Thinking about Selling Your Business? Part Two: Common Business Valuation Methods
There are many ways to estimate the value of a closely held business, and they all seem complicated. But, in reality, it’s not much different than pricing a used car.
Figuring out an asking price for your car is fairly simple. First, keeping in mind the price you paid for the car and factoring in the number of years that you’ve had it, you determine the overall condition of the car by looking at the mileage, tires and belts, interior and exterior paint, etc. Then, you might go online to see the prices at which others are selling that same year, make, and model car in a similar condition. Finally, you might consult Kelly Blue Book to double check that you’ve arrived at a reasonable asking price.
Plus, if you had documentation to show that you’d maintained the vehicle expertly—consistent receipts for oil changes, mileage checkups, drive-train repairs—you may be able to bump the asking price up a bit and even sell your car more quickly.
Calculating a business valuation estimate is similar. First, you need to look at factors that affect the condition of a business:
- Gross revenue
- Cash flow/earnings
- Financial history
Then you look at what others have paid for similar businesses in similar conditions. And just like with your old car, if your business has well-kept documentation (e.g. tax records, financial statements, etc.), you can often sell more quickly and at a premium.
Unfortunately, a valuation—whether for a car, home, or business—isn’t an exact science. It is guesswork that is informed by data. But just because this isn’t a hard and fast number, doesn’t mean we shouldn’t calculate the estimate. Knowing the price range at which you should offer your business is fundamental to a profitable and prompt sale.
There are three basic methods of pre-transaction valuation:
- Asset Based Valuation
- Market Based Valuation
- Income Based Valuation
Each involves detailed analysis and calculation.
Asset Based Valuation
Generally, Asset Based Valuation is used to determine the bottom end price (i.e. liquidation value) for a business. For simplicity’s sake, you might think of this as a sum total of the fair market values for each of a business’ assets.
Unfortunately, with this method it’s difficult to value the soft assets of the business (e.g. trademarks, goodwill, etc.). Goodwill is the name, reputation, and relationship between the business and its customers. It’s the difference between a going concern business and a bunch of desks, computers, and equipment sitting in a storage unit. It is critical to business value because it translates into a consistent, growing, and profitable business that generates cash flow
So, this method usually fails to make a reasonable estimate of the value of the business because it doesn’t accurately value all of the business assets.
Income Based Valuation
Cash flow is the fuel that drives business value, especially in the business sale context. Why? Because when a business is sold the business must pay for itself. In other words, the net cash flow is used by the buyer to purchase the business.
At first glance, this method seems like it should be quite simple. All we need to do is look at the income statement or tax return, right?
Well, no, not exactly. Those sources only show taxable income. But because owners of closely held businesses usually want to minimize their tax burdens, taxable income doesn’t equal the true earning potential of the business.
The tax laws allow businesses to take deductions for ordinary and necessary business expenses. Some of these expenses, however, are discretionary. Though they’re true business expenses, they’re optional because they don’t have to be incurred to maintain the business revenues.
For example, a business owner might take a trip to the annual industry convention in Hawaii, and then add on a couple of days to the end of the trip to adjust for “jet lag.” Or, an owner might have the business pay for his new Mercedes or fully-loaded F-150 that is used in the business.
The trip and vehicles are deductible as business expenses. Yet, if she didn’t make the trip one year, the business wouldn’t suffer, and an ordinary car or truck would have worked just as well.
Recognizing this is the case, we want to get back to the real earning capability of the business. So, those types of discretionary expenses are added back to the net income of the business.
The opposite situation applies to under-paid expenses. For example, if the owner’s spouse works in the business but is not paid a salary, or the owner doesn’t pay rent on a business facility he owns, the real values of those under-paid expenses are deducted from the net income of the business.
Also, anything that is not related to the true operating expenses of the business is ignored, such as owner salary, depreciation and amortization, and extra-ordinary income.
The goal of both add-backs and deductions is to arrive at the true earning capability of the business. The process of determining the true earning capacity is called “recasting” the financial statements, and the end result is the “Seller’s Discretionary Earnings” (SDE) or “Adjusted Net.”
Recasting is done for several years of business operations, and the results are averaged using a weighted average. The most recent year’s earnings are heavily weighted, while the earnings of earlier years are discounted. For example, the present year’s earnings may be weighted at 1.5 or 2 times, while the first year’s earnings may be weighted at .200.
The weighting value depends on the stage of life of the company and the company’s growth over the time period. For a mature company with low growth, the weighting will be consistent. For a start-up venture, the earlier years will be discounted substantially.
This valuation method uses the following formula to determine business value:
Weighted Average of Seller’s Discretionary Earnings Before Taxes
Valuation = —————————————————————————————–
Weighting the earnings may be somewhat difficult, but the real trick with the earnings based valuation is setting the capitalization rate. The capitalization rate is the return on investment sought by the buyer. In other words, it is a statement of the risk involved in your business as compared with the other investments available to the buyer.
For example, if “no-risk” investments (e.g. T-Bills) are generating annual returns of 6.5%, stock market blue chips 12%, and small capitalization stocks 18%, your small business capitalization rate will be in excess of all those rates. This reflects the fact that there is substantially more risk involved in running a closely held business than in investing in a company through publicly traded stocks.
If your business is heavily dependent on owner goodwill, the industry is changing, or your earnings fluctuate rapidly, the capitalization rate could be as high as 50%. For most closely held businesses, however, the correct capitalization rate is between 20% and 33%. Thus, as a rule of thumb, most closely held businesses are worth between 3 and 5 times the weighted average of the normalized earnings before taxes.
Market Based Valuation
The marked based valuation is not entirely independent from the earnings based method. If we recall our used car analogy from above, we compared the relative condition of the car to the base market value to get the sale price. In other words, not all 1996 Dodge Neons are alike.
After recasting the financial results is complete and the true earning ability of the business is known, the business is compared with other businesses that sold in the past and have similar results (i.e. that are in the same condition).
Unfortunately, though, information about prior business sales isn’t freely available on the internet; it is only available from subscription databases. (Don’t worry: Your broker will have access to these databases).
These databases show the SDE, the gross revenues, and the closing sale price for tens or hundreds (and sometimes thousands) of previously sold businesses.
Unfortunately, though, these data aren’t uniform. The sales vary based on a lot of unique factors. So, a mathematical projection is calculated—technically called the “linear regression”—to come up an estimate of fair market value. See Figure 1.
Each dot in Figure 1 represents a sale, and the line predicts the ratio of the sale price to the SDE, also known as the multiplier. The multiplier for Figure 1 is 2.36, meaning that each $1.00 of SDE equal $2.36 in sale price. The multiplier is then multiplied by the SDE to arrive at a probable selling price.
Multipliers vary widely and could range from 0.5 to 3.5 depending on the industry and the size of the business. Businesses where the goodwill is dependent on the owner (e.g. professional practices) have a very low multiple, sometimes as low as 1 or 1.5. This is also the case when the current market is flooded with a certain type of business, the business doesn’t have a good track record, or the gross revenues have been flat for a few years.
On the other hand, businesses that are in demand, have been growing steadily for a long time, or have a good employee team can have multiples that exceed 3. It is rare, though for a business type to have a multiple in excess of 3.5.
Business value is tied to cash because most buyers are financial buyers. That is, they buy because of the money generated by the business. There must be enough cash flow to pay the buyer’s salary and make seller note payments.
What Do You Do Now?
You have arrived at an honest and well-founded value estimate for your business, but now what? There are proactive steps that you can take to try to maximize the value of your business. If you understand what types of buyers you will have and which of those buyers will pay the most for your business, you can then tailor your business to each of those types to maximize the value of your business.
All of these topics and more will follow in “Part Three: Maximizing Your Business Value.”
How Can We Help You?
Here at Alexander Abramson, we focus exclusively on business-related legal matters. We have advised closely held businesses and business professionals for years on everything from raising startup equity to selling a business.
Ed Alexander is also a Florida licensed business broker and a shareholder of Fitzgibbon Alexander, Inc., a Central Florida consulting, business valuation, and business brokerage firm.
We would love to speak with you directly about how we can help you sell your business.
Call us 407-649-7777 to set up an initial consultation.