Selling Your Business for the Biggest Profit - Part 4
May 2004
Valuation: What Is My Business Worth?
Last month's article, What to Look for in a Business Broker, reviewed the criteria and questions to ask when retaining a business broker for the sale of your business. This month, we will talk about some concepts and methods of business valuation.
You've heard the saying that beauty is in the eye of the beholder, business valuation can be said to have similar attributes. The value of a business is ultimately what a willing buyer and seller agree upon as fair. This is not to say that standard valuation methods or sound financial valuation techniques are irrelevant, but rather that a business may have a very different value to a strategic buyer versus a financial buyer.
Since the sale and purchase of a business often has emotional aspects, there are times when deals occur at "irrational" values, either above or below what an orderly market would dictate. Just think of what some internet businesses were selling for just a few short years ago, or more recently the purchase of billions worth of telecommunications infrastructure for fractions of a penny. Market psychology and emotion play a major role in business valuation.
In general terms, the value of a small business should be greater than the book value of its hard assets. But how do you put a price on intangible assets or the going-concern value? There are several well-developed and accepted methodologies for valuing small businesses.
Business valuation methodologies can be classified into several categories, depending on which aspects of the underlying value are the primary drivers. Often, several methods are used concurrently to provide a range of possible valuations.
The first method is to value the business's assets from a balance sheet perspective. This
book value method represents the net depreciated value of the various assets of the business. Although this is a good starting point, it's of marginal value because it reflects historical costs and depreciated assets rather than their current market or replacement value. Book value should be adjusted for what a like asset can reasonably be expected to sell for in the open market. This
liquidation value provides a more accurate picture; however a liquidation price carries very little incentive for a potential seller. You should also investigate to find out if there are any "off balance sheet assets" that have been written off or perhaps never recorded or capitalized.
Another accepted valuation method is based upon
historical earnings. This technique allows for valuing the going concern portion, or "goodwill," of the business over and above the market value of the assets. Most buyers will focus on the
future earnings potential of the business, but forecasting this earnings stream is often difficult. Using audited historical results is a conservative indication of past earning capability, predictability, and future growth and stability.
Most buyers will be primarily interested in the business's future potential. Therefore, valuation based on the company's
expected earnings over a reasonable time period (3 to 5 years), discounted back using an appropriate, risk-adjusted, discount rate to arrive at a net present value provides a defendable answer to how much the business is really worth today. Keep in mind that valuations based on forecasts are the most difficult to develop because they require many estimates and projections. However, if carefully done, this valuation method often results in setting the highest reasonable price for a business.
Several business valuation methods are based primarily on the
market valuation methods for similar businesses at a given point in time. Ideally, market-based valuation methods should be used in conjunction with an examination of the assets and earnings to provide an additional data point and reasonableness benchmark.
Several market based methodologies are:
Industry
rules-of-thumb that are well-established guidelines developed over years of transaction data in stable industries (usually expressed as "multiples").
Price-to-earning ratios for "like" publicly traded companies (P/E ratios).
Specific
market-comparable public and private sale transactions. Much like researching the prices of what similar houses in your neighborhood have sold for in the past six months.
Before placing a value on your business, understanding the different business valuation approaches is critical. Some approaches work well for many types of small businesses; others are designed to fit specific situations. The decision on which valuation approach, or combination of approaches, that is right for your business can only be made by you and your selling advisory team. Occasionally it may be necessary to call in a professional appraiser to help you with the valuation work.
Appraisers are in the business of applying multiple valuation approaches, so they know the nuances and tricks of the trade that a small business owner might not be familiar with. They also keep up with market conditions and customs, two important factors when valuing your business. A reliable appraiser can be very helpful in many selling situations. One advantage of using an appraiser you trust is consistency; he or she will use solid market data and well-developed skills to produce consistent valuations.
By using a combination of valuation methods and a reliable appraiser, you should have a clear idea of what your business is worth and documentation to support those numbers. This knowledge will prove invaluable during the negotiations and will aid you in getting the highest reasonable amount for your company.
