What is My Business Worth? It Depends!
How much is my business worth? If that is a question you, as a business owner wants to know the answer to, then perhaps you should consider a Business Valuation.
At VR in Lynwood, WA we have a third party arrangement with a firm of professional appraisers. These are the same people that provide the opinions of value for the largest lending banks in the country. This company specializes in analyzing and valuing small privately held companies and have the largest data base of comparable sales in the United States of America.
Why can't my CPA tell me how much my business is worth?
Many business owners ask this question - and it's a good one. To know why it's so important to have a valuation you need to understand the difference between how a CPA values your business and how buyers value your business.
Typically, your CPA will give what is called the "book value" which is based on the financial statements of the business. This value does NOT accurately reflect how much your business is worth. It fails to consider such factors as good will, competition, market and industry growth, business expansion opportunities, changes in technology and much more. As a result, this amount is almost always far lower than the true market value of your business.
Our depth of experience coupled with the most extensive database of businesses sold provides us with the knowledge needed to give you an expert opinion of value, delivered in a responsive, timely and efficient manner.
Don't leave money on the bargaining table. Let our third party opinion of value impress the buyer, minimize the negations and maximize your return on the sale of your business.
An important step in understanding how the marketplace places a value on your company is identifying the type of buyer that would likely buy your company. The buyer who perceives the greatest opportunity is the buyer willing to pay the most for your business.
Identifying the right type of buyer for your business requires an understanding of the four main classifications of buyers and knowing where your company fits into the world of businesses (see Preparing to Sell Your Business).
Financial Buyer. By far the largest group of buyers the Financial Buyers are the most common buyer for Main Street and Upper Main Street businesses. These buyers tend to focus solely on present and past earnings and will not typically pay a price based on future earnings. In addition to looking for a return on their investment, the Financial Buyer is buying a job and will consider a price fair, if the transaction meets the following criteria:
• A wage for buyer commensurate with the initial cash investment
• A modest return on the cash investment
• P/E ratios of 1 to 4 times SDE
• Seller financing
• A good fit with their skills and the opportunity to make the business better
The majority of small businesses are purchased by Financial Buyers. VR maximizes the amount the Financial Buyer is willing to pay by finding the right buyer for your business.
Sophisticated Buyers/Private Equity Groups. This group of buyers emerged as a force when the "merger mania" of the late 80s ended and buyers began to recognize the opportunities in the private sector. Lower interest rates have also spurred the growth of these buyers by encouraging the formation of investment groups whose purchases are made using a "schooled" approach. There are two distinct types of sophisticated acquirers and the acquisition criteria, they use, are as follows:
High Net Worth Individuals
• Revenues from $2 million upwards to $20 million
• Expect 6 figure future earnings
• Expect to leverage a part of the purchase
• Expect the seller to finance part of the sale
• Pay 3 to 6 times EBITDA earnings
Private Equity or Holding Company
• Revenues from $10 million upwards to $100 million
• Earnings of $1 million
• Investment of considerable cash or equity
• Pay 3 to 8 times EBITDA earnings
Sophisticated buyers sometimes buy companies smaller than the outlined criteria. A good example of a business attractive to the sophisticated buyer is quick printing, a light manufacturing business expandable into multiple locations through good marketing and solid management.
The Strategic Buyer. These are the very best buyers. They almost always pay cash and pay top dollar. Typically public or very large private companies, their decision to buy usually revolves around considerations of economies of scale, new channels of distribution, market expansion, new technologies or other strategic integration considerations. To attract a Strategic Buyer, your company should fit most, if not all, of the following criteria:
• Sales in excess of $10 million
• Proprietary product or process
• Unique market presence
• Synergistic fit with the buyer's enterprise
• Suitable management willing to stay
Sometimes a business that does not meet these criteria can be the target of a "strategic buyer." A good example might be a small business that an acquirer believes could be franchised or expanded into a chain of similar locations. At VR Business Brokers, we look for every reason that your business might be made attractive to the strategic buyer.
The Industry Buyer. The Industry Buyer is almost always the buyer of last resort. If you have to sell, the Industry Buyer is usually the only buyer you will attract. The difference between the Industry Buyer and all other buyers is the value of goodwill: Industry Buyers rarely pay for it. The Industry Buyer typically will pay:
• Liquidation value
• Book value
• Adjusted Book Value
All too often business owners who are attempting to sell their business on their own say, "Why not? I know everybody in the industry." Unfortunately, 99 out of 100 times, a sale to the Industry Buyer means a deeply discounted sale.
Why are Privately Held Companies Valued?
There are many reasons owners of privately held companies value their businesses. Often times, proper planning for the business and/or family is essential to success and peace of mind of the owner. The majority of the business valuations are not for the purchase or sale of a business. Most of the reasons a company is valued fall into the following reasons:
- Purchase or sale of a business
- Merger
- Business planning
- Gift and estate planning
- Charitable contributions
- Employee stock ownership plans (ESOP)
- Marital dissolutions
- Partner buy-out
- Value enhancement
- SBA financing
- Raising Capital
- Other
What Type of Valuation Does My Company Need?
The type of valuation your company needs will depend on the size of your business and reason for the valuation. At VR in Washington State, we can arrange four types of valuations to meet different needs:
Market Analysis Opinion of Value - A quick reference for those who are curious and need a general value range in a short time frame and only used for small "Main Street" businesses. This is based on historical sold transactions of similar small businesses.
Value Analysis - A snapshot of the business determining the "Fair Market Value." Requires three years of general financial information, research and knowledge of other marketplace issues and is primarily used for "Main Street" businesses, which require more than a general range.
Formal Valuation - An in-depth formal valuation used for most purchase and sale transactions and SBA financing. Requires three years of general financial information and much more information about the company's business history, products, services and market conditions.
IRS 59-60 Valuation - A valuation used for gift and estate planning, ESOPs and merger and acquisitions of large privately held companies, "Middle Market Companies." Requires all of the information of a Formal Valuation plus other documentation.
The Value Analysis, Formal Valuation and IRS 59-60 Valuations are prepared in accordance with the Uniform Standards of Professional Appraisal Practice (USPAP) and the American Society of Appraiser (ASA). Our third party independent appraisers are members of the Institute of Business Appraisers (IBA) and hold the title of Certified Business Appraiser (CBA).
What are the Typical Business Valuation Approaches?
Market Approach - This approach utilizes information from companies that have sold to value the subject business.
- Publicly traded guideline companies
- Closely held guideline companies
Asset Approach - This approach values the subject company by summing the value of individual assets.
- Liquidation of individual assets
- Going concern value (Goodwill)
Income Approach - This approach values the subject company by calculating the present value of subject company's projected income or cash flow.
- Capitalized future returns: This valuation methodology is also referred to as a single period capitalization
- Discounted future returns: This valuation methodology is also referred to as multiple period discounting
Excess Earnings Method - This valuation method is a hybrid method utilizing the concepts from both the asset approach and income approach
- This method was developed to estimate the fair market value of the going concern (goodwill). Often used as a hybrid business valuation method between assets approach and income approach
- This method is often used to value "Main Street and Upper Main Street Businesses." This method values a company by separately valuing the net tangible assets and goodwill present in the business. Once these two separate values are determined, they are added together to determine the value of the company.
Rules of Thumb - Observation of the marketplace
- Formulas that have been developed by observation of marketplace transactions in industries which have a significant number of historical transactions. Industry observations often reflect a common "multiplier" which may be applied to some level of cash flow or revenue amount
- Formula valuations are fairly simple to use and may be useful in developing a "price range".
- Limited - because there is generally insufficient information to derive a proper multiple to apply to subject company.
- Rules of Thumb are not valuation approach, but rather a reasonableness check.
How Can I Enhance the Value of My Company?
It is imperative you secure an third party independent business valuation in order to achieve the highest potential price without leaving money on the table. The financial institution, which will provide financing for the purchaser, will require one anyway and it would be tragic to find out at the last minute that you sold it too cheap after you've already negotiated your price. You will be at a severe disadvantage if you allow the purchaser to be the only one to drive the price with an appraisal supported only by the information he/she chooses to provide an appraiser.
Most of the better prospects for businesses are coming from other states and in some instances from other countries. We live in an era of globalization and all of us are affected by what happens elsewhere, particularly in our own country. It would be a mistake to ignore other economic markets, especially if to use them would be to your advantage. Consequently, you need to use an appraisal firm who has national experience in order to take advantage of higher pricing policies supported by areas, which have different economies. A believable appraiser must have significant experience in all types of businesses with ample computer data to support his/her decisions and credibility to impress the prospect's advisors.
In order for the appraisal to be credible and substantial to other parties to the transaction, your appraiser should be a totally independent third-party who has no other business relations with you at all. Anytime you are involved in a business transaction, you should at least consider the possibility that your decisions and actions may be challenged in a court of law. Therefore, you should only choose an appraiser who would best support you in such an extreme occurrence. Before you choose an appraiser, here is a list of questions your appraiser should be prepared to answer:
- How many business appraisals did you do in the last year?
- What percentage of your time is spent in business appraising?
- What business appraisal designations/certifications do you have?
- What is required to retain these designations/certifications?
- How many methodologies did you use and what alternative methods did you consider?
- What articles and books have you written on the subject of business appraisals?
- Have you worked for this client before and in what capacity?
- By what professional practice do you claim this to be unbiased?
- Have you followed the departure provisions or does your report meet the standards as set by the Appraisal Foundation, as required by law under the Uniform Standards of Professional Appraisal Practice (USPAP)?
It doesn't always cost more to get the best. In fact, because of our many years of experience and reputation in the industry, your VR consultant can help you secure the services of superior appraisers and if necessary, accountants and attorneys at appropriate fees. What ultimately costs you more is to not use the best from the beginning; and you should be suspicious of anyone who does not advise you to use all of these third party professionals, at the appropriate times, and to settle for nothing less than the best!
The Buying Process
Frequently Asked Questions
What is Cash Flow?
Most small business owners (Main Street Business) have used every legal trick in the book to minimize taxes and therefore their financial records need to be Recast or Normalized to reflect the true picture of the owners' benefits and the businesses' money making capabilities. This means looking between the lines to add back to the taxable profits all of the legally taken owner discretionary expenses that weren't absolutely necessary. We analyze the cash flow of each business to put it on an even footing with every business, no matter how the owner takes the profits out of the business. We usually define cash flow as earnings before interest, income tax, depreciation, amortization, total owner's compensation, and other owner benefits; professionally termed Seller's Discretionary Earnings (SDE). This is the total amount of money an owner has available to pay himself or herself, to invest in additional equipment, to make the note payments on the business, and to pay income taxes. Your VR representative will be happy to explain this process in greater detail for you when it is necessary.
What Is a Fair Price for a Business?
Like any other commodity, a business is worth whatever a willing buyer will pay a willing seller in a free marketplace. However, the value of most businesses is determined by what someone can afford to pay for it. Typically, this price will be 1 to 3 times the annual cash flow for Main Street businesses after recasting the Seller's Discretionary Earnings (SDE), with a one-third to one-half down payment, and a note to the seller paid off over a 5 to 10 year period. If the business can earn the income you want and make the note payments, then it's worth the price. There are many "Rule of Thumb" methods for pricing a small (Main Street) business. The most commonly used are:
- Cash Flow Method - One to three times annual SDE or EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) plus owner's compensation. The multiple can vary widely depending on the business.
- Value Method - Value of equipment and inventory plus goodwill (one year's cash flow).
- Gross Sales Method - 3 to 12 months gross sales, depending on type of business.
What is Goodwill?
Goodwill is the difference between the total value of a business and the value of the inventory, equipment, and other "hard" assets. Every business has goodwill, unless it is closed down or failing badly. The amount to pay for goodwill depends on the cash flow of the business and its general attractiveness. If buyers didn't pay for goodwill, sellers might as well sell off their equipment and close down, rather than sell as an on-going business.
Are There Tax Benefits in Buying a Business?
Usually you can take a tax deduction for depreciation on the fair market value of all furniture, fixtures, and equipment at a much faster rate than real estate. The Covenant Not to Compete and the value of training are tax deductible, frequently at high levels. Finally, most businesses have deductible expenses that add to the owner's cash flow.
What's an Offer?
An offer is just that - an offer. If it is not accepted by the seller within the time limit you set, your offer is void. Most offers are contingent offers - that is, they become void unless certain things happen.
All offers are subject to: Your price and terms being accepted by the seller.
An offer could also be contingent upon:
- Books and records approved (to your satisfaction)
- All equipment being in working condition
- Assignment of lease
- Business being sold free and clear of debt
- Ability to get necessary licenses and permits
- Business passing necessary inspections
If any of the contingencies in an offer are not met within the time frame you set, the offer is void and your deposit is returned to you. Most offers are also conditioned upon certain promises by the seller, such as:
- Seller providing a non-compete agreement,
- Seller agreeing to a specified training period.
What is Financial Review or Due Diligence?
The financial review need not be complicated, but the process does generate questions from buyers and sellers. Some typical questions from buyers are:
What is it? - You have the opportunity to check out the books and records of the business and verify the information that you have already seen and heard. You may also have additional questions for the seller. If you are satisfied with the information you see, you release the financial contingency and proceed to the next step in your purchase of the business.
How long does it take? - It's up to you! Many businesses can be checked out in one meeting. More complex businesses can take longer.
What if I find something I don't like? - The contingencies in the offer have to be met. If not, you have the right to make a different offer, cancel your offer and get your earnest money refunded, or look at another business.
Why not do the financial review before I make an offer? - Some buyers have expressed a desire to perform a detailed financial audit, before making an offer. Later they found that the audit didn't replace the need to be comfortable with the business and be truly interested in it. They wasted a lot of time analyzing the books, only to find they couldn't agree with the seller on the price and terms or that the type of business just didn't suit them.
We developed the financial review contingency as a compromise to bridge the gap between the buyer's concerns and the seller's needs. We understand the buyer's need to verify the books before buying the business. We also know it could damage the seller to have confidential information released to strangers or potential competitors. By using the financial review contingency, a buyer can make an offer in perfect safety and the seller is assured he is dealing with a serious party.