Business Valuation

Some fundamentals of Business Valuation:

If you've ever thought of selling your business - and even if you haven't - you may have wondered what your business is worth. Wonder no more. Contact us for a free, no-obligation estimate of the value of your business. Since 1979, we've helped tens of thousands of owners of small to medium sized business owners learn what their businesses are worth.

The Value Pyramid

To understand how businesses are valued, review the Value Pyramid chart above, which represents a simplified framework for determining the value of a business. The four key value factors are:

• Seller's discretionary earnings
• Desirability/ Strategic value
• Risk
• Terms of Sale

Seller's Discretionary Earnings

If you're like most small business owners, you've used every legal trick in the book to avoid paying a penny more of federal and state tax than you absolutely must. You know that one of the biggest advantages of owning a small business is having the opportunity to use the business to minimize your personal income tax liabilities.
Many Buyers don't understand the way in which the books and records of a small business are used to reduce tax liabilities. Even if they do understand, the books and records of your business will almost certainly require explanation before the Buyer can comprehend what he or she is reviewing. One of the main tasks that VR routinely undertakes is to work with the Seller's records to show the business' true money-making capabilities. We use the results to set a price range for the business and to support that price with the Buyer.

The process of making adjustments on the financial statements of a small business is called Normalizing or Recasting. Normalizing or Recasting means working between the lines (i.e., between Gross Operating Profit and Net Pre-Tax Profit) to add back to profitability, all of the legally taken charges and expenses that weren't absolutely necessary. The purpose of Normalizing or Recasting is to identify the dollars that are available to the new owner(s) for their compensation and debt service after all necessary expenses have been paid.

The foundation of value, especially in the market for small- to medium-sized businesses, is Seller's Discretionary Earnings (SDE)-the total cash flow benefiting the owner. Calculating SDE is a bit tricky, so it's advisable to obtain the services of a professional who is experienced in business valuations. The approach is to consider not just the net income, but all the recurring cash benefit flowing through to the owner as follows:

Net Income:

+ Owner salary
+ "Discretionary expenses" (e.g., health insurance, optional travel & entertainment, personal use of products)
+ Non cash expenses (e.g., amortization and some depreciation)
+ Non-recurring expenses (or minus non-recurring income)
+ Non-operating expenses (e.g., interest payments, or minus non-operating income)
= Seller's Discretionary Earnings

The purchaser of a business is buying an income stream, and in most cases, a job. The more SDE a business is generating, the more it tends to be worth, although the relationship is not a linear one. As a very rough rule of thumb, a business typically sells for 1.5 to 3 times annual SDE, with the multiple increasing for businesses scoring well on desirability, risk and terms. See the accompanying chart "Business Value vs. SDE". Businesses that are not generating cash can still have value; provided they score well on the other factors and/ or buyers perceive the opportunity to improve the cash flow.

The next source of value is the "desirability/ strategic value" of a business. Factors in this category include:

• Level of SDE (higher SDEs get higher value multiples)
• Strategic value (primarily for larger and technology driven businesses)
• The fun & ease of operating the business
• Location
• Facilities
• Employee relations
• Operating hours
• Growth potential

Risk

The third valuation factor is the level of risk. Factors in this category include:

• Years in business and with the current owner
• Profit trend
• Quality of books and records
• Franchise membership
• Brand recognition/ strength
• Level of competition
• Dependence on current owner
• Diversification of customer base
• Lease length and terms
• Asset value

Terms of Sale

The fourth and final source of value is the "terms of sale". This is the one source of value that the business seller can almost completely control. Components of the terms include:

• Down payment
• Interest rate
• Monthly payment
• Non compete agreement
• Seller training of buyer

The first three components of the terms of sale assume that the seller is providing financing to the buyer of the business, which happens in the majority of sales. With seller financing, the seller receives part of the purchase price at the time of the sale ("the down payment") and the remainder over several years. The buyer uses the cash flow from the business to pay off the debt. Structuring a sale with attractive terms can significantly increase the value of a business.

Professional Valuations:

VR partners with third party professional appraisal firms that provide a full range of professional valuation services. Our partners and their appraisers belong to the most respected appraisal associations in the country and hold the highest industry designations, making them experts in their field. Professional credentials include designations from the American Society of Appraisers and National Association of Certified Valuation Analysts.

Consideration for a Valuation:

In today’s advantageous market, many business owners still leave substantial money on the table when they sell their companies – most often because they do not truly have a handle on their company’s value. For that reason, the valuation process is a true asset to the business owner and a thorough, professionally prepared valuation will assist them in:

• Helping identify the key value drivers, major strengths, and more importantly, the major weaknesses of a company allowing the owner to solve both obvious and hidden problems prior to the selling process.
• Determining a reasonable selling price. Many owners rely on general rules of thumb, casual advice from friends, or other similarly unreliable sources. Values determined by general multiples or rules of thumb may be too high or too low. Unless the business owner goes through the valuation process, he or she just will not know. If the owner’s expectation of value is too high, it will prolong the selling process until a price concession is made. If the price is too low, money is left on the table.
• Fully understanding the value of the business will assist during negotiation. In this market, one can expect buyers to be sophisticated and experienced. They will conduct a rigorous analysis of the company even if the seller has not. They will look at those factors and value drivers that the owner and his advisors should consider in valuing the company, and they will use that information against the seller in negotiations if allowed.

A true test of accuracy and validity of any valuation is the price at which a company would willingly change hands in the marketplace. The valuation of a privately owned company is both science and art. Since no two companies are exactly alike even within the same industry, trade, or service, there is no one formula or method that is all-inclusive. Our professional appraisal firms use a comprehensive, multi-method approach that considers relevant factors that are unique to a particular company including: company history and longevity, future economic outlook, tangible asset value, intangible asset value and industry ratios.

Also considered, are factors such as historical net cash flow, probability of continued profitability, risk competition, technology changes, ownership transition training, owner non-compete and consulting agreements, as well as working capital requirements. There are many reasons to value a company. Whether it is for an anticipated acquisition or divesture, a partnership buy-sell agreement, stockholder concerns, marital dissolution, or estate planning, a professional valuation makes a world of difference. Since there are many reasons to value a company, there are many different levels of valuation services. From a simple target value for selling your company to a complex IRS-rated valuation, VR can handle the assignment internally or by working with independent third parties.

Risk impacts value! Risk is defined as: the degree of certainty or uncertainty as to realization of expected future returns. Risk takes many forms in mid-sized business: size of company, depth of management, reliance on key personnel, company specific concerns, industry trends, and to a great extent available return on alternative investments (stock market, bonds, t-bills, etc.)

There are three broad approaches to valuation: Income, Market, and Assets. Within each approach there may be many different methods that must be considered. After careful consideration of the relevant factors, a reconciliation of the related approaches is performed to determine which approaches are most relevant to the purpose of the appraisal assignment.

VR is the only contact and interface our clients have when doing a third party appraisal – we do the information gathering, the interviews and the packaging without any extra costs to our clients.