****Buying & Selling a Business: Determining The Value Of A Business

 

Buying & Selling a Business:
Determining The Value Of A Business
Source: Small Business Management

 

The most difficult step in buying or selling a small business is probably determining what the business is worth as a going concern.

 

Many judgment decisions must be made. Yet before negotiations can continue successfully, a value must be established. The value must be acceptable to both buyer and seller, or further negotiation is fruitless.

 

It must result from the logical and objective efforts of all the parties involved.

 

Valuation Methods
There are two basic methods of determining the value of a business. 

• The first is based on expectations of future profits and return on investment. This method is preferable by far. It forces the buyer and seller to give at least minimum attention to such factors as trends in sales and profits, capitalized value of the business, and expectancy of return on investment.
• The second method is based on the appraised value of the assets at the time of negotiation. It assumes that these assets will continue to be used in the business. This method gives little consideration to the future of the business. It determines asset values only as they relate to the present. It is the more commonly used, not because it is more reliable, but because it is easier. The projections needed to value the business on the basis of future profits are difficult to make.

 

Looking Ahead

 

Whichever method is to be used to value the business, the buyer should ask the seller to prepare a pro-forma, or projected, statement of income and profit or loss for at least the next 12 months. For this, the seller will prepare a sales estimate for this period along with a matching estimate of the cost of goods sold and operating expense.

 

The projected statement will reflect the net profit the seller believes possible. The buyer should then make his own estimate of sales, cost of goods sold, operating expenses, and net profit for the next year at least, and as far into the future as possible.

 

In preparing these statements, the buyer should start by analyzing the actual statements of profit and loss for at least 5 years back. He should be sure that the past and projected statements provided by the seller are correct and are consistent with the buyer's proposed future operation. He should also study general and local economic changes that will affect future business. This includes competition.

 

If the buyer is not qualified to prepare projected financial statements, he should consult an independent accountant. This will involve some expense, but the cost will be small compared to the loss he might incur if he invested in a small business with a doubtful future.

 

Financial statements and their analysis and market analysis are discussed elsewhere in this section.

 

Forecasting Sales
The most important projection to be determined in the projected income statement is the sales figure. After this number has been established, the cost, expense, and profit figures are easier to acquire. The data for projecting sales will come from past sales records of the business. The more accurate and systematic these records are, the more confidently they can be used in estimating future sales.

 

How long a forecast? A basic question is this: "Over how long a period of time is it necessary or possible to forecast sales?" Any forecast is uncertain, and the farther a forecast is projected into the future, the greater the uncertainty. While it may be possible to exercise at least reasonable control over the internal operation, the external economic and market factors make forecasting difficult because of lack of control.

 

Perhaps the best way to approach the length of the forecast is in terms of the expected return on investment. Suppose it is estimated that the business should bring a 20 percent return on initial investment. The investment, then, should be returned in 5 years. At this point, the owner would just break even on his original investment. It seems logical to project sales and profits over a span of time comparable to that estimated for return on investment - in the above illustration, 5 years.

 

Any such forecast, however, should give careful consideration to expected changes either in the economy or in the industry market that might affect the pattern of sales change. Mathematically, it is possible to forecast sales with some precision. Realistically, however, this precision is dulled because vital market and economic factors cannot be controlled.

 

Methods of forecasting sales.
There are numerous methods by which sales forecasts can be made. Most of them take their lead from the past sales performance of the company. For establishing trends or averages, 5 years of sales history is better than 3, and 10 is better than 5.

 

Perhaps the simplest method is to assume that the percentage increase (or decrease) in sales will continue and that no market factors will influence sales performance more in the future than in the past. Suppose, for example, that the rate of yearly average increase for the past 5 years has been 4 percent, and that each year has shown about this rate of increase. Then it might be assumed that sales for the next year will be 4 percent greater than the current or most recent year.

 

But what about the year following? The year after that? Can it be assumed that these years will also increase at about 4-percent level? Each additional year into the future reduces the certainty of the predictions.

 

If these negative influences limit the accuracy to such an extent, why try to forecast beyond the immediate future (1 year)? Because such a forecast forces the person making it to give at least a little attention to economic and market factors that might influence the future operation - that might, in fact, indicate that the purchase or sale of the business would not be wise.

 

With forecasts covering more than 1 or 2 years, a more detailed forecasting technique is needed. Such technique should be designed to weight out extreme variations in year-to-year sales and to give a trend or level of sales change that is more realistically oriented to probable future sales patterns.

 

No method of forecasting can set any value on external market conditions, because there is no guarantee that these conditions will carry over into the future with the same relative significance. Nevertheless, their possible influence should be considered.

 

Risk and Return on Investment
If a buyer wants to invest money in a business that is being sold, he should be concerned about receiving a fair return on his investment.

 

Many businesses can make a profit for a short time (1 to 5 years) ; not so many operate profitably over a longer period of time.

 

From the buyer's point of view, what is a fair rate of return from an investment in a small business? The rate of return is usually related to the risk factor - the higher the risk, the higher the return should be.

 

The buyer of a small business should try to determine the risk factor of the new business, though this is difficult at best and in many cases impossible. In attempting to assess the risk factor, the buyer should project the profits of the business as far into the future as possible. He should ask himself how high the risk should be normally and look for conditions that would be likely to affect the sales and profit-making capability of the business.

 

In any event, he should consider carefully the minimum return on investment that he is willing to accept. This concept of risk is important in valuing the business by capitalization of future earnings.

 

Valuing the Business by Capitalizing Future Earnings
The price to be paid by the buyer should be based on the capitalized value of future earnings. Instead, however, in most small business buy-sell transactions, price is based on the purchase and sale of assets, Profits are made by utilizing assets, of course, but actually the assets purchased are only incidental to the future profits of the new business.

 

Capitalized value is the capital value that would bring the stated earnings at a specified rate of interest. The rate used is usually the current rate of return for investments involving a similar amount of risk. The capitalized value is found by dividing the annual profit by the specified rate of return expressed as a decimal.

 

Assume for the moment that the future profits of a business have been projected for the next 5 years and are estimated to average $20,000 a year. (This is in addition to compensation for the services of the buyer and any members of his family.) What should be the sales price for the buy-sell transaction?

 

If this investment were as safe as Government bonds that yields 6 percent, the buyer should be willing to pay 333,000 ($ 20,000 / 0.06 ). If the investment is considered as safe as an investment in an excellent corporate stock that earns 10 percent in dividends and price increases, the buyer should be willing to pay $200, 000 ( $ 20,000 / 0.10 ).

 

Very few small businesses, however, have as low a risk factor as these two investments. What rate, then, should be used in capitalizing the earnings of a small business? Usually, 20 to 25 percent is considered adequate. This means that the buyer should pay between $80,000 and $100,000 for this business. If it earns the projected $20,000 a year, the buyer will recover his initial investment in 4 or 5 years. This time will be extended by income taxes to be paid on the income, but this would also be the case for most alternative investments except nontaxable securities.

 

In using a computation such as this, the importance of long run profits should be kept in mind. Unless profits are possible over a long period of time ( 10 to 15 years), investment in a small business may be a poor decision. The trend of profits is also important. If all other factors are the same, a company whose profits are declining is worth less than one whose profits are increasing.

 

Valuing the Business on the Basis of Asset Appraisal
The majority of buy-sell transactions are based on a value established for the assets of the company. This approach is not recommended, but if it is to be used, the suggestions that follow should be considered. A most important point is to find out early in the transaction just what assets are to be transferred. Usually, the seller has some personal items that he does not wish to sell. Prepaid insurance, some supplies and the like, in addition to cash, marketable securities, accounts receivable, and notes receivable usually are not sold. If the buyer does purchase the receivables, the seller may guarantee their collection, but such a guarantee should be established.

 

The assets most commonly purchased in a small business buy-sell transaction are merchandise inventory, sales and office supplies, fixtures and equipment, and goodwill.

 

Evaluating goodwill. One of the assets that must be considered in a buy-sell transaction is goodwill. Goodwill, in a general sense, arises from all the special advantages connected with a going concerns good name, capable staff and personnel, high financial standing, reputation for superior products and customer services, and favorable location.

 

From the accounting point of view, goodwill is the ability of a business to realize above-normal profits as a result of these factors. By above-normal profit is meant a higher rate of return on the investment than that ordinarily necessary to attract investors to that type of business. The value of goodwill can be computed in either of the following ways :

 

1. Capitalization of average net earnings. As explained above, the amount to be paid for a business may be determined by capitalizing expected future earnings at a rate that represents the required return on investment. The difference between this amount and the appraised value of the physical assets may be considered the price of goodwill.

 

This method uses only earnings in computing the price to be paid for the business, For that part of the calculation, it ignores the appraised value of the assets.

 

2. Capitalization of average excess earnings. This method recognizes both earnings and asset contributions. It starts with the appraised value of the assets and computes what would be a fair return on that value. If the estimated future earnings are higher than this "fair return," the difference between the two figures - the "excess earnings" - is capitalized at a higher rate, and the amount thus obtained is considered the goodwill value. This figure is added to the appraised value of the assets to give a price for the business.

 

Payment of excess earnings is often stated in terms of "years of purchase" instead of in terms of capitalization at a certain interest rate. Capitalization of average earnings at 20 percent is the same as payment for 5 years' excess earnings.

 

As the above discussion shows, the determination of goodwill usually reflects the value of profits that will be realized by the buyer above the normal rate of return; that is, the excess profits. But most small businesses that are for sale do not have excess profits. They usually show nominal profit or none at all. Often the seller makes an offer that seems quite good, but the buyer must be able to eliminate the seller's emotions and reduce all facts to workable relationships.

 

If there are excess profits, goodwill is usually valued by capitalizing them at a fixed percentage established by bargaining between the seller and the buyer. The capitalization percentage needs to be high because profits higher than a normal return are difficult to maintain. Excess profits of $4,000 capitalized at 10 percent will give a goodwill value of $40,000 ( $4,000 / 0.10 ). Capitalizing the same excess profits at 20 percent gives a goodwill value of $20,000 ( $4,000 / 0.20 ).

 

Though goodwill valuation is the first asset valuation to be discussed here, it is normally the last to be computed. Since few small businesses being sold are producing excess profits, the problem of goodwill value is not a pressing one in most buy-sell transactions.

 

Merchandise inventory.
In a service business, placing a value on the inventories is a minor problem; but in distributive and manufacturing businesses, the inventory is likely to be the largest single asset. A manufacturer, for example, has three inventories - raw material, work in process, and finished goods - and each of them presents different problems in valuation. The distributive company has only one inventory, called merchandise inventory.

 

The financial statements presented by the seller will probably reflect an inventory value different from the one assigned in a buy-sell transaction. Inventories are usually carried on the books either at cost or at the lower of cost or market. Market is defined as the current replacement cost to the seller.

 

In determining the value of inventories, the seller has to chose a method of arriving at cost. The most common costing methods are first-in-first-out (FIFO), last-in-first-out (LIFO), and average cost. These methods may give very different values and the buyer and seller must arrive at some value agreeable to both. The most common methods used in valuing inventories for buying and selling small businesses are cost of last purchase and current market price.

 

The quantity of the inventory is usually determined by a physical count. The physical inventory procedures should be decided before the count, and each inventory team should include one representative from the buyer and one from the seller. It is easy to omit items from the inventory count, and here the seller is usually in a more vulnerable position than the buyer. There is more danger of omitting items from the count than of double counting them.

 

It may be that some items of inventory are not to be sold. If so, these items should be segregated before the count begins. Another problem is determining what quality of items are to be included in the inventory. The buyer needs to be cautious when examining the inventories - in most buy-sell situations there is some inventory that is not salable. This is one reason why the buyer should employ as his representatives on the inventory team individuals who are acquainted with that type of inventory. If the buyer and the seller disagree on the value of certain items, the seller will remove these items from the list of inventory for sale.

 

When the inventory is being priced, be very careful in matching price to quantity. Be sure that the units in which the quantity is recorded and the units priced are the same. The physical count should be recorded in duplicate so that buyer and seller can each make separate extensions after all prices have been listed. After independent extensions, the two inventories should be reconciled.

 

Manufacturer's inventory.
When a manufacturing company is being exchanged, the raw materials inventory is taken and priced like the merchandise inventory of a distributive business. The work-in-progress and finished-goods inventories may present a problem. Usually, there is no market price or cost of last purchase to relate to these inventories; consequently, the seller’s cost is generally used for establishing prices.

 

If the seller has unused plant capacity or if his plant is inefficient, his costs may be inflated. Such a situation requires the help of an accountant with a good knowledge of cost accounting.

 

Store supplies and office supplies.
These two items are usually quite small. They should present no problem, though some of them may have no value to the buyer if the name of the company is to be changed. After the usable supplies have been determined, a physical inventory should be taken and priced as in the case of the merchandise inventory.

 

Property assets and accumulated depreciation.
The property-asset account normally reflects the cost of the assets reduced by a provision for depreciation. In many small business buy-sell transactions, no real property is exchanged, because the plant site is leased. The problem of establishing a value on real estate is not as acute, anyway, since the market value for real property does not fluctuate as widely as the market value for personal property, It is customary to have an independent appraiser establish a value for real property. Appraisers' findings on real property are usually more acceptable to both parties than personal-property appraisals - the real property may have multiple uses, whereas personal property consists of single-purpose assets. The book value of real property will be close to the appraisal value unless the property has been held for a long period of time or unusual circumstances have caused sudden and drastic changes of real-property values.

 

Personal-property assets.
The buyer may feel that he knows going values of the personal property and decide not to retain an independent appraiser. In addition, many individuals believe that cost or book value is a good place to begin negotiations for personal property. However, because of the many methods of computing depreciation and also because of conflicting ideas about capitalizing costs, the cost or book value may not reflect a value that is agreeable to both parties.

 

It is difficult to assign a value to personal property equipment because these assets have little value if the company is liquidated. Therefore, a going-concern value should be determined. The price to be paid for this equipment should be somewhere within the range of the cost of new equipment or the cost of comparable used equipment. For this reason, an independent appraiser can be useful, particularly if he is acquainted with the type of equipment being sought or sold.

 

The seller should realize that he may own assets that do not appear on the fixed-asset schedule. Many companies have a policy of not capitalizing any assets below some arbitrary amount ($200 or $300). A complete physical inventory should be taken.

 

If the assets are numerous and geographically dispersed, the seller may be asked to prepare a certified list of the assets giving description and location. The buyer can then test the list by verifying only selected assets at the time of the sale, but with plans to verify all of them within a certain period of time.

 

The value of personal-property assets is usually decided after considerable bargaining. It is better to assign values to individual assets rather than to make a lump-sum purchase of assets. In a lump-sum purchase, there is more chance of overlooking some asset values.

 

The buyer should try to determine the condition of the assets as well as repair and replacement requirements. If he doesn't establish the condition of the assets individually, repair and possible replacement costs may create an unexpectedly heavy drain on his working capital.

 

Income Tax Consequences
Income tax consequences of the buy-sell transaction may be an important bargaining issue if the buyer and seller are aware of them. The seller should be concerned about the amount of tax he will have to pay on his gains from the sale. The buyer should be concerned about the tax basis he will acquire as a result of the transaction. These concerns almost inevitably lead the buyer and seller into conflict in valuing the business.

 

The income-tax laws are highly technical, and the possible variations in a buy-sell situation are infinite. Because of this, a discussion specific enough to be really helpful is impossible here. Both buyer and seller should study the applicable tax laws ; and if an important decision in the buy-sell agreement is to be based on income-tax consequences, the advice of an income-tax expert should be sought. The key to tax savings is tax planning before the buy-sell contract is closed.

 

The seller should keep in mind that he must report any income-tax liability he incurs by selling a going business. Reinvesting the sales proceeds in another business will not enable him to avoid or postpones his income tax liability.

 

A Valuation Example - the Regal Men's Store
This example will help to bring the factors discussed about into better focus. It is not intended to show what should be done but to give some idea of what might be done.

 

The buyer and the seller. Joe Critser is interested in buying a men's clothing store. He has had nearly 25 years' experience in the men's clothing trade - first as a salesman in retail stores and more recently as a sales representative for Sentinel, a major manufacturer of men's clothing. Now 45 years old, Critser is interested in having a store of his own.

 

In February, Critser learns that the Regal Men's Store is for sale. James Rombaugh, owner and operator of the store, is now 67 and wants to retire, he says. He has no heirs, and no employee of the store is financially able to purchase the business. Rombaugh started the store in the late sixties and has been the sole owner since than.

 

The store. Critser's early investigation convinces him that the store has the kind of possibilities he is looking for. Although it has been operated conservatively, it has a good reputation in the community and a creditable standing in the clothing trade. The store has never been particularly aggressive in advertising, the owner has relied on repeat patronage and word-of-mouth advertising.

 

Critser suspects that part of Rombaugh's desire to sell is due to competitive pressure from more aggressive stores in the community. Sales have continued to increase about in proportion to the market in general, but gross margin and profit have been reduced because of lower overall maintained markup and increasing costs of operation. Rombaugh owns the inventory, fixtures equipment, and operating supplies and leases the building at 5 percent of net sales, with a minimum payment of $ 1,000 a month. The current lease will expire in about 4 years.

 

The preliminary discussion. Rombaugh has been well impressed with Critser and agrees to furnish necessary financial information. In their discussion to date, Rombaugh has stated that he feels the business is worth about $100,000 for the purchase of inventory, fixtures, equipment, and goodwill. He will retain all accounts receivable, but he is willing to allow the new owner an 8 percent fee for outstanding accounts receivable collected after the transfer of ownership has been completed.

 

He also wants to keep a few assets for which he has a sentimental attachment, such as a massive roll-top desk purchased when the store was first opened. Rombaugh will assume responsibility for payment of liabilities outstanding at the time of sale.

 

Critser, on the other hand, feels that the business is worth somewhat less than $ 100,000. It is obvious to him through casual inspection that some of the inventory is worth less than the original purchase price, and he doubts the value that Rombaugh would place on goodwill. He also notes that some of the display equipment is outmoded and needs replacement.

 

Before accepting or rejecting Rombaugh's price, Critser suggests that he be permitted to make his own evaluation of the business on the basis of past financial records and an appraisal of the assets. Rombaugh agrees. Following are the major elements of Critser's investigation and appraisal :

 

Past sales

 

XXX1 - $220,000

 

XXX2 - 228,800

 

XXX3 - 238,000

 

XXX4 - 247,600

 

XXX5 - 257,600

 

Forecast sales - XXX6

 

$265,000 - Critser's estimate of sales, which includes a somewhat smaller increase than the average of 3.2 percent per year between XXX1 and XXX5.

 

$268,676 - Rombaugh's estimate based on the average.

 

Five-year operating statement

 

XXX1 XXX2 XXX3 XXX4 XXX5

 

Sales $220, 000 $228, 800 $238, 000 $247, 600 $257, 600

 

Cost of goods sold 139, 980 146, 432 159, 260 160, 940 167, 440

 

________ ________ ________ ________ ________

 

Gross margin 80, 020 82, 368 78, 740 86, 660 90,160

 

Operating expenses* 62, 420 66, 352 62, 674 70, 566 74, 704

 

________ ________ ________ ________ ________

 

Profit 17, 600 16, 016 16, 066 16, 094 15, 456

 

* Includes owner's salary.

 

 

 

Projected operating statement for XXX6

 

CRITSER ROMBAUGH

 

(Buyer) (Seller)

 

Sales $265, 000 $268, 676

 

Cost of goods sold 172, 250 174, 640

 

________ ________

 

Gross margin 92, 750 94, 036

 

Operating expenses* 76, 850 75, 766

 

________ ________

 

Profit 15, 900 18, 270

 

* Includes estimate of owner's salary.

 

 

 

Balance sheet of Regal Men's Store as of January 31, XXX6

 

Assets

 

Cash on hand and in bank $20, 000

 

Accounts receivable $32, 000

 

Less estimated un-collectible 4, 000

 

________

 

28, 000

 

Merchandise inventory 49, 214

 

Sales and office supplies 1, 920

 

Fixtures 20, 000

 

Less estimated depreciation 5, 600

 

________

 

14, 400

 

Equipment 19, 000

 

Less estimated depreciation 8, 600

 

________

 

10, 400

 

Miscellaneous assets 1, 280

 

________

 

Total assets $ 125, 214

 

Liabilities

 

Accounts payable $ 11, 000

 

Payroll and sales tax payable 1, 300

 

_______

 

Total liabilities $ 12, 300

 

James Rombaugh, capital 112, 914

 

Net worth

 

________

 

Total liabilities and net worth $ 125, 214

 

Salable assets

 

Inventory at current book value $49,214

 

Sales and office supplies 1,920

 

Fixtures, current depreciated value 14, 400

 

Equipment, current depreciated value 10, 400

 

________

 

Total salable assets $75, 934

 

Valuation of inventory and appraisal of fixed assets

 

CRITSER ROMBAUGH

 

Inventory by physical count $47, 514

 

90 percent valued at current prices $42, 762

 

5 percent valued at 75 percent of current prices 1, 782

 

5 percent valued at 50 percent of current prices 1,188

 

________ ________

 

Inventory - appraised value 45, 732 47, 514

 

Usable office supplies 1, 680 1, 680

 

Fixtures - appraised value 13, 600 13, 600

 

Equipment - appraised value* 9, 400 9, 400

 

________ ________

 

Total assets-appraised value $70, 412 $72,194

 

* Independent appraiser. Excludes assets to be retained by Rombaugh.

 

How much to pay?
If Critser feels that his return on investment should be capitalized over 5 years, his offering price, based on anticipated profits for the year ahead, would be $79,500 (5 years=20 percent per year; $15,900 / 0.20=$79,500 ). If, on the other hand, the purchase was based on the appraised value of assets only, the purchase price would be $70,412 plus any provision for goodwill.

 

Since both of these figures are well below the suggested price of $100,000, negotiation will be necessary. Here are some questions that might arise :

 

1. In light of future sales and profit possibilities, are the assets worth more than the sale price?

 

2. Is the risk less than Critser anticipates? To pay $ 100,000, he would have to reduce his risk level to between 6 and 7 years.

 

3. Is Rombaugh's price too high in the light of future sales and profit possibilities under new management?

 

4. How much confidence does Critser have in his ability to realize an acceptable return on his investment?

 

5. Is the actual value of this business as a going concern closer to $68,000, $80,000, or $100,000?

 

6. How much is the goodwill of this business actually worth to Rombaugh? To Critser?

 

7. What kind of compromise might be satisfactory to both the buyer and the seller?

 

 

http://www.bizmove.com/buying/m5g.htm

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.

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