A quick scan of the subject will show many different kinds of business valuation, all purporting to be useful for someone thinking of selling their business.
How about we take a look under the covers.
First, what is a valuation used for? It seems obvious, but let’s just put it in writing at the outset.
We are trying to determine the approximate value that an average buyer will likely put on the business.
Note that “value” here is a verb—it is something buyers do, not something that somehow exists as part of the business.
To do that we should look at historical evidence regarding how buyers value businesses, no?
So, how do buyers do that? How do they think (and feel)? What do they look at? What counts, and how much does it count?
To be useful, the valuation method must be based on actual marketplace experience. We could go to a licensed appraiser, and that would certainly give us such a perspective, but it can be very expensive (typically in the thousands of dollars, and more suitable for a courtroom setting than the simple sale of a business.)
Fortunately, there is another way—an objective method that has quantified how buyers actually think (and feel) about the various elements of business value. There are two basic building blocks in this method. Here’s how it works.
Building Block #1: Historical Cash Flow, or Sellers Discretionary Earnings (“SDE”)
This first building block is based on a careful analysis of tax returns and financial statements. We must remember that a primary objective of tax returns is to minimize tax liability. We pay our accountants to show how little taxes we owe (i.e., how low our profits are!) Not necessarily the best way to show the business in its true light, is it?
To get a true picture of its performance, we need to adjust various factors. It is often astonishing to see what a difference this makes as we move from a tax strategy picture to one that shows the real “take-home” cash, or Sellers Discretionary Earnings (SDE).
For starters, we must move several expenses over to the positive side:
- Taxes (income taxes)
These elements are related to the owner’s financial situation and tax strategy—not the business itself. Perhaps you have heard of EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization?) This is how investors develop a clear picture of the business as a “cash flow engine” without regard to who owns it, how they finance it, or what their tax situation is.
But there is more. Business owners can pay themselves whatever salary they wish, or none at all (again depending on their individual tax strategy.) We must make this element conform to their average hours worked in the business if they perform “employee-level” functions.
In other words, we want to show how much cash has been coming out of the business after all expenses (including labor that has been performed by the owner) by inserting a fair market value replacement expense.
This is a critical item, often ignored by sellers and even by brokers. We cannot portray an occupation (i.e. a job) as a business and hope to sell it as a financial investment for a multiple of earnings.
There can be other adjustments as well; for example if the owner of the business owns the business premises. This relationship must be calculated at the fair market lease value of the real estate, not necessarily what the business has been paying (often the mortgage payment.)
Once we have calculated the adjusted Seller’s Discretionary Earnings for each of the past three years, the results are put together in a weighted average. The most recent year counts more heavily than the prior years. Why is this? Because that’s how buyers think.
This weighted average becomes the completed building block #1.
Building Block #2: Risk Analysis and Buyer’s Required Rate of Return
A proper Risk Analysis will tell us what to do with Building Block #1. It shows, in a scored objective procedure, how buyers will likely look at various risk factors to determine:
- How likely is it that the historical cash flow will continue, and
- How much of a return do they want in order to justify that level of risk?
This is where it gets interesting. How do we convert feelings and fears about risk into a required percentage return on investment (ROI)? Fortunately, that chore was done years ago by an astute broker. He observed the questions and concerns that buyers had and applied quantitative scores to them. This methodology has an algorithm that converts the raw score into a percentage ROI.
The safer the business, the lower the risk. The lower the risk, the lower the required ROI. For a very safe business, the typical buyer is willing to accept a lower ROI, which means they will pay more for it.
This figure is expressed as a percentage and as a multiplier. For example, a 33% required annual ROI is equivalent to a multiplier of 3 times Sellers Discretionary Earnings.
Now we have Building Block #2.
The easy part: get out a #2 pencil!
All we have to do at this point is multiply Building Block #1 by Building Block #2. For example, if the weighted average Sellers Discretionary Earnings is $100,000, and the calculated Multiplier is 3, then the estimated value of the business (on the basis of its historical cash flow) is $300,000.
This is typically the best way to value the business, and it is a necessary first step. But there is one other test to apply before launching a campaign to sell the company.
When we sell a business based on the value of its cash flow, it’s like selling a box that churns out money every year. We are selling the box and everything in it required to run the business. All of the assets (tangible and intangible) must be handed over to the buyer
But what if the tangible assets are worth more than the cash flow value? Simple–that would be the way for the seller to get the most value. Just liquidate the assets.
Liquidation is usually not the best-case scenario, but it can happen. We must look at it. Using our $300,000 example, and assuming that the tangible assets could be liquidated for $400,000 without having to sell the business, then that would be the way to go.
No fuss, no muss. Just call an equipment broker, vehicle dealer, or whoever buys whatever assets the business has been using, and the deal is done.
However, there is a potential problem with this scenario: liquidation usually brings only pennies on the dollar. It is typically much better to sell the business as an intact “cash flow engine” and hand over all of its assets at the closing.
Still, we must compare the two approaches before deciding which would be best.
Summary and Conclusion
So there we have it—what the heck is a business valuation and how do you do it.
One nice thing about this method: it tells prospective buyers that you have thought through the elements of value from their perspective. They likely started off expecting an adversarial negotiation, and they find out that you just want fair market value—no more, no less.
No big negotiating buffers, no wondering if a low-ball figure is really meaningful, no calling names. Just an objective discussion that easily accommodates the buyer’s other players: lender, accountant, partners, and various advisors.
This is how buyers look at potential acquisitions, and how we must as well.