumb formula. Others will vary. To apply the
rule of thumb to a business that varies significantly from the average is not
appropriate. |
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Some buyers value a company by simply multiplying the Earnings Before
Interest, Taxes, Depreciation and Amortization (EBITDA )
by a factor, typically in the 3 to 6 range. This straightforward approach
tends to be used for companies with sales over $5,000,000 that have a
management infrastructure in place The advantages are:
The disadvantages are:
Even when the EBITDA method is appropriate for valuation, certain
adjustments and allowances need to be made before the simple formula can be
applied. And of course, the actual multiplier used (whether 3 or 4 or 5 or
some other number) is likely to be vigorously negotiated between buyer and
seller. If you would like to know if the EBITDA method may be appropriate for your
company, please contact us. |
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In some instances , a buyer will pay a somewhat
higher price than any of the above methods would justify. This could be the case when a buyer sees clear and immediate synergies; if
the buyer can make 2 + 2= 5. A strategic buyer may pay a premium if for
example, he can gain immediate and sizable economies of scale, gain a new
distribution channel for his existing products, or a new product that can
take immediate advantage of his existing distribution channels. A buyer may
consider this method of valuation when a very high proportion of the seller's
gross revenue will, after the acquisition, fall to the buyer's bottom line. A few examples where we have been able to sell companies based on
synergies include: Example 1: We have sold several payroll service companies. Payroll service companies
(such as Paychex or ADP) often acquire smaller
companies in their industry. When they do so, they are more concerned with
top line income than bottom line profit. More accurately, they are concerned
with what the bottom line income would be if they were to transfer the
selling company's customer base to their own system where they have excess
capacity. They can add incremental payrolls without a corresponding increase
in expenses. A payroll service company that has gross receipt of say,
$500,000 and is breaking even, could represent a
profit of several hundred thousand dollars to an acquirer already in the
business that can process more efficiently and can eliminate much of the
smaller firms overhead. To the buying payroll service company, a more important calculation than
the selling company's earnings is a comparison between the cost of gaining
customers through acquisition vs. the cost of gaining equivalent customers by
traditional methods like hiring salesmen, advertising, etc. Because payroll
service firms can accurately estimate their processing expenses based on
gross revenues, these companies tend to sell for a multiple of their annual
gross sales with only minor regard for their profit or loss. Example 2: Some time ago, an outdoor furniture company approached us looking to
acquire a complimentary company. They had great distribution of their porch
and patio furniture and specifically wanted to acquire a company that made or
imported a product that could be sold through the channels they had built. We
were able to find an importer of wicker planters that matched its
distribution channel perfectly. They agreed to pay a premium based on the
synergies they knew they could achieve. Example 3: A few years ago we represented a mail order seller of knitting supplies
for sale. We found a buyer, a large mail order company of quilting supplies,
and showed them how they would gain economies of scale, synergies, and
customers that could be cross-sold (knitting customers would buy quilting
supplies and vice-versa). They buyer paid a premium justified by the
excellent synergies. Warning There are companies that overplay this synergy concept by claiming to be
in touch with buyers who will pay far more for your business than any
valuation method would justify. They may be foreign buyers who are anxious to
get a foothold in the However, the rest of the sales pitch is that you need to pay them a large
amount of money upfront, as much as $50,000, or the
names of these overly generous buyers won't be revealed. They make their
money primarily based on the upfront fees. After you pay the upfront fee,
you'll get a very nice write-up of your company with fancy charts and printed
on the finest cloth weave paper, but you won't get a buyer to overpay for
your company. When buyers buy based on synergies, they typically pay a reasonable
premium over the financial methods described previously, or based on some
logical method that reflects the buying companies likely earnings (such as
with payroll service companies, above). For example, instead of using a
multiple of 3.5 times EBITDA, they may use 5.5 times EBITDA. Now the
difference between a multiple of 3.5 vs. 5.5 is significant to be sure, but it
is not the double or triple valuation that you were promised, before you paid
the hefty upfront fee. We (and other honest intermediaries) make our money based on performance,
not on upfront retainers. We have no incentive to make unsubstantiable
claims of buyers willing to throw logic to the wind and pay huge sums for
your business. We only get paid for making the deal, not for talking about
it. |