Chapter 14
Valuation
So here we are—this is the chapter you have been waiting for! Or maybe you just jumped ahead in the book, hoping to find a quick answer to your most important question. It’s the question you are burning to have an answer to.
“What is my business worth?”
What you really want to know is: will you earn enough money from the sale of your business to make that retirement at the beach a reality? Or: will you make enough money from the sale of this business to fund the start of your next business. Or, maybe you’re trying to find out if you’ll make enough to help you get out from under a problem and pay off your bills. No matter what your circumstances are, you need to determine if you will be able to move on. Well, no matter why you’re asking, here is my official answer:
“It depends!”
Now I understand that’s probably not the answer you wanted. Try this one:
“The value of your business is whatever price you can convince a buyer to pay for it.”
The problem is that most people are looking for a simple answer to a complex question. What you’re looking for is a quick easy formula that provides an easy answer.
“I heard my business is worth two times revenue.”
“I heard my business is worth ten times EBITDA.”
Well, sure it is—if you can get someone to pay that much for it. We have already decided that some buyers—particularly strategic buyers—may be willing to pay more than others. Would you be willing to settle for a 2× multiple of revenue if you thought you could get 3×? Other buyers may not be interested at that price at all. How long do you want to wait for a buyer willing to pay a higher price? P.T. Barnum is famous for saying, “there’s a sucker born every minute,” so you never know. Maybe it’s your lucky day. That buyer who is willing to pay an outlandishly high price might come along. It could happen!
But instead of relying on luck, keep in mind that business buyers tend to do their homework and don’t just buy on impulse at any price, so you might have a long, frustrating wait ahead of you. Before investing, business buyers want to know what a business is worth. There is no quick, simple method for determining the correct value to place on a business. But mistakes can cost a lot of money. There are in fact a number of methods for estimating the value of a business, but they rarely return the same results.
The problem is this: the best way to determine what your business is worth—its fair market value (FMV)—would be to receive offers from multiple buyers. Without that, any valuation or appraisal is merely an estimate of the value of your business. The problem with this, of course, is that you need to establish a price before speaking to buyers. It’s “the chicken or the egg” problem. You need to determine an accurate estimate of the value of your business. Let’s look at a couple of ways to get to this.
The best way to determine what your business is worth—its fair market value (FMV)—would be to receive offers from multiple buyers.
So, let’s start here. What do YOU think your business is worth? Most business owners have a gut feeling for what they think the value of their business might be. Unfortunately, there are many things that can make the gut method go wrong quickly. There are just too many factors that come into the equation, and most small business owners have no experience determining the value of a business. It’s too easy to make a mistake. Here is an example of a typical conversation with a small business owner:
“I went to the industry conference last year, and I know as a fact that three of our competitors were being offered $5 million. That was easily two times revenue for them.”
Now we need to ask some questions these folks might not have thought to ask.
“Well, what state are they located in?”
“Were they profitable?”
“When was the last time they updated their equipment? Or were they still using old inefficient tooling or software?”
Maybe you need a gut check! Now you’re getting defensive.
“I know one of them was doing very well and was making good money. He just finished modernizing his entire shop.”
“He is a shrewd businessman, and I had trouble competing against him on a couple of contracts.”
How do you know he didn’t outsmart himself? Maybe he could have gotten $8 million instead of $5 million. That’s a lot of money to leave on the table!
“I’ve already had an unsolicited offer for $5 million from a competitor.”
That’s great, but maybe the competitor is looking for a discount and was setting a low bar to see if you’d bite. Keep him in mind, though, in case you want to add him to your list of potential strategic buyers to approach later. Many owners make assumptions about the value of their business based on rumor and outdated information, but they may be making a costly mistake. Since this is an important deal for you, don’t rely on your gut. Determining the value of your business is too important to make an uneducated decision.
Many owners make assumptions about the value of their business based on rumor and outdated information, but they may be making a costly mistake.
Financial Analysis and Certified Appraisers
There are in fact many techniques available for estimating the value of a business. Performing a true valuation (a business appraisal) is a complex task. Financial analysts have developed a number of models to help make accurate determinations. These techniques include market-based approaches, such as determining an FMV by looking at comparable sales; income-based approaches that rely on revenue and EBITDA multipliers; and more complex analytical methods like discounted cash flows and asset estimates. Often, the problem with these methods is determining which model to use! (It depends on the business circumstances.) But, at least this takes them beyond the gut feeling method!
You might think the financial analysis and the models used to assess the performance of your business would be the greatest determinant of business value. After all, isn’t the bottom line the bottom line? If I invest $1 million in this business it will return $100,000 a year, but if I invest $1 million in another business it will return $200,000. Well, what happens if the business returning the $200,000 is a high-risk business? Is it worth the risk? Not if you are a strategic buyer looking for a business in a specific industry.
“Which business would be more valuable to YOU?” It depends.
“What price would you be willing to pay?” It depends.
Fair market value depends on the motivation of the buyer, and the best way for you to determine the fair market value for your business is to find multiple buyers.
Performing an accurate appraisal is a critical task at a time when you can’t afford to make a mistake. Don’t ask me—I’m not certified as an appraiser. Don’t ask your cousin Jake. Don’t “ask around.” Have an appraisal performed by a certified business appraiser who can perform a comprehensive valuation of your business. The appraiser will give you an estimate of the fair market value of your business. But remember this, regardless of which method is used, it is still an educated estimate.
Get a professional valuation from a certified business appraiser to perform a comprehensive valuation of your business.
Value vs. Price
Now ask yourself this. Suppose you knew exactly, to the dime, what your business is worth—exactly what its fair market value is. Is that the price you would ask for it? Maybe you should list your business at a price that is a little higher than fair market value, knowing that a buyer will try to negotiate your price down. Why wouldn’t you plus it up a little? What about the commission you are going to have to pay to your agent for the sale? Is your price going to try to cover all or part of that? The fair market value of your business and the price you ask for it are not the same thing. A buyer is trying to purchase the business at or below the fair market value. You—the seller—are trying to establish a price for your business.
For accounting purposes, the definition of fair market value was defined by the US Supreme Court as the following:
“The fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.”13
Does a strategic buyer have a compulsion to buy? We assume they do, and the reason we are looking for strategic buyers is that we expect them to pay more than a financial investor. Typically, strategic buyers will pay 10–15 percent higher than a financial buyer (an investor) because they have other compulsions (incentives) to buy your business.
The fair market value of your business and the price you ask for it are not the same thing.
You don’t want to accept a price that is lower than the fair market value of your business, particularly if there is a chance to get a greater price from a strategic buyer. That would mean “leaving money on the table.” You don’t want to hold out for a much higher price and lose a potential offer at the fair market value, either. Your problem just got a little more complex. The appraisal you had done is an estimate that sets the bar for what you hope will be your minimum price. You will want to list your business above that.
Use Caution Applying Metrics
Let’s go back to the real estate models we discussed in chapter 4 for a moment. In real estate, the model that is used to price a new property is a market approach. It looks at comparable homes that have recently sold in the area (referred to as “comps”) to get the average price buyers paid for properties with similar characteristics. In this model, adjustments are made for minor differences between the properties to estimate the price for the new listing. If there are many comps in the area, a good estimate of a property’s value can be established. There are differences, however, between the real estate market and the market for your business.
The residential real estate market is much larger than the market for a business. There may be thousands of comparable houses (“comps”) in an area. By defining a common metric between the comps, such as price per square foot, it is possible to use that metric to estimate the price of a new home.
“There were 150 homes between 5 and 10 years old with three bedrooms, a fireplace, and a pool that sold for an average $185/square foot, so this 2,300 square foot house with similar characteristics and age should be priced at $425,000.”
By contrast, the local business market is much smaller. There may only be one business of that type in the area so there would be no valid comps to establish an average price for the business. A larger geographic area—maybe even nationally—might help to find comps for similar businesses, but it’s difficult to find a simple metric as in real estate to estimate the price, because business pricing has far too many variables. We know, for example, that a business located on Main Street would have a higher price than a similar business located on a back street on the outskirts of town, and we know that some towns are more affluent than others, which directly impacts the price of a business. Business prices cannot be established using a simple metric such as price per square foot.
There are many sources of business data containing information on industry trends and average industry sales (such as revenue and EBITDA multipliers) that can be used as guides. Because of the number of variables, there can be a wide variance in these multipliers. See the reference section at the end of this chapter. You must do your homework when using these databases and anticipate that the value of any multipliers you use will be subject to your negotiations with a buyer. You will be tempted to increase any multiplier, knowing that a small increase in the multiplier may result in a significantly higher valuation. The buyer on the other hand knows that even minor downward adjustments will result in significantly lowering the valuation. Any negotiations with a buyer over the correct value of a revenue multiplier or EBITDA multiplier is best handled by someone who can speak with authority on the subject. If your gut is telling you the EBITDA multiplier should be 11 instead of 7.5 and you have no solid backing for your position, you are likely to lose the negotiation and a good amount of money. This is a pure case of a little bit of knowledge being a dangerous thing. These negotiations are best done through an intermediary.
There are many sources of business data containing information on industry trends and average industry sales (such as revenue and EBITDA multipliers).
Now let’s go back to our original car example for a moment. If you’re planning to sell your car, you probably won’t leave balding tires on it; you’ll get it washed and have the oil and filter changed before asking a car dealer, “what’s my car worth?” There is a Blue Book value14 that can be looked up for a car, but the condition of the car remains a big variable. Better get out that bucket and sponge! Unfortunately, there is no Blue Book for a business. Everything you have been doing to position your business up until this point has been directed at optimizing your business to put it in the best possible condition. The goal is to maximize your return because you understand that the condition of a business is determined by more than soap and water. The financial, legal, and operations infrastructure positioning are all significant variables in determining the condition of your business. When you see industry trends, such as a multiplier expressed as two or three times (2×–3×) revenue, your goal in your positioning efforts is to put your business in the high end of that bracket.
Automation Can Help
There are software applications (apps) available that provide industry trends to generate a business valuation. These applications are very inexpensive (or even free). Don’t be surprised when you get different answers from different applications, though. They may use different models or different data sources to determine fair market value, and they are genericized solutions (not specifically tailored to meet the unique circumstances of the business). You can use the results from these applications to help establish a general price for your business, but use them cautiously. When you use any of these software tools and databases try to honestly reflect the condition of your business.
If you just can’t wait and need a reasonable estimate of the value of your business, I have found (and used) the ValuCast App from the Acquivest Financial Group.15 It provides a reasonable answer—and it’s free—so go ahead and try it.
Warning: Nothing in this chapter is intended to reduce, replace, or discourage you from hiring a qualified professional to advise you on the sale of your business.
No matter what method is used, no matter which financial analysis model is employed, the value you place on your business is an estimate, and, in the end, the price a buyer may be willing to pay is what eventually determines the true value of the business. The estimated fair market value of the business may not be the same thing. The true value of your business will be the price you eventually agree on.
How Can a Professional Appraiser Help You?
As you have seen, there are “a lot of moving parts” (many variables) to be considered for a business valuation and numerous ways to establish a price both the buyer and seller will eventually agree on. The most reliable way to establish a price for your business is to have a financial analysis performed by a certified appraiser who is trained to perform business appraisals. It should be a professional who has the experience to interpret the environmental factors and published industry data (including comparable current industry sales). The professional should also be able to realistically determine industry average revenue and earnings multipliers and will factor in the condition of your business and its geographic location. The financial analysis they perform should factor the cash, real estate, and other tangible and intangible assets of your business along with its revenues, earnings, and cash flows.
The most reliable way to establish a price for your business is to have a financial analysis performed by a certified appraiser who is trained to perform business appraisals.
Performing an independent valuation of your business makes tremendous sense. The cost for these services alone are generally modest—particularly when compared to the cost of an error that results in underpricing your business and not getting the full potential return or overpricing and not selling. If this is a once-in-a-lifetime deal or your retirement lifestyle depends on the price you sell your business for, hiring a professional is not a corner you want to cut. Even if you have a great outside accounting firm or CPA, they may not have the specific experience with the industry to do a valid appraisal. You will need to hire a specialist.
Many times, business owners simply take the recommendation from a business broker or investment banker (more about these services in chapter 16) to establish a price for their business. It’s important to remember that these individuals work on commission and therefore may have a conflict when it comes to pricing your business. If they price high they get a higher commission, but if they price low they get their commission sooner. A banker or business broker can provide you with an “estimate of value” but only a certified appraiser can provide you with an actual “appraisal.” If your banker or broker doesn’t have a certified appraiser on staff, consider having an appraisal performed by an independent professional. This may put you in a better position to negotiate commission rates with your broker or banker later.
A business broker or investment banker may work on commission and therefore may have a conflict when it comes to pricing your business.
To be very clear: I am not recommending you avoid hiring a business broker or investment banker. Quite the opposite. I absolutely recommend you hire a broker or banker as your sales agent—and that you get an actual appraisal of your business performed by a certified appraiser.
Valuation References
Even though you are planning to reach out for professional help, you will need to know what questions to ask, and you will need to understand how to weigh their recommendations. There are many resources available to help you with this complex subject; if you want more information, it may be worth your time to check some of these references out before making this important decision. If you really want to dig into this subject, I recommend Valuation: Measuring and Managing the Value of Companies.16
There are also numerous web resources available, again many of them free or for a small subscription fee:
–ValuAdder is a great overall reference which I find handy because it provides links to a broad range of services (ValuAdder, “Small business valuation guide,” www.valuadder.com/valuationguide/business-valuation-guide.html).
–International Business Brokers Association, www.ibba.org.
–AICPA (The American Institute of CPAs), “Forensics and Valuation Library,” www.aicpa.org/interestareas/forensicandvaluation/resources/fvs-on-line-professional-library.html.
–US Census Bureau, www.census.gov. Note: Use the search term “small business.”
Jim’s Bakery Example
In the previous chapter I described a method for modeling a business and showed how this could be used to create credibility and trust with a buyer. That being true, the extension of the software model for a business to include an integrated valuation sheet makes this a great tool to use when explaining how you arrived at your valuation and how that supports your price. It allows the effect of changes to variables, like the effect of EBITDA adjustments and financial recasts, to be seen as changes in the valuation of the business.
The example valuation sheet for Jim’s Bakery is shown in Figure 14.1. One of the conclusions you may jump to is: if I have this sheet, I won’t need that professional. Wrong! I still highly recommend that you retain a business broker, an investment banker, or a certified business appraiser to assist you with this task. Determining the correct values for the variables, and adjusting the algorithms used in the model to match the recent sales in your industry and all the other variants discussed in this chapter, are still best done by a professional. Ask them to modify this sheet for you. The fact is, this sheet may turn out to be a much more useful tool for you than for your buyer. Play “what if?”—see the impact of your changes and make your decisions before ever speaking with a buyer.
The example valuation spreadsheet is linked to, and is driven from, the summary spreadsheet. It shows a current range of valuation from $16,233,169 to $18,801,280. The fact that these values are as of June for the current year (based on the model) and are likely to finish higher (certainly by the time the deal might close in January) if the current sales performance continues is a valid negotiating point with the buyer. The price for Jim’s Bakery should be negotiated higher than the valuation numbers, but remember—it’s a negotiation and the motivation when setting a price is also a variable.
As an additional note: The financial information contained in this chart is at the correct level to include under the financial section of your “Book,” as shown in the example provided in Appendix B. By including the entire table, you will introduce the valuation into your negotiations and establish your expectations prior to the buyer submitting an offer.