Can you answer that question? Perhaps not, but I’ll bet you know how much money is in your wallet. That’s because you wouldn’t dream of managing your day-to-day financials without knowing how much cash you have on hand.
And, the same is true for running your business. You can’t possibly operate a business worth hundreds of thousands – or even a million or more – while ignorant of its total worth. Why? Because all major business decisions must factor in the value of the firm. For instance, deciding how much to invest in inventory or taking out a loan will hinge on your business’ worth.
Unfortunately, barely half of all small independent business owners ever do a valuation. And, even then, fewer still actually know exactly what their blood, sweat and tears are worth in tangible dollars and cents.
Why You Need to Know
There are several specific reasons for learning precisely what your business is worth. Whether you’re considering selling the business, recruiting new investors, bringing employees into ownership or gifting the business to heirs, a valuation will help you put a precise number on its present and future value.
Why would you consider selling some or all of your business? Answers are myriad, ranging from wanting to realize capital for investment or retirement, to getting a tempting offer. Or, the next stage of growth for your business may require additional capital. Or, your fellow shareholders may want to realize their investment and cash out.
Finally, there may be no obvious succession, or perhaps, running the business is simply less challenging or rewarding than it used to be. Whatever your reason for selling, the chief goal is to obtain the highest price.
If you’re selling, how about an “earn-out?” This allows buyers to mitigate their risk with some payment hinged on future performance. This may increase the value you receive for the business but clearly carries more risk and complications for you. Often, an earn-out is employed to ensure the value of good will.
Selling or not, it’s important to learn what your business is really worth. So, how do you do that? The simplest but most expensive way is to hire a professional to tell you. Business valuation, especially if the firm is small, is an imprecise science. Even more so, it’s an art, based partly on hard numbers and partly on soft figures, such as cash-flow projections and “goodwill.” And, each business is like a fingerprint, unique in its details.
The best way to get an accurate valuation is to find a reputable valuation expert, one recommended by an attorney or accountant. Look for a CPA who is also a certified valuation analyst or belongs to a group like the American Society of Appraisers or the Institute of Business Appraisers. There are rules of ethics in those societies to which members have to subscribe.
Having a valuation document prepared by an outside expert adds a great deal to your credibility. A buyer will see exactly how you arrived at your business valuation. The library can provide you with many contacts. One we found useful was [email protected]
So, how much does it cost for a professional valuation? That depends on the size of your company. For example, it might cost $5,000 for a firm with about $l million in annual sales. A “review appraisal” will cost about a third of the original.
Hopefully, your appraiser specializes in the tire or automotive service business or, at least, in small, private business valuation.
Tangibles and Intangibles
First, remember that value boils down to current and expected free cash flow – earnings before interest, taxes, depreciation and amortization. Buyers will take present cash flow and project out five years then set a price on those earnings that guarantees a decent return.
Other factors are number of years in business, number of employees, amount and condition of equipment, facilities, supplies and inventory. Also affecting business value is the type of customers and the degree to which they are tied to the owner. And, finally, stability of earnings will affect business worth.
Intangibles affecting worth include location. For instance, a technology firm located in Silicon Valley commands a higher value than one in rural California because of proximity to the necessary workforce. And, diversification is a plus, with 50 outlets more valuable certainly than, say, just five.
Then, there’s the value of goodwill. How do you price that intangible but important asset? Goodwill embraces the list of suppliers and customers, the businesses reputation, and even the reputation and integrity of its ownership and management.
Perhaps you must depend only on yourself to do the evaluation. Then, this article is for you. Consider, first, that private companies are lucky to fetch five times their earnings, a multiple that has remained steady through the years.
Remember, cash is king. Earnings and cash flow are most important. When all’s said and done, valuing a company depends on one of two commonly used measures – the multiple of normalized earnings of the firm and capitalization of future cash flows. An appropriate multiple is one of the following: price/earnings ratio or earnings before interest, tax and amortization deductions.
The multiple-of-earnings measure arrives at a capital value from reported historic or projected profits, adjusted for abnormal or non-recurring items. Earnings are calculated before interest, tax and amortization. While similar to price/earnings ratio, this is a pre-tax multiple considered by many as more appropriate when a company has significant debt levels.
The other common valuation measurement takes future cash flows and discounts them to give the present value for your business. With all valuations reliant on projections, the result is only as good as the assumptions.
Cash flows offer a useful valuation, particularly where the trading or profit stream is irregular or there is significant investment required before delivering profit growth.
In fact, earnings and cash flow are the essentials in which most buyers are interested. They’ll want to know that your business will provide a stream of dollars that’s predictable, steady and high. While some buyers prefer to look specifically at cash-flow statements, others will focus on your income statement to examine earnings before interest and taxes. Still others will place the most weight on earnings before interest, taxes and depreciation.
The point is, your income stream is key. You need to prove the size and regularity of your positive cash flow, preferably with audited financials going back at least three years.
A very important aspect of your cash flow and earnings is their ability to be replicated in future years without your presence. If your professional expertise or salesmanship is the main reason the business makes money, you will have a hard time convincing the buyer that the cash stream will continue in future years.
There are three approaches to valuing a business. First is the asset-based approach, which considers costs to replace tangible assets. If earnings do not support a value greater than the assets, then the value of a business is simply the value of its tangible assets.
The second method of valuing a business is the market approach. This determines value by using ratios or factors derived from earnings, sales and/or assets of past transactions of similar businesses. These ratios are then applied to the company’s sales and earnings to derive an indication of value.
This method includes the well-worn “rules of thumb.” But rules of thumb are risky because they are based on accepted averages – hence the term “rules of thumb.” But what if your business is not average? This is where your specific results will have to be applied to reach an acceptable value.
Finally, there is the income approach, which converts earnings into value using a capitalization rate, discount rate or multiple. Consult your CPA if you decide to use this method.
One way to apply the income approach is first to determine discretionary earnings, which can be the average of the last several years or your most recent year. Then, pick a multiplier, which ranges from zero to three. Most small businesses sell in the range of 1.5 to 2.5 times the average. For instance, 1.5 times $150,000 equals a $225,000 valuation, plus the value of net liquid assets.
But, to repeat an earlier recommendation, do consider using a professional business appraiser by contacting one of two Web sites: American Society of Appraisers or Institute of Business Appraisers.
Lastly, do not keep your appraisal report with the rest of your business documents. In the event of your death, for estate tax purposes, you won’t want your executor to be bound by the numbers shown in that appraisal.
Remember always that, in this cruel world of ‘buyers prevail,’ any object’s true worth is not what you say it is; it’s what a customer is willing to pay. Determine precisely what that amount is, just like you do with the cash in your wallet.
10 Steps to Maximum Value
Here are 10 steps you can take right now to maximize the value of your business:
1. Customer Diversity
If too much business is concentrated in too few of your customers, it is seen as a negative in the acquisition market. It’s a real plus if none of your customers accounts for more than 5% of total sales. If you find yourself with a customer concentration issue, start focusing on a program to expand customer diversity.
2. Management Depth
An acquirer will look at the quality of the management staff and employees as a major determinant in valuation. You should make the move of assigning your successor a year in advance of your scheduled departure date. If you have a strong management team in place, try to implement employment contracts, non-competes and some form of phantom stock or equity participation plan to keep those stars involved through the transition.
3. Contractually Recurring Revenue
All revenue dollars are not created equally. Revenue dollars from a contract for annual maintenance, annual licensing fees, a recurring retailer fee, technology licenses, etc., are much more powerful value drivers than projected sales revenue, time and materials revenue or other non-recurring revenue streams.
4. Proprietary Products/Technology
This is an area where typical valuation rules do not necessarily apply. If strategic acquirers believe that a new ‘technology’ can be acquired and integrated with their superior distribution channel, they may value your company on a post-acquisition performance basis. The marketplace rewards effective innovation and yawns at ‘me too’ commodity-type products or services. Continue to look for ways to innovate in all facets of your business. If you create a ‘technology’ advantage in your company, think what that could mean to a much larger company.
5. Penetration of Barriers to Entry
In its simplest form, a large restaurant chain buys a small, family-owned restaurant to acquire a grandfathered liquor license. Owning hard-to-get permits, zoning, licenses or regulatory approvals can be worth a great deal to the right buyer. The government market is extremely difficult to penetrate. If your product or service applies, and you can break through the barriers, you become a more attractive acquisition candidate.
6. Effective Use of Professionals
Reviewed or audited financials by a reputable CPA firm cast a positive halo on your business, while at the same time reduce a buyer’s perception of risk. A good outside attorney reduces the risk even more. A strong, professional team is a great asset in growing your business and in helping you obtain maximum value when you exit.
7. Product/Sales Pipeline
Smaller companies often are more agile and have better efficiency than their high-overhead big brothers. In service industries, your ability to move quickly is critical, and big companies evaluate the build-versus-buy question. Small companies that develop new products or services or methods of delivery are viewed as being more valuable to larger potential acquirers – especially one that has the strength to leverge those ‘innovations.’ A win/win scenario is to sell out at a price, in cash and stock at closing, that rewards the smaller company for what it has today plus an earn-out component tied to product revenues with the new firm.
8. Product Diversity
A smaller company that has a quality portfolio of products but lacks expansive distribution can become a valuable asset in the hands of a strategic buyer. A narrow product set, however, increases risk and drives down value.
9. Industry Expertise and Exposure
Encourage your staff to gain industry-specific and/or management education and training. Encourage local media to use you as the voice of authority on tire/auto issues. Your company will be viewed in a more positive light, get more business referrals and an industry buyer will remember you favorably as an acquisition candidate.
10. Written Growth Plan
Capture the opportunities available to your company in a two-to-five-page written growth plan. What additional markets could you pursue? What additional products could you deliver to your same customers? What segments of your current market offer the most growth potential? Where are the best margins in your customer base and product set? Can you expand in those areas? Can you reposition your products for different markets? What about strategic alliances or cross-marketing agreements? Documenting these opportunities can add to the purchase price.
When it comes to unlocking the market value of your privately held company, it is not limited to the bottom line. While profitability is hugely important, the factors above can also result in significant premiums over traditional valuation approaches.
When you sell Microsoft stock, there is no room for interpretation about the market price. But the market for privately held businesses is different. It’s imprecise and illiquid. There is plenty of room for interpretation. And, when you are able to get the best-possible interpretation by the marketplace, it means a big pay off when you decide to sell.
Business Valuation at a Glance
In a nutshell, business valuation methods fall into the following categories:
• Business assets, including book value and liquidation value methods
• Historical earnings, including debt-paying ability, capitalization of earnings or cash flow, gross income multiplies and dividend-paying ability methods
• A combination of assets and earnings, namely, the excess earnings method
• The market for similar businesses, including comparable sales, industry rules of thumb, and price/earnings ratio methods
• Future earnings, namely, discounted future cash flow or earnings methods
• Interactive business valuation calculator