An Introduction
to Business Valuation
The information that follows is not intended to be an all inclusive guide to Business Valuations nor is it designed to qualify the reader as a business appraiser but rather to help the professional business broker obtain a better understanding of valuing and pricing the small business. The valuation process is full of judgements and estimates and historical financial records. Nonetheless, determining proper valuation is one of the most important considerations of business brokerage.
PURPOSES OF BUSINESS VALUATION
Business valuations can be performed for a number of different reasons, and often, become intertwined. Here are the most common:
1) Buy or sell due to retirement, illness, unhappiness, boredom or un-profitability, etc.
2) Divorce or Property Settlement
3) Death, Insurance, Estate and Gift Tax Purposes
4) Financial Considerations or Requirements: bank loans,
loan collateral, taking a company public, etc.
5) Merger, Acquisition or Consolidation of a Business
6) Dissenting Shareholder or Minority Shareholder Buy out
7) Shareholders Buy and Sell Agreements
8) E.S.O.P.'s (Employee Stock Option Plans)
The focus of our discussion will be the valuation of business for the purpose of buying and selling.
Small businesses are like individuals, there are no two the same. There is seldom any comparable sales data of similar companies with the same type products nor is there replacement cost data for a business which has evolved over the years. Unlike real estate, you can't value a business in the same manner as the realtor values the house next door.
There are many factors affecting the value of a business: the changing economy, the industry, the size of the enterprise, the location of the business, the risks involved with owning the business, the profitability of the business, the physical condition of the business assets, the terms of the sale, the management of the business, and the motivations and objectives of the investor, just to name a few.
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Business valuation is calculated by methods ranging from crude rules of thumb to exotic and intricate mathematical formulas that can be easily manipulated, either by design or by lack of understanding.
Valuation has become more of an art form rather than a science and is therefore heavily dependent on the subjective judgement of knowledgeable individuals who have analyzed the particular business in sufficient detail in order to provide an intelligent conclusion.
The buyer and seller both have very different viewpoints. The seller's value is built on intimate knowledge of the business and often is controlled by years of hard work and personal emotion, whereas, the buyer will be working with snapshots of financial information provided by you. As a business brokers, we often times must convince both the seller and the buyer of our valuation and, making the task even more complex, listen to the opinion of accountants and lawyers, both of whom may have his or her own method. It therefore becomes quite portentous that the business broker understand the various methods, concepts and approaches employed. But remember, regardless of what valuation method you use or how certain you are about your selection, you must view the valuation from the buyer's perspective because it is he who will need convincing, it is he who will work the business, it is he who will make the investment and it is he who will ultimately take the risks. and therefore, set the price.
THE FOUR ELEMENTS OF VALUE:
The value attributable to the ownership of a particular business can be broken down into four distinct elements of value:
1) The Right to Current Return. Every investor is entitled to the associated earnings and cash flow of the business.
2) The Right to Future Growth. Each investor is entitled to any and all growth attributable to the corresponding increase in value of the business during its life cycle.
3) The Right to the Underlying Assets. Each investor is entitled to "take back" the investment at any time.
4) The Right to Control. The investor has the managerial ability to control downside risk, control the assets, control of policies and procedures, pay scales and profits.
THE DEFINITIONS OF VALUE
The word "value" is an ambiguous term. Its exact meaning depends on its context, and circumstances. In business brokerage, there are different definitions of value a broker will encounter when valuing a business. We will discuss the most frequently used definitions below:
1) Fair Market Value. This is the most common definition of value defined as " the price at which property would change hands between a willing buyer and a willing seller where both parties are not under any compulsion, and both parties have reasonable knowledge of the relevant facts. This definition was taken from the Internal Revenue Service Ruling 59-60, a very prominent guideline and reference to business valuation.
2) Fair Value. The value used in context of legal disputes, such as dissenting shareholder litigation or oppression cases and is normally determined by state statues and case law.
3) Investment Value. The value of an ownership interest to a specific owner or prospective owner and the financial returns incident to ownership interest.
4) Intrinsic Value. The inherent value an investor considers, after evaluation of all available facts, to be the true or real worth of a business.
5) Going Concern Value. The value of the company as an operating business, i.e. , the value of systems, procedures, plant and factory arrangements, in place management, established distribution, advertising and marketing networks, employee training, supply sources and contacts, customer lists, concepts implemented and working and the value of other intangible elements of the business, particularly its goodwill.
6) Liquidation Value. The value of the business that would result from selling its assets and settling its liabilities. There are basically two types of liquidation values:
a) Orderly Liquidation Value. The assets will be sold off within a reasonable period of time, that is, six months to a year.
b) Forced Sale Value. This type of liquidation assumes that the assets will be sold as quickly as possible, such as through an auction.
7) Book Value, or Net Book Value as it is often called, is an accounting term relating to the historical cost of the assets as carried on the books and records of the company after deducting an allowance for depreciation.
BUSINESS VALUATIONS - APPROACHES AND METHODS
The value of a business is derived from its future benefits but those benefits cannot be measured with great certainty. All companies have different earnings, and different associated risk factors. Therefore, different approaches and methods have evolved over the years . These approaches and methods provide us with the ability to determine the estimated future value of the business.
There are three basis approaches to business valuation: The Income Approach, The Market Approach and The Cost or Asset Approach. Within each approach, there are a number of methods employed. Our list is not intended to be all inclusive but the most applicable and popular for business brokers will be discussed in detail.
INCOME APPROACH
The Income Approach is defined as: A general way of determining a value of a business or equity interest in a business by using one or more methods wherein the value is determined by converting anticipated benefits, (i.e., normalized or restated cash flows, pretax earnings, or after tax earnings) into a value. The methods under this approach will usually apply some form of capitalization rate to these anticipated benefits.
METHODS UNDER THE INCOME APPROACH:
* 1) Capitalization of Earnings
* 2) Capitalization of Cash Flow
* 3) Excess Earnings (considered as a Hybrid Method using Income & Asset Approach Characteristics)
* 4) Discounted Cash Flow
* 5) Discounted Earnings
* 6) Sellers Discretionary Cash Flow
* 7) Asset/Earnings
MARKET APPROACH
The Market Approach is defined as: a general way of determining value of a business or an equity interest in a business using one or more methods that compare the subject to similar investments that have been sold, and then applying appropriate units of comparison and making adjustments based on the elements of comparison, to the sales price of the subject comparables.
METHODS UNDER THE MARKET APPROACH:
* 1) Market Comparable (used for larger companies)
or Direct Date Method (used for smaller companies)
* 2) Rules of Thumb
COST OR ASSET APPROACH
The Cost or Asset Approach is defined as: a general way of determining a value of the business's assets and/or equity interest using one or more methods. The assets valued under this approach will include all current assets, tangible and intangible operating assets and non-operating assets, however, goodwill and other related intangible assets are not normally included.
METHODS UNDER THE COST APPROACH:
1) Net or Adjusted Asset Value
2) Liquidation Value
3) Cost to Create
THE INCOME APPROACH
The Income approach requires the development of some form of "capitalization" or "discount" rate and refers to the conversion of anticipated benefits into value. Many Business Appraisers and Accountants use "quantitative factors" to determine the capitalization rate of the subject company, others, including business brokers often use " qualitative factors", some use both. Typically, capitalization rates can run 10% for a low risk business, 20% for a medium risk business and as high as 30% for a high risk business. Generally speaking, the higher the capitalization rate, the riskier or less desirable the business. The equivalent percentages to the above multiples would be 5 = (20%) , 3.33 = (30%), and 2.5 = (40%). or simply divide 1 by the capitalization rate to determine the multiple.
FEASIBILITY AND JUSTIFICATION OF PURCHASE PRICE
For the three primary requirements for a good business, remember the 3R's:
(1) Provide a Reasonable Salary to the new owner
(2) Must produce enough cash to Repay Debt service to seller
(3) Provide buyer with a reasonable Return On Investment.
RULES OF THUMB
" Rules of Thumb may be self-fulfilling prophesies, the more one is used, the more people are willing to accept it."
Jeff Wright, Author, "What a Business is Worth"
" A Rule of Thumb is a market-inspired pricing tool, based on collective feelings of those in the business or closely associated to it, that indicate what a business should sell for or could be purchased for."
Tom West
FOUR TYPES OF RULES OF THUMB
*1) MULTIPLE OR % OF SALES
*2) MULTIPLE OR % OF ADJUSTED EARNINGS
*3) UNIT MULTIPLIER - "X" dollars per patient, client, patron, student, etc.
Funeral Directors = "X" dollars per prior year burials
Automobile Rental Agency = "X" dollars per available automobile
Certain Restaurants = "X" dollars per restaurant seat
*4) MULTIPLE OF EARNINGS OR SALES PLUS ASSETS OR
% OF EARNINGS PLUS ASSETS
* Values calculated under any of the above types usually do not include inventory
NOTE; VALUES CAN BE SIGNIFICANTLY DIFFERENT BY GEOGRAPHICAL REGION
RULES OF THUMB AND THE EXPERIENCED BUYER OR BROKER
Some experienced buyers and brokers will rely heavily on " SALES " rather than on "profits" simply because that are familiar with industry Cost of Goods Sold, occupancy costs, etc. Experienced buyers can quickly calculate their " true net"