If you're considering selling, what you need to know about business valuations. Buyers: Good info, too!
SELLERS MUST OVERCOME THE PRICE-VALUE PERCEPTION
A business rarely sells at the asking price, even when sellers arm themselves with a professional business valuation. In general, the economic value of a business is reflective by its worth in an open and competitive market. However, other forces are in play and understanding the rationale and perceptions that influence price and value determination by buyers and sellers may help a deal reach fruition.
While sellers tend to take the optimistic pie-in-the-sky premise, the buyer's approach is more practical and cautionary:
What determines the seller's business value?
- Similar businesses produce similar utilities.
- Long-term efficiencies may be maintained or increased after transfer of ownership.
- Value is independent of economic and product life cycles.
- An exchange-value exists and FF&E help determine value.
- Companies within an industry command a uniform and homogeneous value.
- State, completeness, and accuracy of financial statements.
- Existence of off-books revenues.
- Seller's motivation.
- Lenient recasting of financial statements.
- Seller's sentiment influenced by greed.
- Expectations based on future personal financial needs.
What determines the buyer's price?
- Supply and demand market forces negate comparability.
- Long-term efficiencies are unknown. A payback analysis is more appropriate than a discounted cash flow analysis.
- Price is directly related to adequate debt service and an expected reasonable compensation (benefit to owner) to the buyer.
- Business assets may be utilized differently. FF&E has little or no value.
- Perceived value (listed price) is always higher than actual price since the seller inflates value to allow for negotiation.
- Restrictive recasting of financial information.
- Buyer's sentiment influenced by fear.
- Post-acquisition operational and financial results are expected to decline in the first year due to learning-curve pressures and unfaithful customers, leading to greatly reduced financial projections and acquisition price.
In addition, factors such as relative bargaining positions and skills of either party will influence the final price.
Some gaps may be bridged by explanations and reckoning. Benefits to owner, which is a key element for both approaches, is a good example of reducing differences through logic and rationale. Another example is a well-prepared and supportive due diligence package that may help reduce emotional arguments and uncertainties. Supporting material acts as a great "confidence builder" between the parties. Supportive information and techniques may include:
- A comprehensive informational memorandum that portrays all aspects of the business including history, industry's current state and outlook, operations, management, marketing, customer base, and financial projections.
- Tax returns that reflect the true activity of the business.
- Pre-qualification of the business for financing.
- Seller agreement to hold a note.
- Ability to attract many buyers to create a sense of competition for the business.
Pre-qualifying a business in effect establishes an independent, third party valuation for the business. The loan to value ratio used by the financial institution determines a value by default, which may support the value perceived by the seller. The seller's agreement to hold a note provides a sort of "warranty" and also indicates a level of confidence in the business's strength, while reducing the buyer's required equity investment.
In summary, understanding the fundamental factors that influence a seller's determination of value and a buyer's market determination of price will help bridge the gaps between the two. Information is a key element in a typical deal as it provides a countermeasure to market forces and relative bargaining positions. Partial, incomplete or lack of information tends to shift attitudes from rational to emotional, thereby adversely influencing the buyer's perception of intrinsic value, and weakens the seller's bargaining position.
5 BUSINESS VALUATION MYTHS
As you work tirelessly to meet the everyday challenges of running your own business, you may wonder why you should be interested in reading about valuing your business. After all, valuation is something you will be concerned about some time in the future when there is need for a valuation. If you feel like this and you stop reading, you will be missing an opportunity to ensure that your business will survive and prosper.
Understanding the factors that determine the value of any business will pay tangible dividends by focusing you on ways to increase your short and long run profitability. Moreover, if you choose to sell your business at some point in the future, this knowledge will assist you in positioning your company to receive the highest price. There is no time like the present to begin to understand what a business valuation is, under what circumstances a valuation is customarily completed, and the critical issues to watch out for when events dictate that you undertake a business valuation.
What is a Business Valuation?
We first turn to the central issue-What is a business valuation? To answer this question, consider the following example. You own eBay stock and you want to know how much it is worth. Well, all you have to do is pick up the business section of the daily newspaper or go to any financial website, locate the stock tables and multiply eBay's closing price by the number of shares you own. Through this simple exercise, you have valued your eBay shares or what you would receive in cash if you sold your shares at the closing price.
In concept, valuing your private business is the same as valuing eBay stock. But, because your company is private, there is no stock table that you can conveniently turn to. No need to worry, however, because there is a pseudo-science, or some say an art form, that provides the foundation for skilled business appraisers to estimate what your business is worth. The problem is that the valuation process is often viewed as a black box. As a result, a whole mythology has grown up around valuation of private businesses. To help demystify the valuation process, let me introduce you to my top five myths about valuing a private business and explain how to avoid the pitfalls these myths present.
Top 5 Business Valuation Myths
Myth 1: Valuing a private business should only be done when the business is ready to be sold or a lender requires a valuation as part of its due diligence process.
Although the business sales and lending processes generally require that valuations be completed, if these events represent the first time an owner has a valuation completed, then you can be sure critical business and estate planning issues have not been addressed. If the business is to have a life beyond that of its current owners, then effective planning for ownership transition requires a regular valuation of the business.
Ownership transition may include gifting some percentage of ownership shares to family members during the owner's life, thus reducing any tax on the owner's estate at death. If a company has several owners, a buy-sell agreement with accompanying life insurance should be in place so that if an owner dies, the remaining owners have sufficient funds to purchase the deceased owner's interest at an agreed upon value. The buy-out value under these agreements should be updated regularly to reflect the company's financial progress over time and the valuation approach used should be one of several acceptable to the IRS.
Myth 2: Businesses in "this" industry always sell for "X" times annual revenue (the revenue multiple). So why is a valuation necessary at all?
The short answer is that data on selling prices indicate that revenue multiples within an industry are generally all over the lot. These rules of thumb used by business brokers, the individuals who often facilitate private business transactions, are median multiple values. The median value indicates that half of the revenue multiples are below the median value and half are above. Thus, the median value is just a convenient midpoint and does not represent the revenue multiple for any actual transaction. Unless the company that is being valued is truly a median company, then using the industry rule of thumb for this purpose is clearly wrong.
For example, according to a well known source for business transaction data, Pratt's Stats, recent revenue multiples for companies in the auto parts industry ranged from a low of .98 to a high of 83 with a median of 2.9. If you were valuing your company for sale and your annual revenue is $100,000 then the value of your business could be as low as $98,000, as high as $830,000 or somewhere in between. Where your company lies along this continuum is obviously of the utmost importance and can only be determined by a valuation approach that incorporates academically validated methods with industry-specific valuation factors. Myth 4 below discusses the legal and tax implications of assigning a value to your company that is outside a permissible range.
Myth 3: A local competitor sold his business for three times revenue six months ago. That's the best comparison for the value of any related business.
Maybe yes and maybe no. What happened six months ago is not really relevant to what something is worth today. What your business is worth today depends on three factors: 1) how much cash it generates today; 2) expected growth in cash in the foreseeable future; and 3) the return buyers require on their investment in your business. First of all, unless your company's cash flows and growth prospects are very similar to the competitor company, that company's revenue multiple is irrelevant to valuing your company.
Moreover, without getting into the nuances of finance, even if the competitor company was equivalent to yours in every respect and both companies were sold today, if interest rates were higher today than six months ago, the companies would likely sell for less than three times revenue. Conversely, if rates were lower today than six months ago, the companies may be worth more than three times revenue. In short, the value of your business, like the value of eBay stock, is likely different today than six months ago because economic conditions have changed.
Myth 4: How much a business is worth depends on what the valuation is used for!
The value of a business is its fair market value (FMV). According to the Internal Revenue Service, the FMV is what a willing buyer will pay a willing seller when each is fully informed and under no pressure to act. While there may be a FMV range, the wider the assigned valuation range is, the less reliable is the valuation and the more likely it becomes that the valuation will face greater scrutiny from potential buyers or the IRS.
Consider the example of a parent selling a business to a child. The incentives to assign a low valuation under these circumstances are significant. Given that the parent pays taxes on the difference between the value of the stock sold to the child and its value on the company's books (book value equity), establishing a low value on the company's stock results in the parent minimizing the capital gains tax owed to the IRS. The child, on the other hand, has to come up with less money, because the sales price of the business is much lower than its FMV. These types of transactions are common and the IRS is always looking for abuses. Alternatively, an owner of a business may make a charitable contribution of company stock. In this case, there is a significant incentive to place the highest possible value on the donated shares, because this will result in the largest charitable tax deduction. If the value of the donated shares is outside the FMV range, an IRS audit may well be in the donor's future.
Myth 5: Your business loses money, so it is not worth much.
Most private businesses appear to lose money. Appearances, however, are often misleading. Not long ago, a friend of mine was considering buying an auto parts business in California. The asking price was approximately $950,000 and, according to the company's tax return, it hardly made a profit. Like many businesses of this type, this business was generating a great deal of cash, but this cash was masquerading as legitimate expenses.
One expense category really stood out: payments to officers. This payment included the owner's wage of $80,000 per year and a bonus of $150,000 that the owner paid himself at the end of year. The $80,000 wage is what the business would have to pay a stranger to do the same job as the owner. This was a real expense. The $150,000, on the other hand, represents what finance people call a return to capital. It is the cash the business generated and it is this cash that determines the value of the business.
Unlike public companies, the separation between ownership and management does not really exist in a private company. Thus owners have some discretion over how they categorize cash flow generated by the business. Quantifying the size of these discretionary expenses is often a critical determinant of the company's value. As such, owners should keep a tab on what these discretionary expenses may be so that, when they are ready to sell the business, they can document these facts to the buyer. By doing so, the seller increases the buyer's confidence that the business does legitimately generate the cash the seller claims and, accordingly, increases the buyer's willingness to pay the asking price for the business.
In the final analysis, there are many important reasons that business owners should know the value of their businesses long before they decided to sell. By understanding the basics outlined above, you should be able to successfully plan the financial future for you and your family by understanding the value of your most important asset-your business.
WHAT A PRO NEEDS TO VALUE YOUR BUSINESS
A professional valuation of your business is essential to its marketability. When you are preparing to sell your business, you need to assemble as much information as possible about your business. Full and complete documentation adds credibility and will ensure that you get the best possible price for your business. Once assembled, a detailed valuation of your business can be made. If your broker does not ask you for most of the information on this checklist, he cannot prepare an accurate report.
- Current year Balance Sheet and Profit & Loss statements (up to date within the last 60 days).
- Federal Tax Returns for last three years.
- Balance Sheet and Profit & Loss statements for last three years (fiscal or calendar years to match Federal Tax Returns).
- A second copy of #3 above, noting as they apply to line items on the statements, any references about the following. Use a separate sheet of paper for the descriptions and give specifics:
- Any non-business items such as personal telephone, auto expenses, life and/or health insurance, living expenses or phantom payroll.
- If there is an owner draw in payroll please state amount of draw/salary, wages. If there is more than one family member please state separately. If payroll to a family member(s) is the result of a day to day role in the operation of the company, please describe role, duties, responsibilities and hours worked per week. If the person or persons need to be replaced by the new owner please indicate fair market value of services if you were to hire someone as a replacement.
- Any non-recurring or one-time expenses or revenues, for example, cost of litigation or sale of an asset.
- Any items (sales, cost, or expense) that are non-business related.
- Any items that would change for a new owner like a new premise lease amount.
- Number of years business has been operating.
- Number of years owner has been operating this business.
- Monthly sales/revenues for past 24 months by month.
- List of your primary competitors and assessment of their impact on your business in the past, today and in the future.
- Factors affecting the future market for your business products or services.
- Factors making your business unique from competition.
- Copy of premise lease.
- Copy of any equipment leases to be assumed by buyer.
- Copy of any purchase contracts to be assumed by buyer.
- List of any litigation past, present, or expected.
- Copies of brochures, ads and other marketing materials.
- After all these items are given to your broker they will prepare two or three documents depending on your business:
- A marketability report comparing your business and its performance to other businesses in the appropriate region of the U.S. in the same category, and approximate business size showing fair market value for your business.
- A reality check of your asking price showing book, fair market and most probable selling price, and, more importantly, the feasibility of a business acquisition loan and buyer's return on cash and total investment.
- Your broker will call you to review this in person and you will decide together the best course of action for you.