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 Knowing Your Business Value
What’s it Worth to You (them)?
By Dan Maloney CPA CFP CM&AA
Valuation –The Eye of the
Beholder Strikes Again
“Fair market value” is often
defined as the amount at which property would change
hands between a willing buyer and a willing seller when
neither party is under any compulsion to buy or sell and
when both parties have reasonable knowledge of relevant
facts. That’s a mouthful, often misunderstood, and also
“pie in the sky.” First, if there is no compulsion to
buy or sell, there will be no transaction. Second, in
the entrepreneurial business arena, having a grasp of
all relevant facts is only but a dream. What it comes
down to is a simple definition: a business is worth only
as much as someone is willing to pay for it, and that
value is always in flux. In today’s volatile economy,
minimizing the “flux factors” is key to success.
What are You Selling? A
Business or a Job? Both are in Demand.
A business is fundamentally
an investment and determining a reasonable value doesn’t
have to be confusing. Investments are priced on their
ability to generate financial returns. Consequently, a
business’s value is based on its ability to generate
profits.
In computing the financial
returns, sometimes called seller’s discretionary
earnings (SDE), the owner’s salary is often added back
to income to compute discretionary earnings generated.
Unless you’re “selling a job” as part of the package, be
careful. A new owner is entitled to a wage for services
rendered in running the business in addition to earning
“investment” returns. Just as professional managers
wouldn’t pay a company for the right to work there,
business sellers shouldn’t exaggerate the business’s
investment return by including the entrepreneur’s fair
wage as a component of the investment return. Keep
salary and investment return separate.
For example, say a business
generates a cash flow of $250,000 per year, before owner
salary. If a fair wage for the business manager is
$100,000 (whatever it would take to lure a qualified
manager), then the “investment earnings” are $150,000.
If buyers are seeking a 20% investment return, a
reasonable purchase offer would be $750,000 or a price
equal to five times the “investment earnings”. Note: in
this example, the offer is only 3 times SDE, not the
factor of 8 to 10 that gets overheard in cocktail party
settings. Most entrepreneurial businesses sell based on
earnings multiples between two to four times earnings.
Multiples increase as the size of businesses increase,
generally due to perceptions of less risk.
Proper Tax Reporting is Key
to Successful Pricing – And to Financing
A note to sellers here is
especially important: buyers and bankers discount any
earnings claims not properly reported on tax returns.
Getting a multiple on earnings in the form of a higher
sales price far outweighs any benefit from saving a few
tax dollars by being “unintentionally aggressive” in
your income tax reporting.
The Future May Be Golden,
but You Still Can’t Sell Silver for the Price of Gold
Sellers asking higher
earnings multiples should be prepared to demonstrate the
likelihood of the business generating future earnings
that are trending higher than current earnings. Market
studies, business plans and competitive analyses are
more important in today’s economy than ever before.
Sellers should also be prepared to answer questions
about their reason for selling the business when “the
next big deal” is at hand. Too often, the “big deal just
around the corner” is a myth. Be prepared to negotiate
an “earn out” to put teeth behind “anticipated” earnings
claims.
All Businesses Aren’t
Created Equal
Companies are unique, and
searching for truly comparable businesses is often a
ghost chase. Don’t put much faith in the comparable
method. There are many variables to investigate when
valuing or buying a business. Factors making a
difference include management teams, documentation of
policies and procedures, updated information systems,
financial controls, independently prepared financial
statements, curb appeal, and many more.
In Entrepreneurial Business
Valuations, Art Wins Again
Valuing a business is far
from science. A valuation is more of an art form and is
based on facts, historical multiples, perceptions, and
full disclosure. Having a third party valuation is
always wise. In fact, having an independent valuation
increases the odds of successfully selling the
business. Whatever valuation approach is used, be sure
to keep the presentation simple. Sophistication doesn’t
always sell. If the buyers don’t understand the methods
used, they won’t be compelled to close the deal.
The Financing Roadway
Isn’t a Straight Path
In today’s current market,
banks are not anxious to lend money for business
acquisitions. Only the best-run and best-documented
companies get financed. Be prepared. The Obama
Administration has plans to ease financing restrictions
and lower SBA fees. Don’t be left out.
Good
Businesses are in High Demand
The
current economy, uncertain employment outlook, and pent
up demand of Private Equity Groups for business
acquisitions all bode well for prepared sellers of
successful, properly valued businesses. Throughout the
valuation and business transfer process, continue to ask
yourself the questions: “Would I pay my asking price?”
and “Would I buy my own business?” Document your
answers. Be ready for the questions from cautious
buyers.
Click
here to read more Strategic Planning articles.
Daniel J. Maloney CPA CFP
CM&AA is the Founder and Principal of Certified
Acquisition Associates LLC, a business intermediary firm
specializing in sales, mergers & acquisitions of
successful privately-owned companies.
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