For What It’s Worth – Know Your Business’s Value
By Dan Maloney CPA CFP CM&AA CBI
Business worth or valuation –The Eye of the Beholder Strikes Again
“Fair market value” or business worth 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 changing economy, minimizing the “flux factors” is key to success.
What are You Selling? A Business or a Job? Both are in Demand. Both Have Values
A business is fundamentally an investment but determining a reasonable value can be very confusing. Investments are priced on their ability to generate financial returns. Consequently, a business’s value is based on its ability to generate profits. It boils down to the interplay of risk and cash flow. Cash flow is called EBITDA (earnings before interest, taxes, depreciation and amortization) in larger companies, and SDE (seller’s discretionary earnings) in smaller companies.
In computing the financial returns using SDE, the owner’s salary and benefits are added back to income to compute discretionary earnings generated. This is where it gets tricky. 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 to better understand the real business value.
Example of business worth.
For example, say a business generates a cash flow of $250,000 per year, before deducting the owner’s salary (the SDE amount.) If a fair wage for a business manager is $100,000 (whatever it would take to lure a qualified manager), then the “investment earnings” are $150,000 (the EBITDA amount.) 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/EBITDA”. Note: in this example, the $750,000 offer is only 3 times SDE. You can see that the same company has different multiples of earnings, one for EBITDA and one for SDE, so understanding the valuation terms is important.
Cocktail Party Values
Note that the multiple factors used in the example are 3 and 5, not the factors of 10 to 12 that get 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. It can get very confusing, so do your homework.
Tax Reporting is Key to Successful Pricing,
Financing and Value Realization
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 documented real earnings and a resultant higher sales price far outweighs any benefit received from saving a few tax dollars by being “unintentionally aggressive” in your income tax reporting. For example, suppose an entrepreneur was “creative” in claiming tax deductions of $25,000. The business would show $25,000 less taxable income and save about $10,000 in income taxes. If the SDE multiple was 5, that would equate in $125,000 less in sales price. A little understanding of the “multiples game” can bring much more value and higher sales prices.
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. Documents such as market studies, business plans, competitive analyses, earnings growth reports, and demonstration of new revenue stream possibilities become more important than ever before. Sellers seeking unusually higher multiples should 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.
Value Drivers Make a Difference
Companies are unique, and searching for truly comparable businesses is often a ghost chase. Don’t put much faith in the comparable method. You’re not selling your condominium with a cookie cutter floor plan. Businesses vary greatly and there are many variables to investigate when valuing or buying a business. Value drivers make a difference. Value drivers include cohesive management teams, documentation of policies and procedures, updated information systems, financial controls, growing profit margins, recurring revenue streams, 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, full disclosure, and opinions of the person doing the valuation. Having a third party valuation is always wise. Having an independent valuation increases the odds of successfully selling the business. It can help lessen the emotional fears of overpaying by the buyer or underpricing of the seller. Whatever valuation approach is used, be sure to keep the presentation simple. Sophistication doesn’t always sell. If the buyers don’t understand the valuation report 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. Just like buyers, banks are risk averse. Only the best-run and best-documented companies get financed. Banks evaluate both the business and the buyer. They will review the buyer’s resume, work history, credit reports, management experience, among other things. Be prepared. There idea of your business worth will be different than yours.
Properly Valued Businesses are in High Demand
The current economy is improving and pent up demand of individual buyers, family offices and 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. What is my business worth to an investor?
About the author:
Daniel J. Maloney CPA CFP CM&AA CBI is the Founder and Principal of Certified Acquisition Advisors LLC, a boutique Intermediary and M&A advisory firm providing guidance to entrepreneurs, both buyers and sellers, throughout the complex M&A process. It specializes in the purchase and sale transactions of lower middle market companies. The firm prepares entrepreneurs and their businesses for sale by engaging in pre-acquisition “self due diligence” activities, thereby lessening the possibility of seller remorse while facilitating successful M&A transactions. To learn more about preparing your business for sale, visit www.certifiedacquisitions.com.
Copyright 2017 Daniel J. Maloney