How does a business transfer agent go about valuing a business?

 

How does a business transfer agent go about valuing a business?

Leading business transfer agents discuss the myriad issues surrounding business valuation:

• such as the various causes of overvaluation,
• how the same business can be given significantly different values by different agents, and
• how the urgency with which you need a sale is often pivotal to the price you achieve.

Don Glossop, Andon Frères
"The valuation of companies is not a precise science, it's a complex process based on an array of different information that can be subject to change. It's not like valuing a residential property, where you can rely on similar properties in the area and make adjustments based on numbers of bedrooms, a single or double garage or an en-suite bathroom, etc.

 

"All companies are different, their valuations are subjective, and there are many factors that can affect a company's value. These include tangible factors such as profitability – historic, current and forecast – the extent of contracted income or recurring revenues, the strength of the balance sheet – net asset value – etc.

 

"Intangible factors also need to be considered, for example the company's reputation, longevity and track record, the quality of its products and services, its customer base, any dependence on particular customers, its management, the market it operates in – for example, an emerging market with high growth prospects or a mature market likely to decline in future years – threats and risks to the business, and so on.

 

"The buyer's circumstances might also affect potential value. In general, there are three types of buyer.

 

• "Management, individuals with experience looking to buy their own business, typically don't have the funds to buy a business outright and have to borrow to raise the asking price, in which case servicing the debt has to be factored into their calculations of value.
• "Then there are corporate buyers, not in the same industry, but in, say, an adjacent, complementary sector, looking for diversification, that can see benefits from such an acquisition and might be prepared to pay a premium.
• "Finally, there are trade buyers – ie, competitors – who work in the same sector, have similar or larger operations and can see synergies and potential economies of scale, which again might make them be prepared to pay a premium.

 

"Having said this, it should be remembered that a buyer wants to buy as cheaply as possible. An analogy is the sale of painting or piece of pottery at an antiques auction – the bidding starts low but can rise substantially depending on how badly the bidder wants to complete the purchase.

 

"It's fair to say that most vendors tend to overvalue their businesses and unfortunately, some brokers overvalue businesses because that's what the vendor wants to hear and to improve their prospects of securing the business. Vendors should remember that a broker has nothing to gain by putting forward a low valuation; it's likely to be an honest appraisal based on information provided and his experience in the marketplace.

 

"They should also remember that the broker doesn't determine valuation. This is determined by what a buyer is prepared to pay and what a vendor is prepared to accept, and without agreement by both parties, there will be no deal.

 

"The vendor should be aware of high valuations accompanied by high fees that are not related to the sale of the business."

 

Derek Burgoyne, Cornerstone Business Agents
"The sad truth is that of the many thousands of businesses currently on the market the majority are set at an extremely optimistic asking price – to put it mildly.

 

"Why is this? The reason is usually one (or more) of the following:

 

•This is the price the business owner would like to achieve and no one has put him/her right. Even if good advice is given, it is often ignored
•This is the price the business owner needs to achieve – to cover loans, pay the agents, banks and other creditors
•An agent with little experience has suggested the price (the less experience and confidence an agent has in his/her ability to value a business the more likely he is to overvalue to please the client)
•An agent suggests the price as a way of gaining the instruction as a sole selling agent. This enables them to get a large up-front fee or to make it more likely that he/she is instructed ahead of a competitor (with the intention of going back to the client after a period of time to suggest lowering the price if no interest has been generated)
•There is a lack of financial information supplied to the agent, who then has to value on verbal indications of turnover and profitability. As most owners usually overestimate their turnover and profitability, the business is overvalued
"To ensure a business is valued accurately I would suggest the following: invite two or three agents to value the business and ask for an explanation each time of how the value was calculated. The explanation should include examples of similar businesses recently sold – or on the market at least – and what adjustments and multipliers have been applied to the net profit to value the goodwill of the business.

 

"Advice should also be given on how the value could be increased. What improvements would have to be made to the property, should the lease be extended, what financial information should be provided, etc."

 

Shaun Sweeney, Turner Butler
"Anyone can give a business away. Some business transfer agencies find it simple to go in with what I would call an extremely reasonable valuation, and effectively give the business away.

 

"A client may have spent 35 years building the business up, and have a long-term view of the sale – in other words, he may have three years to sell it and prefer a more dedicated agent who would achieve a substantially higher value.

 

"So every business and every client is different when it comes to valuations. If a seller wants to sell within a week, he'll have a different valuation to one with long-term view of selling.

 

"Some business transfer agencies are accused of overvaluing to get advance fees. But I think sometimes, they’re reflecting what the client wants rather than the market valuation.

 

"I'd say that valuation and overvaluation depends on many factors. If your client wants a quick sale, the asking price may be lower than a well prepared, well presented sale.

 

"You should never knock another agent for overvaluing, because he might have seen something in the business that others haven't.

 

"We get lovely letters from our clients, and one recurring theme is that we got more for their business than they expected.

 

"We sold one restaurant for £1m. Their testimonial said: "We've been on the market for two years with other agents, and despite taking a fee in advance, failed to sell the restaurant.

 

"You valued our business at £150k more than our previous agent and sold for an even higher price. Only you could sell a restaurant in England, to Australians living in America, for a Frenchman married to a Polish wife."

 

"People could say we overvalued that, but he wasn’t desperate to sell, and we saw the potential in the business, where maybe another agent just saw it as just another business."

 

David Rhodes, Horizon Business Agents
"I'd say it's a simple thing to value a business – there are well known criteria. I'm aware that certain agents ignore this and effectively overvalue to gain instruction, not to sell the business.

 

"The fact is, these agents know what's on their books and they know what they're selling. If they're valuing at a certain figure and they're not selling them then it must surely show that they're overvalued.

 

"I tell the client what I think the market will bear. There have been times where a buyer pays more than I advised the client it was worth, but 95% of the time I'm about right.

 

"It's up to the agent whether they take on an instruction at the figure the seller wishes to market at. Ultimately, you're the expert, not the seller.

 

"If you're the one telling them that it's worth 'X amount', you should be able to stand by that valuation.

 

"Sometimes people don't like the truth. Overvaluations often happen because the vendor gets greedy.

 

"A number of times vendors have told me that they knew their business wasn't worth the figure they'd asked, but they thought they'd give it a try anyway.

 

"Then there are owners who need a certain amount of money to get out of trouble. One told me last week that if he couldn't get a certain price for his business then there was no point in selling it, as he couldn't pay off his debts otherwise, in which case he rather go bankrupt. Others simply want to get their original investment back."

 

Rupert Cattell, Amberglobe
"Overvaluations are usually caused by salesmen who have been given very aggressive targets by their employers and are required to get a large up-front fee to meet those targets.

 

"Be wary if a valuation is significantly in excess of everyone else's valuation, if a lack of understanding of the sector is apparent, and if they have an impractical view on how quickly the business will sell. Vendors get told by some people that they can sell a business within six weeks – which is just nonsense."

 

Norman Younger, Kensington Business Brokers
"Two things spring to mind. First, when the vendor has a particularly good business and believes it's worth above and beyond its true value, and they can hold that view so strongly that the buyers believe the hype. It's like houses, when people put crazy prices on them and people pay it because they're scared of getting left behind.

 

"Then of course you get a buyer who doesn't do his homework properly and doesn't want to follow the advice of his agent.

 

"Or it could be that someone has a particular reason for wanting that particular type of business or location, so to them it's worth more than to most people. That would be an overpayment in terms of market value, but not from their point of view.

 

"But some people might look at how much a buyer paid for 'X' business to determine the price of another business, not realising the misleading reasoning behind the valuation."

 

 

http://www.businesstransferagents.co.uk/info/articles/how-does-a-business-transfer-agent-value-a-business.aspx

A buy-sell agreement prepares for a possible change in a business’ ownership.

By Brenda McEachern

VALUING YOUR BUSINESS

When a business principal dies or becomes disabled, what are some options for the business? A buy-sell agreement is a plan that provides for an orderly change of ownership under certain circumstances. It’s designed to establish a value for the business and sets out the terms under which the interest of the disabled or deceased shareholder will be sold to the remaining shareholders.

If properly funded, the shareholder’s family will receive fair market value (FMV) for the shares, providing them with capital to help maintain their standard of living. Also, the remaining business owners are protected from the unwelcome intrusion of the deceased’s family into their business as shareholders.

The most cost-effective method to fund a buy-sell agreement, in the case of the death of a shareholder, is through life insurance. This approach helps to ensure that the required amount of capital will be available.

Assuming the use of life insurance, how much to put in place must also be examined, with reference to the particular business situation. For example, an arm’s-length arrangement would demand that the full FMV of the shares be covered. With a family business, however, there is flexibility to insure the tax bill, 100% of FMV or a lesser percentage.

There are three common priorities for businesses:

1. Maximizing the Benefit of the Capital Dividend Account (CDA)
Private corporations are entitled to maintain a notional tax account, called the capital dividend account (CDA), which keeps track of various tax-free surpluses accumulated by the corporation.
These surpluses may be distributed as capital dividends free of tax to the corporation’s Canadian
resident shareholders.

2. Maximizing the Capital Gains Exemption

Shareholders of farms or active businesses may qualify for a lifetime $500,000 capital gains deduction. This exemption benefits both the deceased and the surviving shareholders by reducing taxes to the estate and reducing the capital gains tax to surviving shareholders when they
ultimately sell the business.

3. Minimizing Tax

If tax minimization is a priority it is necessary to identify for whom—the deceased, the estate or the survivor. Even if the shareholders do have insurance funding in place, the tax implications vary drastically for these stakeholders, depending how the insurance proceeds are distributed.

Brenda McEachern is an estate and trust lawyer with Canada Life.

http://www.advisor.ca/images/other/ae/ae_0204b_valuingbusiness.pdf

Valuing A Business

Valuing A Business

Leith Oliver

Thinking of buying a business? Leith Oliver helps you to calculate what it might be worth to you, and offers some thoughts on franchise fees and goodwill payments.

In New Zealand, the proportion of small business ownership has always been high. However, it is only relatively recently that the idea of owning your own business through buying a franchise has come to the fore.

Despite the success of many franchise systems both in NZ and overseas, there still exist some misunderstandings and even suspicion about franchising on the part of prospective purchasers. If you buy an existing business you can look at the outlet or the plant, look at the trading history, see real figures and real customers. But if you buy the rights to set up a franchise in a new territory, doesn't it seem a lot of money to pay for something which doesn't even exist yet?

In any existing business, the seller will ask an often substantial amount of money for an item called "goodwill" – the factor which assumes that because the business has an established client base, they will keep on coming when the new owner takes over. There is certainly merit in this concept, but I have seen many cases where goodwill figures of $30-50,000 have been asked when the real value of the business has been nowhere near the total amount asked.

The problem for any prospective purchaser, whether of an independent business or of a franchise, is to know what it is really worth. I would like to suggest a way of working this out, and to look at how you can apply this process to evaluating a franchise.

From a purchaser's point of view, buying a business is an investment decision. Like any other investment decision, the value of the investment is based upon the returns available from it. Where you are purchasing a business, the returns are represented by the trading profits, and so the purchaser is mostly interested in the value of the available profits that the business can generate.

Of course, in a new start-up business (such as a franchise), there may be a particularly important element of capital gain to be considered as well.

What do you value?
When a business is offered for sale, the seller will ask a price based on the values of various assets. The most obvious of these are the tangible assets of the business – the plant and equipment used to run the business, and the stocks of goods that are traded. In many cases, other intangible assets are also included in the asking price. These may include goodwill, branding and trademarks, and manufacturing or trading licences.

Although they are the most obvious of the items to be valued, establishing the true value of tangible assets is not straightforward. For example, should assets be valued at book value (the value they have in the business's accounts) or at market value (the price you would get for them if you sold them tomorrow)? Computer equipment is a case in point. If the business paid $5000 for a computer system last year, it might still be worth $3300 on the company's books – but who would buy an out-of-date computer for that much money?

Ultimately, the price for the assets is a matter of negotiation between buyer and seller. If the value of the assets is set at a higher level, then the buyer benefits from future available tax write-offs. If the assets are valued low in the purchase transaction, this benefits the seller through current tax write-offs.

Another question to ask about tangible assets is: "Are they the right assets? Are they the right type and quality, and is there the right amount?" If the assets are inadequate, then extra funds will be needed quickly to get the business functioning properly. Alternatively, if too much money is tied up in inefficient assets then the business returns will be poor. When you buy a franchise, you know that you will be getting the benefits of the franchisor's experience to ensure that you buy the right equipment and the right stock to start up with.

Intangible assets

From a purchaser's point of view, the intangibles such as goodwill and branding present an even greater difficulty in valuation because the values used may be discretionary and subjective – they may be just what the seller thinks they are worth, and may have no foundation in reality.

On the one hand, the fact that they add value to the business is obvious – but how much value? On the other hand, what happens if the business doesn't do well and the assets need to be sold – will these intangible assets have any value then? A good franchise brand will – an independent name won't.

These questions are all hard to answer, and generally mean that a purchaser should not use asset values directly in establishing a purchase price for the business.

Valuing the profits
To my mind, valuing the profits is the solution to the problem of valuing a business. If we regard the purchase of a business as an investment, then the true value can be established by valuing the profits that result from its operation in a given business environment. This method takes the business as a total operational unit and values its ability to produce returns for the shareholders.

The following outlines how to value a business by capitalising the net profit.

Every investment has three components:

1 The dollar amount invested


2. The dollars returned from the investment.


3. The return expressed as an interest rate received on the investment.

These form a simple equation:

The Investment x The Interest Rate = The Return

Eg, an Investment of $20,000 at 10% Interest Rate would give a return of $2,000. And, rearranged, you can say

The Investment = The Return ÷ The Interest Rate.

When purchasing a business, we want to calculate what the Investment value (ie, the price) should be. Using the equation above, we can calculate the maximum total price that the business is worth to us as an investor if we know:

i) the annual dollar return figure, and

ii) what we expect as an interest rate on our investment.

Establishing the annual return
The first of these, the annual dollar return figure, is the figure for Net Profit Before Interest & Tax (NPBIT). Note that the interest cost is excluded because it relates to the borrowing needs of the owner – not the business.

This figure will be provided by the seller either from past trading records or from budgets of future trading figures (in the case of new start-up franchise businesses, actual figures may be provided from the trading histories of existing franchises or a pilot operation). It is up to the buyer to satisfy themselves that the expected future profits are reliably represented in the valuation process.

The NPBIT figure represents Total Sales Income minus Total Costs. In most cases, the business costs are easily identified and future predictions can be checked for validity with some certainty. Note that a reasonable salary for the owner/manager must be included as one of the operating costs (not all businesses show this).

The Total Sales Income, however, is a different story. Many complex factors influence the future sales revenue of any business. Changes in the economy, increased competition, new regulations and shifting markets, along with the unknown performance of a new owner, all mean that sales predictions suffer from a high degree of uncertainty (and much more with an independent business than a franchise). For this reason, it becomes the buyer's responsibility to make their own forecast of future sales, using the seller's figures as a starting point only, and then moderating those to arrive at a conservative prediction.

Note, however, that when you are dealing with a reputable and well-established franchise, they will be basing their projections on a substantial amount of data, and will often already be providing cautious figures. Beware of revising these down again to the point where an obviously sound proposition begins to look unprofitable!

When the buyer is satisfied that the sales and cost figures are realistic, the NPBIT can be calculated for use in the next process.

Establishing the Required Rate of Return
The Required Rate of Return (RRR) is tied to one main business factor – risk. This marriage between RRR and risk is all around us in the commercial world. An investment in Government Bonds gives low interest because the commercial risk is low. Placing your money in an investment account with the local Savings Bank pays a little more because the risk has increased slightly. In contrast, investing on the stock market carries much higher risk and therefore investors expect much higher rates of return. Credit card companies give you an unsecured loan each time you use your card, and consider the risk to be high enough to warrant the current interest charge of around 20%.

The question is: "What rate reflects the risk of investing in a small business?" In this case, the RRR must take account of two risk factors:
 i) the financial market rate for an unsecured small business investment, and
 ii) the unique risk attached to a particular purchase situation.

A quick check with finance brokers suggests that the current market rate for small business investment risk is about 33%. Add to this an allowance for unique risk factors (eg. short trading history, lack of reliable figures, seasonal business, aggressive competition, etc) and you could easily have a RRR on the purchase of 40% or more.

Alternatively, the risk might be reduced by circumstances (eg. the vendor leaving money in the business or remaining associated with it, the presence of some unique competitive advantage, forward contracts assuring future sales revenues, etc.). In this case the RRR may reduce to somewhere below 30%.

Whatever factors are present, the point is that the buyer must take responsibility for establishing a RRR that they believe compensates them for the business risk they are taking.

An example
Last year I was asked by a prospective purchaser to help in valuing a business that distributes machine parts to the crop harvesting industry. The business was being offered for sale as follows:

Sales $200,000pa

Price:

Vehicles and Other Plant $30,000

Goodwill $25,000

Stock $65,000

Total $120,000

After analysing the trading accounts for the past three years, we established that the NPBIT had been reliable and consistent at about $30,000 per year. Independent valuations on the assets verified the value of the plant at $30,000 and stock at $65,000. The seller was prepared to leave some money in the business and would also remain associated with the business as a supplier. These factors acted to reduce the risk but were more than offset by another concern. The crop harvesting industry is very dynamic and unpredictable. Its fortunes are governed by weather, the volume of growing contracts from the food processing industry, and fluctuating market prices for produce. Because of the variability and riskiness of the industry we decided that an RRR of 35% was an appropriate reflection of the purchase risk.

The amount my client was willing to offer for the business could now be established using the equation introduced earlier:

The Investment

= The Return ÷ RRR

= $30,000 ÷ 35%

= $85,714

With reference to the original asking price of $120,000, my client's eventual offer of $86,000 was in fact saying "given the riskiness of the venture there is not enough net profit to generate a goodwill figure, and there is probably too much stock being carried relative to the trading performance of the business."

Note that if we had used another RRR the result would have been different. A 30% RRR, for example, would have given the following result:

Investment

= $30,000 ÷ 30%

= $100,000

The maximum price the buyer would pay with a RRR of 30% now has room for $5,000 of goodwill.

Five step process

The valuation process for a purchaser can thus be summarised as follows:

1. Establish a reliable estimate of the future sales.


2. Forecast the costs and expenses.


3. Calculate the resulting forecast of net profit before interest and tax.


4. Establish the required rate of return.


5. Calculate the value of the business by using the equation above to capitalise the expected future NPBIT.

A valuation that results in a figure less than the tangible asset value indicates operational inefficiency in the existing business, and eliminates any value for goodwill or other intangible assets. Conversely, if the valuation results in a figure that is higher than the tangible asset value, then the extra establishes the value of the intangible assets.

Are franchised business any different?
The example above shows what happens to the sale value of a business when the risk for the buyer is reduced. If the RRR used in the valuation calculation is reduced because of lower risk, then the maximum price a buyer is willing to pay increases. This has great significance for franchised businesses, because a good franchised business system includes many risk-reducing characteristics.

I group the risk reducing factors of franchised businesses into three types: those that support the system, the relationship between franchisor and franchisee, and marketing benefits. Some of the more obvious factors which reduce risk are given below:

1. Support Factors
There are a number of documents and procedures that have become standard items in well-developed franchise systems.

1. Good franchisors issue disclosure documents to purchasers of franchises. The disclosure document gives background information on the identity, financial health and viability of the franchisor.

2. The franchise agreement sets out in detailed form, the responsibilities and authorities of both parties. In the final analysis it is an insurance policy for both sides and helps the business system to run smoothly and effectively.

3. In established franchises a proven business system has been developed and documented in a set of operational manuals. The manuals provide a clear operational path and detailed methods and procedures that keep the business operator focused on producing efficient outputs and consistent quality.

4. Even in younger franchises in most cases pilot operations will have been run to test the system. These provide invaluable sets of operational information that help new operators to be successful and also provide sets of performance benchmarks that can be used for financial forecasting.

2. Relationship Factors
1. Franchising differs from other businesses at the time of a sale in that the franchisor, who is directly or indirectly involved in the sale, stays in an ongoing and often personal relationship with the new operator. The success of the franchisor and the franchisee are bound together in an interdependent relationship. It is in the franchisor's best interests that the franchisee is successful.

2. In addition, a franchise system is a family of businesses which together represent a pool of experience and knowledge. Support and learning from other franchisees is always available.

3. In most cases the relationship with the franchisor extends to ongoing training and management systems support. This improves the competency of new business operators and provides a system of in-house management advice and trouble shooting.

3. Marketing Factors
1. Franchised businesses have stronger branding and market presence. They are more visible in the marketplace due to multiple locations and regular advertising.

2. Combined marketing budgets enable the use of professional marketing services. Promotion and advertising are well planned and organised, and advertisements are professionally produced, giving stronger communication to the market.

3. Group purchasing factors enable franchised systems to buy at better rates and from a wider range of sources than individual businesses. Lower costs convert directly into competitive advantage over other businesses.

4. The impact of competitive activity and market changes is often reduced because the franchisor will be working on future developments all the time. Franchises often lead market changes rather than following them.

These three groups together will have a significant downward impact on the RRR used for valuation purposes (dropping the market rate to perhaps 20% in cases of a well managed franchise). This reduced risk helps to explain the higher economic value attached to franchised businesses.

By producing good financial results over a number of years and recording them in reliable accounting systems, the value continually improves. An investor who runs a franchised business efficiently stands to make a good capital gain on resale of the business, because strong recorded profits combined with low risk will make the business an attractive opportunity and maximise the selling price.

Value for money

One of the reasons people give for 'going it alone' rather than buying a franchise is because they resent paying a franchise fee – some comment that it is like paying goodwill for a business which hasn't got any customers yet.

But valuing assets, as we have seen, is a flawed process. If instead you use the procedure of capitalising NPBIT which looks at the whole performance of the business, you see a picture which more truly reflects the value of a proven franchise system.

If you look at the example I gave above and apply a RRR of 20% to the equation, it produces a value of $150,000 – or $55,000 goodwill. That figure is significantly higher, but reflects the lower risk of buying a franchise. Rather than goodwill, you might call it the franchise fee. And you might consider it a sum worth paying for a greater chance of success, because no matter how cheaply you buy a business, if it doesn't succeed you will lose your money.

At the end of the day, many will tell you that a business is worth what someone is prepared to pay for it. To some extent that is true, but as a prospective business purchaser it is up to you and your professional advisors to ensure that you do not pay more than the investment is worth to you. Buying a franchise can offer many significant advantages. The lesson to be learned from valuing businesses by their profitability is that theapparent 'additional' cost of a franchise fee may be worth every cent.

About the Author
Leith Oliver is a lecturer in management, small business and franchising at UNITEC Institute of Technology and at the University of Auckland

http://www.franchise.co.nz/article/view/82

Why Value the Business?

Valuing a Business

1. Why Value the Business?
There are four main reasons for valuing a business.

1.1 To help you buy or sell a business.

Understanding the valuation process can help you to:

There is a better chance of a sale being completed if both the buyer and seller start with realistic expectations.

•Improve the business' real or perceived value.
•Choose a good time to buy or sell.
•Negotiate better terms.
•Complete a purchase more quickly.

1.2 To raise equity capital.

•A valuation can help you agree a price for the new shares being issued.

1.3 To create an internal market for shares.

•A valuation can help you to buy and sell shares in a business at a fair price.

1.4 To motivate management. Regular valuation is a good discipline. It can:

•Provide a measurement and incentive for management performance.
•Focus management on important issues.
•Identify areas of the business which need to be changed.

http://www.is4profit.com/business-advice/finance-and-money/valuing-a-business/why-value-the-business.html

Price/earnings ratio

5 Price/earnings ratio

The price/earnings ratio (P/E ratio) is the value of a business divided by its profits after tax.

Once you have decided on the appropriate P/E ratio to use (see below), you multiply the business’ most recent profits after tax by this figure. For example, using a P/E ratio of 5 for a business with post-tax profits of £100,000 gives a P/E valuation of £500,000.

5.1 P/E ratios are used to value businesses with an established, profitable history.
• P/E ratios vary widely
Multiple values
A small unquoted business is usually valued at between five and ten times its annual post-tax profit. Previously — most notably in the IT market — the ratio has exploded, with some valuations being drawn from multiples of 70 or more. However, the differential has closed significantly, with IT-based companies seeing the sharpest drops.
Following the so-called ‘correction’, commonly accepted earnings multiples to value quoted firms range from nine or ten to 25, although some exceptions remain.

5.2 Quoted companies have a higher P/E ratio. Their shares are much easier to buy and sell. This makes them more attractive to investors than shares in comparable, unquoted businesses.
• A typical P/E ratio for a large, growing quoted company with excellent prospects might be 20.
• Typically the P/E ratio of a small, unquoted company is 50 per cent lower than that of
a comparable quoted company in the same sector.

5.3 Compare your business with others.
• What are your quoted competitors’ P/E ratios? Newspapers’ financial pages give historic P/E ratios for quoted companies.
• What price have similar businesses been sold for?

5.4 P/E ratios are weighted by commercial conditions.
• Higher forecast profit growth means a higher P/E ratio.
• Businesses with repeat earnings are safer investments, so they are generally awarded higher P/E ratios.

5.5 Adjust the post-tax profit figure to give a true sustainable picture.
How to calculate profit
If you are considering buying a business, work out what the ‘true’ profitability is.
A Compare the owner’s stated profits with the audited figures.
• Question any differences.
B Look for costs which could be reduced under your ownership. For example:
• Consultancy fees.
• Payments to the owner and to other shareholders.
• Unnecessary property leases.
• Supplies — is there a cheaper supplier?
• Overlapping overheads.
C Look for areas to ‘restate’ (the accountancy term for changing a figure from one kind of cost to another). For example, money spent on software development may have been capitalised by the owner. You might consider that it should have been treated as a cost.
• Use your own accounting policies when calculating the business’ profits.
This will often result in a significantly different profit figure.
D When looking at future profits, bear in mind the costs of achieving them. These may include:
• Servicing increased borrowings.
• Depreciation of investment in plant, machinery, or new technology.
• Redundancy payments.
The arrival of new management often leads to major changes which may mean higher costs and lower productivity in the first year.


http://www.iod.com/intershoproot/eCS/Store/en/pdfs/cf1val.PDF

****How much is your business worth?

How much is your business worth?
If you are thinking of selling up, what could you get for your business?


General Principals
The largest influence on the price you will get for your business is the Law of Supply & Demand. If, when you sell, there are plenty of buyers with ready cash and few sellers, you will get a good price. If the converse is true, you will either not get a good price or, even worse, you may find you cannot sell up.

Generally, people do not buy a business for what it is; they will buy for what the business does for them. Namely earn them cash to repay their investment, provide them with a living, and build for the future. With cash (not profits) uppermost in their mind on the first two of these, the price is often based on something called 'EBITDA'. EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortisation) is an accountancy term that represents the sustainable cash profits of the business assuming nil borrowing costs.

To value the business, a multiple is applied to EBITDA. The Law of Supply & Demand essentially dictates the multiple for a particular business sector, or any part of it, or any particular firm. There is no universally agreed multiple for a particular sector, or firm, and multiples vary widely between and within particular sectors depending on a number of factors, but principally the certainty and size of the future cash flows of the business. The multiple applied to your business will depend on a combination of factors, we go into some of these factors in detail below.

Pricing a business is thus more of an art than a precise science. It is not merely a calculation based on two predetermined numbers, and valuers, purchasers and vendors often arrive at differing figures. At the end of the day it is you who has to be satisfied that you have got the best deal under the circumstances.

To get the best price, the main issue you should concentrate on is timing. When the business is ripe for sale, it is often not the right time for you personally or there are too few purchasers with ready cash. All other permutations apply, except the one where all the circumstances fit together neatly. Consequently selling your business generally involves some form of compromise. This makes the decision more difficult for you, especially if you are emotionally tied to the business. There is always a lot going on in the business when you sell, negotiations are intense, and feelings high: selling is a stressful time for you. So it is important that you plan in advance how you are going to sell the business. Only by doing so will you maximise the price you will get. When planning, you should bear in mind the following:

Size
Forget the old maxim, size is important. Large firms attract bigger multiples and more interest than smaller firms because they are perceived as being less risky. Larger firms are less likely to fail and are less reliant on the owner's involvement. Your firm, however large it grows in its niche or how profitable it becomes, may be too small to attract the right purchaser, namely the one with cash. Thus ignore the price achieved for one of your larger, more inefficient, competitors: you may never achieve a similar multiple however good your business is.


Growth
Growth prospects are one of the more major factors affecting the multiple. Buyers will pay more for businesses with higher growth rates as they repay their initial investment quicker than those with low or no growth. Consider selling up before turnover or profits have levelled out. This may go against the grain where you have put in place the basis for such growth, but increasing the multiple, as opposed to increasing the EBITDA, will have a bigger impact on the price you achieve.

Profitability
High gross margins and good levels of cash generation from profits give buyers more flexibility going forward and reduce the risk of the investment proving bad. Buyers will pay more for businesses that consistently report better than industry average figures.

However, the fact that you operate an extremely tight ship may put a buyer off paying too high a price. Buyers will look for easy wins/cost savings, so if a buyer identifies areas where he can make large efficiency savings or growth that could make your company more valuable to him. It is often worthwhile specifically targeting potential purchasers able to achieve such synergies.

Sector
Some sectors attract better multiples than others. There are a number of reasons for this: fashion (such as the dot-coms, energy businesses etc); estimates as to future growth prospects; robustness at times of boom and bust etc. In general, the more certain the future cash flows of a sector, or company, the higher the multiple.

However, some niches within a sector can command a premium from time to time, depending on the then demand for the particular product/service. Building a 'sustainable competitive advantage' and 'Unique Selling Point(s)' in a small niche can produce a handsome price at a time of boom in that sector generally and a better than average price when times are bad.

Business Mix
Diversification, although often reducing operating risk, does not always add to value: it can reduce the value of the overall business. Buyers may only be willing to take on that part of your business that fits in well with theirs; they could either discount the overall price, leave you with the part they do not want or, in the worst case, you could find your business un-saleable. It may be safer to stay in a particular part of the sector, especially for smaller businesses, as it can be difficult to find a buyer who will appreciate diversity.

Customer Base
The quality of your customer base is one of the main factors influencing the multiple used. Customer bases made up of blue chip clients in growing industries attract higher multiples, particularly if there are opportunities for the buyer to sell additional services in to them. If specific customers, or customers in a particular industry, make up a large part of your business, it will affect your pricing, because buyers will see you as having too many eggs in one basket.

Other Factors
Another important component is the strength of the balance sheet. Once buyers have bought a business, they want to focus on growing it and integrating it into their own organisation, rather than deal with historic balance sheet problems.

Buyers will assess the former owner's management of working capital. Businesses with a history of good cash, debtor, and creditor management attract higher multiples than those with a poor track record.

Other balance sheet factors that can influence a firm's value such as the amount of bank / factor debt, and any impending litigation.

The Deal
It is important to many buyers to retain the owner, at least for a period of time, to help introduce them to customers and make sure staff are comfortable with the new regime.

Often a buyer will agree to pay an incentive (this is termed an 'earnout') to the owner to encourage him to stay and to seek to avoid bearing the entire risk of the acquisition. Buyers often look to pay the former owner a share of profits earned over a two or three year period.

Earnouts can constitute a major part of the purchase price. The smaller the company, the more uncertainties there are that could affect how the business might perform, and thus the more likely it is that the buyer will seek an earnout. With planning an exit taking up to two/three years, and the earnout a similar period, it could be five years before you can book your sun lounger fulltime.

Earnouts is one area where your advisers really earn their money. Earnouts create conflicting interests between the current and former owners of the business; there is a risk that the buyer will look to reduce or defer profits in order to minimise the earnout paid. The former owner will look to maximise profits and hasten their recognition. With the former owner having little or no influence post sale over strategy, accounting policies, expenditure etc, there is a very real risk that he could receive less than originally envisaged for the business. It is important that your advisers protect your position wherever possible.

There is a balancing act to be struck, you will have to decide how much money you are willing to wait for and form your own view of the risks involved based on the likely future profitability of the business and your assessment of the purchaser, as against accepting a lesser, but more certain, sum now.

Today's Market
At the end of the day, any business is only worth what you can get for it at the time you sell it. A mathematical calculation of value is a mere indication of potential worth, a discussion tool to be used during the negotiation process. Confidence levels set the level of demand for your business, and in turn how much purchasers may be willing to pay for it. Whilst any downturn will ultimately effect multiples, to get maximum value and increase the certainty of a sale, it is more important than ever that owners considering selling prepare and position their business ready for sale early, and that during the sale process is carried out in such a way as to target purchasers with the right fit, hunger and cash to complete a deal.


http://www.startinbusiness.co.uk/features/features/29_01_2003_biz_valuation.htm

How To Value A Business

How To Value A Business
Accurately valuing a small business is often the most challenging part of the process for prospective business buyers. However, it doesn't have to be an overwhelming or difficult undertaking. Above all, you should realize that valuation is an art, not a science. As a buyer, always keep in mind that the "Asking Price" is NOT the purchase price. Quite often it does not even remotely represent what the business is truly worth.

Naturally, a buyer's valuation is usually quite different from what the seller believes their business is worth. Sellers are emotionally attached to their businesses. They usually factor their years of hard work into their calculation. Unfortunately, this has no business whatsoever being in the equation.

The challenge for you, the buyer, is to formulate a valuation that is accurate, and will prove to provide you with an acceptable return on your investment.

There are several ways to calculate the value of a business:
Asset Valuations: Calculates the value of all of the assets of a business and arrives at the appropriate price.
Liquidation Value: Determines the value of the company's assets if it were forced to sell all of them in a short period of time (usually less than 12 months).
Income Capitalization: Future income is calculated based upon historical data and a variety of assumptions.
Income Multiple: The net income (profit/owner's benefit/seller's cash flow) of a business is subject to a certain multiple to arrive at a selling price.
Rules Of Thumb: The selling price of other "like" businesses is used as a multiple of cash flow or a percentage of revenue.
Let's look at each to determine what's best for your purchase:
Asset-based valuations do not work for small business purchases. Assets are used to generate revenue and nothing more. If a business is "asset rich" but doesn't make much money, how valuable is the business altogether? Conversely, if a business has limited assets, such as computers and office equipment, but makes a ton of money, isn't it worth more?

Income Capitalization is generally applicable to large businesses and most often uses a factor that is far too arbitrary.

The "Rule of Thumb" method may be too general since it's hard to find any two businesses that are exactly the same. Valuation must be done based upon what you, as the buyer, can reasonably expect to generate in your pocket, so long as the business's future is representative of the past historical financial data. Notwithstanding this, the "Rules of Thumb" methodology is an good place to start but is a bit too broad to consider by itself.

The Multiple Method is clearly the way to go. You have probably heard of businesses selling at "x times earnings." However, this can be quite subjective. When buying a small business, every buyer wants to know how much money he or she can expect to make from the business. Therefore, the most effective number to use as the basis of your calculation is what is known as the total "Owner Benefits."

The Owner Benefits amount is the total dollars that you can expect to extract or have available from the business based upon what the business has generated in the past. The beauty is that unlike other methods (i.e. Income Cap), it does not attempt to predict the future. Nobody can do that. Owner Benefit is not cash flow! It is, however, sometimes referred to as Seller's Discretionary Cash Flow (SDCF).

The theory behind the Owner Benefit number is to take the business's profits plus the owner's salary and benefits and then to add back the non-cash expenses. History has shown that this methodology, while not bulletproof, is the most effective way to establish the valuation basis of a small business. Then, a multiple, based upon a variety of factors, is applied to this number and a valuation is established.

The Owner Benefit formula to use is:
Pre-Tax Profit + Owner's Salary + Additional Owner Perks
+ Interest + Depreciation less Allocation for Capital Expenditures

Why Add Back Depreciation?
Depreciation is an expense that allows a business to deduct a certain amount of money each year from an asset so that its purchase value is reduced by its overall useful life. As an example: if the business buys a $25,000 truck and its useful life is estimated at 5 years, then each year the company can deduct $5000 off its income to lessen its tax burden. However, as you can see, it is not an actual cash transaction. No money is physically leaving the business or changing hands. Therefore, this amount is added back.

Why Add Back Interest?
Each business owner will have separate philosophies for borrowing for the business and how to best use borrowed funds, if necessary at all. Furthermore, in nearly all cases, the seller will pay off the business's loans from their proceeds at selling; therefore, you will have use of these additional funds.

A Note About Add-Backs
After completing any add-backs, it is critical that you take into consideration the future capital requirements of the business as well as debt-service expenses. As such, in capital intensive businesses where equipment needs replacing on a regular basis, you must deduct appropriate amounts from the Owner Benefit number in order to determine both the true value of the business as well as its ability fund future expenditures. Under this formula, you will arrive at a "net" Owner Benefit number or true Free Cash Flow figure.

What Multiple?
Typically, small businesses will sell in a one-to three-times multiple of this figure. Now, this is a wide range, so how do you determine what to apply? The best mechanism I have found is that a one-time multiple is for those businesses where the seller is "the business." In other words: "as out the door goes the seller, so too can go the customers." Consulting businesses, professional practices, and one-man businesses come to mind.

Businesses that have a strong track record, repeat clients, historical pattern of growth, more than 3 years in business, perhaps some proprietary item, or an exclusive territory, a growing industry, etc., will sell in the 3-times ratio. The others fall somewhere in-between.

So now the big question: what number/multiple do you apply to the Owner's Benefit number? The answer is simple: nearly all small businesses will sell in the 1-to-3 times Owner Benefit window. Of course, this is a very wide range.

Also, the actual total Owner Benefit figure will impact the multiplier. As the Owner Benefit number increases, so too will the multiple. As an example, a business generating $200,000 in OB, may be worth a 3 times multiple, but one generating $500,000 or $1,000,000 can be worth a four or five times multiple.

The Rules to Apply To Establish A Multiple:
You also want to calculate the Return on Investment (ROI) that you can expect to achieve when buying a business. Let's say that you have $100,000 for a down payment. If you go to Las Vegas and let it rip on "17 black," well you should be entitled to enormous odds. Wouldn't you agree? On the other hand, if you invest it in commercial real estate, which is a solid, stable investment, then 10% return on your money seems about right, doesn't it? In fact, when the real estate market heats up, the return cvan diminish to 5% or so, and still investors are satisfied.

Buying a business is clearly a greater "risk" but definitely far less than gambling it at a casino and so you should expect something in-between. I've always felt that a 25% return on your investment should be the minimum and you can, if negotiated well, get as high as 35% -50% ROI.

If You're New At This, Here's What To Do:
If you don't know how to read an income statement, then learn. It's important for this process. It's simple, and can be done quickly.
Work with your accountant, if necessary, to determine the true Owner Benefits of the business. Be careful about the add-backs. Make certain that any benefits being added back are not necessary expenses needed to run the business.
You can only add back something that has been expensed.
Calculate a multiple in the 1-3-times window based upon the business's strengths and weaknesses. Note that the multiple will increase along with the Owner benefit figure.
Determine your investment level and an acceptable ROI.
Understand that value is personal.
If the business is right for you, it is all right to pay a slight premium, but not to drastically overpay.
Consider applying other valuation formulas simply as a test to your figure.

Professional Valuations: Do You Need One?

For most small businesses, hiring a professional to perform a valuation is not necessary. First of all it is expensive, and more often than not, it simply does not reflect reality. I read a valuation recently on a local company handling specialized telecom components in a very restricted marketplace doing $700,000 a year in sales and netting $100,000. The valuation started off: "The company is focused upon the specialized B2B telephony arena and operates within a broad industry which generates annual revenues of $42 billion in North America. Leading competitors include Nortel, Cisco….." I threw out the entire report after reading that one sentence. Why? How on earth can you possibly compare a $42 billion dollar industry and a $700,000 local distributor of telephone systems? Don't waste time or money getting a professional valuation done for a small business acquisition. Let the seller do that if they so choose. If you want to look at a variety of scenarios, there are some very good, inexpensive software packages available that will do the same thing at a fraction of the cost.

The Key Points:
Remember that valuations are not scientifically based; they're subjective.
Use a variety of methods.
Owner Benefits is the number on which to base your multiple
Uncover how the seller established the asking price
Valuation is a personal formula - What's the business worth to YOU?
Consider the potential return on your cash investment
Final Word: Never, ever buy a business just because the price is right - first and foremost be certain that the business itself is right for you!

About the Author
Richard Parker is the author of How To Buy A Good Business At A Great Price ©, the most widely used reference resource and strategy guide for buying a business. This comprehensive simple to follow guide contains 420 pages of expert tips, proven strategies and winning negotiating techniques. Mr. Parker has purchased ten small businesses in the past 14 years. As President and founder of Diomo Corporation - The Business Buyer Resource Center, his materials have helped thousands of prospective small business buyers realize their dream of business ownership (click here to read some of their stories). His programs are sold in over 50 countries. Available in hard copy or via immediate electronic download. To order a copy click here. Review the complete course outline.

http://buying.businessmart.com/how-to-value-a-business.php

Valuing a Business

Valuing a Business
Last updated: 7/11/2008 View printable version

Selling your business will probably be the largest financial transaction you will ever undertake. Getting the right price is crucial.

You will have worked hard over years, maybe even decades, to build a successful company, and will want to maximise the amount you receive; realising its full value will be the ultimate reward for all your hard work and dedication.

And going into a potential deal with an idea of the figure you expect to negotiate enable you to manage the process far more effectively.

Before thinking about approaches to the so-called ‘art’ of valuation, you should consider your reasons for selling. Most advisors recommend formulating an ‘exit strategy’ before you even start a business; selling it when you have achieved your objectives, financial or otherwise, is the most common route.

Selling for the right reasons

Although many business owners continue driving forward well beyond their planned exit point, it’s worth remembering the old maxim: “it’s better to sell out than burn out.” Why not cash in while you are still young and healthy and enjoy the proceeds from all your hard work?

But even in a successful business, a sale can be precipitated by other factors – personal problems, for example, or disagreements among partners or directors. You might receive an unsolicited approach from a company, offering unimaginable amounts of cash for your business. More commonly, you might realise that the current economic climate is ideal for a seller – and not necessarily because of any wider indicators (unheard of purchase prices for similar companies, for example).

Too many sellers choose to exit when their business enters a downturn, when the value of their business looks lower to vendors. In an ideal world, you should aim to sell when your business looks set for growth: when turnover and profit is up, and when buyers will be desperate to get a share of the action.

Of course, some businesses are sold because the owner feels they are unsuccessful or are likely to become so in the future – but this doesn’t mean they are worthless. The right vendor – one that knows the sector – could find a business like this more attractive than a thriving one, because he or she might have the capital or resources to provide the missing link that would trigger growth and quickly boost its value. Even if a company isn’t a ‘cash cow’, it will, in most cases, have some form of assets, real or otherwise, that will represent value to the right buyer.

Valuation is an art, not a science

Understanding the valuation process will allow you to understand the ‘mind’ of that buyer. It will also help you to maximise the value of the business – by realising what you need to do to prepare a business for sale.

Many commentators claim valuation is an art, not a science. Renowned financial journalist Michael Brett once quipped that, in that case, it is the only form of art that regularly appears on company balance sheets.

What is really meant by this phrase is that valuation involves a lot of guesswork and lateral thinking. There is no ‘right’ figure – it could be worth half as much to one buyer as another. If your main product is a widget and demand suddenly surges in Brazil, this ratio could be one to three, or one to 10 if investment bankers have suddenly decided to take an interest in your sector.

If you are selling a house, valuers can use the sale price of other houses in the same street that were sold recently to reach a figure. But this method does not work well in valuing a business: it is highly unlikely that one with the same number of employees in the same part of the country will have been sold within the past month or so.

Valuations, even when carried out by experienced corporate financiers, can go horribly wrong – for example, Ford bought Kwik-Fit for £1bn in 1999, only to sell it for less than half the price three years later. Conversely, there are a host of examples of stock market analysts criticising acquisitions that subsequently outperform all expectations.

Nevertheless, there are four ‘models’ you should consider using to estimate the right price for your business:

• asset-based,
• price/earnings ratio,
• entry cost and
• discounted cash flow.

Some are more appropriate to particular sectors or company types than others, but there is no absolutely correct approach for any business.

Throughout the process, you will need to bear in mind what ‘components’ your business has: the assets it owns, the goodwill it has with customers and suppliers, and the expertise of its employees.

The asset-based approach is the most conservative of all valuation models. It is appropriate for businesses such as property companies or manufacturers, where assets form a large percentage of the ‘worth’ of the business (in the former case, buildings or development sites; in the latter case, expensive tools or machines). This method gives you a rough idea of the minimum price you can expect to negotiate – a financial comfort blanket.

To use this method, you simply add up the value of your assets and subtract any liabilities. Using the figures in your accounts – the net book value – is a good starting point, but remember that accountants are obliged to be prudent; they must give the minimum the assets could be sold for.

You will need to adjust those figures to reflect changing circumstances and market value. For example, have assets gone up in value? Or would they be difficult to dispose of, whatever the original cost? Has your accountant exaggerated the possibility of bad debts? In your calculation of liabilities, remember to include the company’s obligations – for example, rent or redundancy payments.

Price/earnings ratio

The price/earnings ratio is usually the most familiar valuation method to people with a modicum of business knowledge. It’s the most common way that analysts compare the values of companies quoted on the stock exchange. It’s not always appropriate for smaller, unlisted businesses as it can only really represent the value of established companies with a history of steady profit.

A value is determined using this method by dividing the market value per share by the post-tax earnings per share. So if the value of a single share on the stock market is 100p and the post-tax earnings per share are 5p, then the price/earnings ratio is 20. This means then that the business will be valued at 20p for each 1p of current earnings. So the higher the ratio, the higher the value you place on the business.

According to the Institute of Directors (IoD), a small unquoted business is usually valued at between five and 10 times its annual profit, depending on its history, potential and other market factors; a large, growing quoted company with good prospects can have a P/E ratio of over 20.

The IoD recommends looking at newspapers such as the Financial Times to gauge historic price/earnings ratios for companies in your sector, and adjusting them accordingly – it says that the P/E ratio for a small private company is around half of that of a listed company in the same sector. However, it is very difficult to get figures for comparison for other privately owned enterprises, as the details of the actual deal will remain confidential, with speculation in the trade press or clauses tying in the vendor often inflating the real figure.

Nevertheless, it should be possible to get a rough range for the P/E ratio. And of course, as mentioned earlier, you will have begun preparing your business for sale well in advance of making any concrete plans, taking measures to increase the apparent profitability of the business.

Calculating entry cost gives you an idea of how much it would cost to build a start a business and build it to the same size and with the same profits as the one being sold. To do this, you have to work out how much it would cost to purchase your assets all over again, develop the products, recruit and train the workforce, and build up a customer base – all from scratch.

You must also be quite brutal with your business and put yourself in the buyer’s shoes: if the business was located elsewhere, or used different raw materials, would it have a lower entry cost?

Finally, there is the most technical of all methods: discounted cashflow. Like the price/earnings ratio, it is best used for businesses that are stable, mature and generate cash, i.e., enterprises in which you have confidence that the returns and profits will at least match the historic values for the next decade or so.

To calculate this, establish the estimated profits for a given time period in the future. You then adjust this figure to take account of the diminishing value of money over time. How much would you have to leave in an account, at current bank interest rates, to produce those profits over that period of time? This will give you a ‘base figure’ for how much a person might be prepared to pay – but any company will be riskier than investing in a savings account. So replace the bank interest rate with a higher figure reflecting that greater risk (which will produce a lower initial sum).

For example, a company makes a profit of £10k per annum, which is forecast to remain steady for the next 10 years. Let us assume our potential buyer wants to achieve a 10% rate of return. But £10k received in five years time is not worth the same as £10k received today – because if I received that £10k today I could put it in a bank (where let us assume there is a 5% interest rate) and in five years time it would be worth £12,763. Working backwards, then, £10k received in five years’ time is actually worth £7,835 today, whereas £10k in 10 years’ time is actually worth £6,139 today. Adding all these figures together will give the buyer an idea of how much he should pay now to receive the returns from the business in the future.

Although there is no right approach for any one business, certain industry sectors use industry-standard ‘rules of thumb’ as shortcuts to valuation. These quick rules are also commonly used in the trade press to discuss the dynamics of the industry. For example, investment management companies are rated on the percentage of fund under management; estate agents are valued on the number of branches they have; and suitable prices for nursing homes are worked out on the basis of the number of beds. Retail and leisure businesses – such as pubs – tend to use standard multiples of turnover or profit after tax.

The ‘multiplier’ used when calculating the value in this way will vary depending on the security of the income. Sectors in which personal relationships are of paramount importance tend to use lower multipliers than asset- or technology-reliant businesses, for obvious reasons.

If you or your colleagues are an obviously key ingredient of the company’s success, buyers may well offer a higher price if you are prepared to commit to staying on as an employee or consultant for a fixed period of time. This reduces disruption and smooths the transition to new owners. However, the buyers may offer to pay a second sum at the end of that period – a risky route if they already own companies that are not entirely solvent.

Whatever the sector, though, buyers tend to regard bigger businesses as more secure – they have greater resources with which to weather any unforeseen economic storms. Buyers will pay more for such reliability.

Businesses can have other advantages that will increase the security of their profits. For example, a business might have intellectual property rights over a particular manufacturing process, recipe or marketing logo; or it might have a contract with a major multinational or with the government.

The nature of the buyer

Finally, the value of the business will also depend on the nature of the buyer. Acquirers will generally fall into two categories:

• financial and
• strategic.

A financial buyer, such as a venture capitalist, will generally look at your business in isolation, analyse the viability of its profits, and examine whether it could increase them if it were to streamline the company.

A strategic buyer, on the other hand, will be in the same or a related sector. Combining your business with his might enable him to cut costs in a way not possible for the financial buyer. He could centralise the sales and marketing function, for example. This type of buyer is also likely to have a greater understanding of – and faith in – the sector, and, consequently, your business model.

But while strategic buyers tend to be able to offer higher sums, they are few and far between.

Approaches from competitors are also dangerous. Do you really want to give a potential buyer divulge the mechanics of your business, only for him or her to abort the sale and remain a competitor? Then, he or she would be equipped with knowledge of your weak points, which he or she could then exploit, and your strengths, which he or she could then replicate?

One of the great advantages of knowing about valuation techniques is that it allows you to see what steps you can take to increase the value of your business.

http://uk.businessesforsale.com/uk/valuing-a-business.aspx

Valuing a Business: The Buyer's Perspective

 

Valuing a Business: The Buyer's Perspective
Last updated: 10/25/2007 View printable version

 

 

Often times, public company data is used when attempting to value a privately-held firm. This comparison usually requires substantial adjustments to offset the risks inherent in the privately-held or closely-held company. These potential risk characteristics are usually elements that are overlooked by sellers, but not by potential buyers.

 

Sellers obviously look at their companies much differently than do prospective acquirers. Owners and company officers tend to place value on different factors than a buyer. However, when it comes time to sell, it's important that the seller consider those factors that are important to a buyer.

 

Interviews with buyer prospects reveal that they are concerned with, and influenced by, the factors outlined below. They are often the basic considerations that determine whether they actually purchase the business, as well as the price they are willing to pay. It is the buyer's evaluation of these factors that can make or break a possible sale.

 

Buyers tend to look at these elements as risk factors. They also look at the expectation of future earnings. The following characteristics affect, both positively and negatively, the future earnings potential of and the risks involved in a target business.

 

Historical Earnings

 

The history of a company's earnings is very important to a prospective buyer. A long history of stable, and hopefully increasing, earnings is a positive factor in whether the buyer will pursue the acquisition.

 

Conversely, a brief history or inconsistent earnings will certainly be a negative factor. A short time frame (for example, a company that has been in business for a year or less) and erratic earnings present obvious risk factors.

 

Entrepreneurs often underestimate the costs (and time) necessary to get the company to a profitable level.

• Start-ups are difficult to sell under the best of circumstances.
• The next time period in the life of a business is after three years, at which point there is some history, and a track record is beginning.
• The third period is usually after the company has been in business for a minimum of five years. Now the company has a track record and a reasonable history of performance.

 

Growth Prospects for Both the Business and Industry

 

If the buyer is from the same industry, then he or she should already have the answers to these questions. If the buyer is from a different industry or business type, then these are very important issues.

 

Certainly, no one can predict the future, so these issues are subjective at best. Thanks to the Internet, however, information is much easier to obtain than ever before. If the buyer perceives the target business to be in a growth industry, then the valuation can be considerably higher than one that is not.

 

Depth of Management

 

Just as a skilled and well-trained workforce commands a higher value, so does strength and depth of management. Generally speaking the smaller the company, the less depth of management.

 

A business that is primarily dependent on the owner or a manager will bring substantially less in the marketplace than one that has key management in place. Many prospective purchasers also want more than one layer of experienced management in place.

 

Some buyer concerns about management:

 

Will top management stay beyond any contractual periods?
Is the current management motivated and what incentives do they need?
Are current management values, etc., consistent with the buyers?
Does current management have the leadership skills to move the company forward?
Is the depth of current management sufficient to fulfill projected growth plans?
Is current management able to handle change?
Employee Stability

 

Well-trained and skilled employees are a big asset. National studies indicate that over 50 percent of employees are unhappy with their jobs. Having a skilled and happy workforce in place is especially important for new owners without industry experience.

 

Prospective purchasers are equally concerned with the high-cost of finding, hiring and training new employees. For these reasons, companies with a well-trained, skilled and contented workforce will command a premium value. Companies that utilize low-skilled employees and have high employee turnover will bring a much lower price.

 

Terms of Sale

 

Is the company solid enough to support debt financing as opposed to equity capital? Are the company owners, if privately owned, willing to help finance the acquisition? The answers to these questions impact value. The availability of capital can be a significant factor in increasing the value to an acquirer.

 

Diversification

 

Diversification has two elements. The first is the diversification of products or services. Can they be readily expanded? Do the products or services just fill a niche and therefore limit expansion? What limitations does the company have, such as customer or supplier restrictions?

 

The second element is geographic. Providing the product or service on a national level certainly increases value and decreases the risk to the buyer. Conversely, only local or regional distribution reduces value and increases risk.

 

Industry characteristics that increase value

 

Industries with strong trade or professional associations
Industries with low failure rates
Industries with any type of regulation, licensing, patents - anything that might restrict the amount of competition
Industries with established products or services coupled with stable pricing

Competition

 

Companies in very competitive industries may have less value than ones with little or moderate competition. Heavy competition can lead to lower prices creating lower volume and profits. However, concentrated competition, for some businesses, such as auto dealers clustering in auto malls, can actually increase sales.

 

Business Type

 

This element is most likely to be in the "eyes of the beholder." The buyer's perception of risk may focus almost entirely on the type of business or industry. Businesses that are easily started obviously have less value than those that are equipment/capital intensive or require very skilled workers or specialized knowledge. Industry trends can play an important role in the value of a business.

 

Some industries seem to be simply more "popular" than others. Manufacturing represents less than 10 percent of all businesses, but the demand for this type is very high. The demand for retail businesses that must compete with the large "box" stores is very low.

 

Location and Facilities

 

A well-located office and/or facility will, at least psychologically, increase value. Well-maintained fixtures and equipment will definitely increase value. Everything else being equal, an attractive plant with well-maintained equipment located on the "right side of the tracks" will have a higher value than one without these advantages.

 

Summary

 

The business characteristics described above outline some of the pitfalls or risks in using public company data when looking at the privately-held or closely-held company. Buyers obviously - and sellers certainly - should be aware of the factors or characteristics described above as they heavily influence the ultimate value of a company, the time it takes to sell, and sometimes whether it will sell at all.

 

Note: Much of the above information is based on an article contained in the Mergers and Acquisitions Handbook of Small & Midsized Companies, published by John Wiley & Sons.

 

http://us.businessesforsale.com/us/valuing-a-business-the-buyers-perspective.aspx

Inventory Valuation: Tricks and Traps!

by Toby Tatum

Buying or selling a small business, if done in a way that minimizes the potential for purchase negotiations to fall apart or for post-transaction animosity—or possibly even litigation—between the buyer and the seller, can be a complicated process. As a business broker and as a former business owner who has bought and sold several restaurants, I have experienced first hand dozens of tricks, traps and unpleasant surprises that lie waiting to snare unsuspecting buyers and sellers. I addressed all of these things in my book, Anatomy of a Business Purchase Offer.

There is one incident that I'll tell you about here that I encountered as a business broker assisting a client with selling his discount liquor/convenience store. It had to do with the amount the buyer would pay for the seller’s inventory.

In this case, which is typical, the purchase offer indicated the amount the buyer would pay for the inventory on hand at close of escrow. The offer stated that the buyer would purchase the inventory at the seller’s cost and included the caveat that the price stated in the purchase offer was only an estimate; that the exact value of the inventory would be determined via a physical count to be taken immediately preceding close of escrow.

As agreed between the parties, in the early morning hours on the day escrow was to close, the seller had an inventory counting service come into his store, count every product on the shelves and note the retail price of each item. The seller therewith came to the closing meeting with an exact representation of the value of his inventory at retail. And here is where the transaction process fell apart.

During the course of purchase negotiations, the seller told the buyer that, on average, his merchandise’s retail price was 30% above his wholesale cost. So, with a letter from the inventory counting service stating that the value of the seller’s inventory at retail prices was determined to be $130,000, the buyer agreed to pay 70% of that amount, or $91,000. The seller said that was not enough, an argument ensued and the buyer, together with the business broker assisting him, walked out of the meeting. The deal had fallen apart at the very last stage in the process.

Fortunately for me at least, since I wasn’t going to get paid unless the deal closed, the buyer and seller got back together later that day and consummated the transaction. The buyer agreed to pay the seller $100,000 for his inventory instead of the $91,000 he previously insisted was the correct amount.

So, whose calculation of the seller’s cost for the inventory was right, the buyer’s or the seller’s? I’ll give you a hint: I was representing the seller. Since the seller’s merchandise was marked up 30% (on average) above its wholesale cost, then the cost of goods sold reflected on his Profit & Loss statement was 76.9%. For example, if an item cost $1.00 and is sold for $1.30, the cost of goods sold expressed as a percent of the selling price is $1.00 divided by $1.30 which equals 76.9%. Therefore, once the retail value of the inventory was determined to be $130,000, the correct way to calculate its wholesale cost was to multiply that amount by the seller’s cost of goods sold of .769 as reflected on his P&L. $130,000 times .76923 = $100,000.

In the example I just cited, determining the wholesale cost of a business owner’s inventory given its retail price is simple. However, not all value determinations are this simple. In some cases it may be best to separate merchandise by the categories appearing on the profit and loss statement and calculate the wholesale cost of each category using the method described above. In other cases, the best way is to match each item of inventory with the vendor’s invoice—it all depends on the unique circumstances of a particular business, what’s reasonable and practical and what the buyer and seller can agree upon. I recommend that the buyer state the valuation methodology for the inventory in the offer itself. Doing so should avoid the kind of unfortunate incident I have related here.

A few days later the buyer asked me to meet him at the store he had just purchased. He said he wanted to show me something. When I met him at his new business he showed me several items on the shelves. Although he had no proof, he said it appeared that the seller had gone through his entire stock of merchandise the night before the escrow closing day and placed new retail price stickers on everything—at higher prices than his standard 30% mark-up!

Be careful, it’s a jungle out there!


http://www.businessbookpress.com/articles/article103.htm

VALUING THE BUSINESS

Valuing the business is not as hard as you think, but you should never completely rely on a broker's or seller's estimate as to what a business is worth. Remember that buying a business is fundamentally an investment and consequently the business is worth only as much as its ability to generate profits for you based on how much money you must put into it. If you are going to work in the business as most people do, then the business should also pay you a fair wage in addition to the profits. The best way to determine a business's value is to work backwards from the available profits that a seller can prove.

 

For example, let's say that a business has a total of $100,000 pre-tax profits (proven by IRS tax returns for the latest full year of operation), before allowing for an owner/manager's wage. You plan to work full time in the business (and believe me, you probably will!), and a fair wage for the work if you were to hire someone to do it is $40,000. That leaves $60,000 of available profit to work with but don't forget to deduct the income taxes that you'll have to pay on this, probably about $18,000 depending on the state and city the business is in, plus other personal factors (figure at least 30%). That gets you down to about $42,000 of profits left to be able to either

• pay off the debt you incur to buy the business or
• to provide you with a reasonable return on your cash investment (if you're lucky enough to have this much cash).

 

There are many ways to work with this $42,000, but most lenders of money to buy a business, whether they are the sellers themselves or others, want to see a relatively short payoff term (let's say 5 years) and a fair interest rate on the money (let's say 10%). When you do the math to determine the values of $42,000 yearly payments for 5 years at 10% interest, the amount turns out to be about $165,000. This is the approximate total value of the business and a good starting point for negotiations.

 

When I say total, I mean total. The total value and therefore the business's selling price must include all closing costs, assets, transfer and franchise fees, etc. Remember; a business is worth only as much as its ability to produce profits for you. Of course, if you change the time period for payoff of the purchase price, the interest rate, the anticipated taxes, and other factors, the price you can afford to pay for the business can go up or down.

 

 

http://www.businessbookpress.com/articles/article109.htm

Common methods of valuing a business

There's a range of ways to value a business. Valuations based on multiples of future earnings and the capitalisation of future cashflows are the most common. There are a number of common valuation methods:

1.  Businesses with a record of sustainable profits are often valued at a multiple of earnings. Profits are adjusted for any unusual, one-off items to arrive at an estimate of 'normalised' earnings. Smaller businesses are usually valued at a lower multiple than similar, larger companies.

2.  Mature, cash-generating businesses can be valued in a similar way but based on cashflow. Future cashflows are estimated and discounted - this is known as discounted cashflow. Long-term cashflow is worth less than cashflow due shortly.

3.  An asset valuation might be appropriate for stable businesses with significant tangible assets - property or manufacturing businesses, for example. Your starting point is the value of assets stated in the accounts - known as the 'net book value'. These figures are then refined to reflect factors such as changes in the value of assets or bad debts.

4.  The cost of creating a business similar to yours can be used as a basis for valuation. Costs could include buying equipment, employing staff, developing products, attracting customers, and so on. It may be possible to estimate this 'entry cost' as a benchmark of your business' value. Of course, if the cost of entry is low there's little likelihood of you achieving a successful sale.

In some industries, there are established criteria for valuing businesses, eg by the number of branches an estate agency has.

A potential buyer may use more than one method to get a range of values for your business. In the end, however, any price will be a matter for negotiation.


Pneumonic:  MADE
Multiple of Earnings
Asset Valuation
Discounted Cashflow
Entry Cost


http://www.businesslink.gov.uk/bdotg/action/detail?r.s=sc&r.l1=1073861225&r.lc=en&r.l3=1074410825&r.l2=1074400490&r.i=1074411173&type=RESOURCES&itemId=1074411241&r.t=RESOURCES

Investment Club Performance

Investment clubs serve many useful functions.

• They encourage savings. 
• They educate their members about financial markets.
• They foster friendhsips and social ties.

 Unfortunately, their investments do not beat the market. 

Ref:  Barber, Brad, and Terrance Odean, 
"Too many cooks spoil the profits:  Investment Club Performance." 
Financial Analysts Journal, Jan/Feb 2000, 17-25

Using data from a large discount brokerage firm, Barber and Odean looked at the performance of 166 investment clubs over the period 1991 through 1997.  They found that these clubs tended to purchase high-beta, small-cap growth stocks and had an average holding period of about 18 months.  They found that 60% of the clubs underperformed the market, by an average of 3.7 percentage points per year.