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The Ultimate Guide to Business Valuation: Part 1

How to make sure you get maximum value when buying or selling a business

Buying or selling a business will probably be the largest financial transaction you ever take on.

Settling on the right price is crucial for both sides of the transaction.

As the seller, you will have worked hard over years, maybe even decades, and will want to maximize the amount you receive. As the buyer, you will want to ensure you’re receiving maximum value for your dollar, and feel reasonably secure in the eventual profitability of the transaction.

To accomplish those goals, both parties need to be able to effectively arrive at a realistic valuation for the business in question. This guide is designed to give you the basic guidelines and powerful tips to help you do just that, no matter what unique circumstances are involved.

When and why a business sells

Most advisors recommend formulating an exit strategy before you even start a business.

The exit strategy is a strategic plan for how you will eventually cash out, or otherwise devolve yourself of ownership, since no one person can expect to own and run a business forever. Understandably, selling it when you have achieved your objectives — financial or otherwise — is the most common strategy entrepreneurs pursue.

While planning when and how you’ll sell your business years in advance is ideal, even a successful business may wind up unexpectedly for sale due to other factors like personal problems (sickness, divorce, or needing to relocate) or disagreements among business partners.

You could potentially receive an unsolicited offer from another company, often a competitor. Or, you might realize that the current economic climate is good for a seller and decide to take advantage of it.

Of course, some business opportunities are sold because the owner feels they are unsuccessful or are likely to become so in the future — but that doesn't mean their businesses are worthless.

Even during difficult economic times, entrepreneurs with cash are in the market to buy. That’s because, in most cases, businesses have some form of assets, real or otherwise, that will represent value to the right buyer.

Understanding the valuation process is important for sellers because it will allow you to understand the mindset of that optimal business buyer. It will also help you to maximize the value of the business by learning and applying what you need to do to prepare your unique business for sale.

Understanding business valuation is vital for buyers because it can help you determine if a seller is being fair and realistic in their asking price. And, if that’s not the case, this knowledge provides powerful leverage during negotiations. It also serves as a key means of identifying great buys and prioritizing potential purchases over time.

So, let’s dive into exactly what business valuation is, how it’s accomplished, and what you, as a prospective buyer or seller, should be doing to get the most out of this valuable skill.

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What is business valuation?

Put simply, business valuation is a broad umbrella term that covers numerous methods buyers and sellers can use to place a dollar figure on the total quantifiable and unquantifiable value of a company. Since both tangible and intangible assets and liabilities are often included in the transaction, business valuation is far from a simple, straightforward equation. In fact, calculating figures is only a small part of the total process.

Many experts claim business valuation is more of an art than a science. What they mean is that valuation involves a lot of educated guesswork and creative thinking.

There is truly no right answer, because the same exact business could be worth half as much to one buyer as another. So, valuations are often presented as reasonably wide ranges with qualifying factors included. This provides the best negotiating tool for buyers and sellers alike, although in most cases, buyers and sellers will arrive at different overall ranges and may still need to settle outside of them.

This is a challenge known as “the valuation gap,” which is discussed in more detail in the next section.

Due to all the factors involved, and the highly unpredictable human side of the equation, business valuation is a specialized skill that smart business owners and buyers will outsource to experts with plenty of experience. These can include business brokers, experienced attorneys, or accountants that specialize in business sales transactions.

To accommodate these varied factors, there are numerous models you can consider using to estimate the right price for a business. Some are more appropriate to particular sectors or company types, but there’s no “best” approach for any one business.

This is part 1 of our Ultimate Guide to Business Valuation.

Part 2: The Methods of Business Valuation

Part 3: Boosting the Value of Your Business

The Ultimate Guide to Business Valuation: Part 2

Unlike most tangible objects, such as a house or a car, determining the value of a business is complicated.

This is by the fact that there are no truly comparable sold properties to research in most cases.

The difference between two companies in the same industry, providing the same service, even with the same revenue, can still be so great that it’s almost a meaningless comparison.

Characteristics such as customer concentration, amount of revenue, geography, management strength, etc., are all big factors in determining a purchase price for a buyer.

This is being further exacerbated by the economic cycle.

In a downturn, for example, buyers are seeking to buy at the rock-bottom price because of the economy. And because of the overall economic situation, they perceive additional risk and seller desperation that would not likely come into the conversation in better economic times.

Sellers, on the other hand, may point to deals and valuations from prior to the downturn since it’s not viable for them to exit their business at the price the buyers are offering today.

This "valuation gap" is larger than ever, and it’s unlikely to be effectively narrowed because, as noted above, there’s no real standard for buying companies.

Both the buyer and the seller feel the other is being unrealistic, when it’s actually impossible to define what realistic is.

This seeming roadblock can be rectified, however, by a skilled business broker or other experienced intermediary. We’ll discuss more about how that generally works out in the next section.

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10 Methods for Business Valuation

Because of the inherent complexity of the task at hand, there are probably far more than ten business valuation methods used throughout the world.

Experts may argue semantics or group two or more of the following methods under the same umbrella, but every generalized list of methods you can find is likely to include reference to all of the following:

Industry-based valuation

One rule of thumb for valuation uses a simple formula to estimate the value of the business through pricing guidelines based on the industry it’s in.

For example, fast-food businesses could be historically valued based on 40% of their annual revenue, while motels may be based on a set price of $20,000 per room.

Certainly, this method gains instant points for simplicity, but a seller must keep in mind that — even within the same industry — each business has unique qualities which can raise or lower these set values.

Therefore, industry-based valuation of this nature is rarely used as anything more than a ballpark estimate or starting point early in the valuation process.

The exception may be a transaction with extremely tight time constraints or a very low price point, in which neither the buyer or the seller feels a more thorough valuation is worth the time, effort, or expense.

Comparable business-based valuation

With the availability to check out dozens upon dozens of businesses listed for sale online, owners can search for comparable businesses to base their valuation on.

This is a great source of free data on businesses that are currently for sale or have recently sold. Owners and buyers alike can look for comparable businesses, then assess what a given business is potentially worse.

If you’ve ever bought or sold a house, you’ll recognize this as the most common means of setting a reasonable price for residential real estate.

Buyers and sellers can use the sale price of other similar houses in the same neighborhood that were recently sold to reach a fair asking price.

But, like the industry-based valuation, this method does not work well in valuing a business.

Because of the natural differences between every company, it’s unlikely that even one truly comparable business can be found. Much less one with the same number of employees, same basic revenue, same market share, and in the same part of the country that’s been sold within the past month.

Asset-based valuation

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 financial advisors 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.

Asset liquidation-based valuation

A variation of the asset-based method would be to determine the liquidation cost of the business.

In this method, the value of the business would be based on the estimated cost that any equipment, inventory, receivables etc., would fetch on the open market if sold immediately.

It is often applied to companies with considerable tangible assets, such as real estate properties, but this approach can be misleading if the book value of assets (like buildings and equipment) is inflated for some reason.

The problem can be addressed by adjusting the book value to factor in asset depreciation and maintenance or replacement expenses. Fluctuations in market price of real estate should also be considered.

Other variations to the formula include tangible or economic value.

Tangible book value is calculated as total assets minus soft assets (those less tangible assets described above.) Economic book value comprises both tangible and intangible assets and adjusts their values according to current market prices.

For a business on the brink of shutting down, this is likely the best of the simple valuation methods, since it clearly itemizes the minimum value the buyer is likely to receive if the company ceases to function following the sale.

It’s therefore a popular choice for business sales that take place in lieu of filing bankruptcy or another collapse.

Successful business owners may use this method when buying out failing competitors, with the value being the competitor’s existing stock, equipment, facilities, and/or customer list.

However, the asset liquidation method again falls short in circumstances where the company being sold is still a viable business, or can easily be made such through restructuring or investment.

That’s because much of the value in a business isn't included in the raw cost of the business assets. For example, an established customer base, goodwill, brand equity, and future growth potential.

Entry/startup cost

Calculating entry cost gives you an idea of how much it would cost to start and build a business 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 develop the products, recruit and train the workforce, and build up a customer base — all from scratch.

Other entry expenses include purchase or lease of the premises, facilities, research and development, branding and advertising.

As a seller, this method requires being brutally honest with yourself and putting yourself in the buyer's shoes: if the business was located elsewhere, or used different raw materials, would it have a lower entry cost?

While this itemized approach attaches a monetary value to hard assets, it fails to effectively account for the intangible components that the owner puts into establishing the business and nurturing its growth.

As a result, it tends to lean more heavily toward the buyer’s benefit, rather than being a highly equitable valuation method. It’s often used, therefore, when the seller is highly motivated and/or under a tight time constraint.

Discretionary income-based valuation

Another simple but effective way of valuing small businesses involves determining the current owner’s discretionary income.

This offers valuable insight into what a buyer can expect to earn on a monthly or yearly basis (assuming no substantial changes are made to the company’s current situation), what their ROI is likely to be and how long it will take to realize that return.

To determine discretionary income, take the amount the owner has declared on their income tax, add in any discretionary expenses such as automobile expenses, travel expenses, salaries, interest costs for business loans and depreciation.

Then, add those discretionary expenses back into the owner’s declared income and multiply the result by 1.5 to 2.5 to come up with the final value for the business.

The multiplier provides a significant range in which to negotiate the final price based on intangible items that the equation does not factor in, as described in previous methods.

This valuation method’s greatest limitation is its assumption that the business will continue to operate unchanged after changing ownership.

This assumption depends largely on how the company is currently set up and run.

If the current owner plays in integral role in daily operations (rather than a more distant oversight role), a prospective buyer will need to very careful to determine if he or she can fill that same role in the same way. If not, the discretionary income method of valuation is likely to be misleading.

Price/earnings ratio valuation

The price/earnings (P/E) ratio is one of the most common business valuation methods, and tends to be a go-to strategy for professionals.

It's the most common way analysts compare the values of companies quoted on the stock exchange, so sellers and buyers can both place confidence in its validity.

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 $1.00 and the post-tax earnings per share are $.05, then the price/earnings ratio is 20. This means then that the business will be valued at $.20 for each $.01 of current earnings.

The higher the ratio, the higher the value you place on the business.

You could look at financial newspapers to gauge historic price/earnings ratios for companies in your sector, and adjust them accordingly — the P/E ratio for a small private company is around half of that of a listed company in the same sector.

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.

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 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.

Regardless of the size or age of the business, however, it should be possible to get at least a rough range for the P/E ratio, making it a solid choice for most circumstances.

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Discounted cash flow

Discounted cash flow valuation is among the more complex methods available, as it focuses heavily on the intangible side of a company’s value.

It’s appropriate for companies that have growth potential but lack hard assets and a financial track record.

The most common modern day example is the Web-based startup. The method deducts intangible criteria from projected cash flows or NPV (net present value).

Forecasting cash flow is not an easy task, and it’s really far more art than science.

The gamble works both ways, and sometimes, actual cash flow ends up being far greater than forecast, which is how billionaires are made in the 21st century.

Clearly, the discounted cash flow method of business valuation is not one a DIY entrepreneur or investor should focus on. For the best chance at winning this bet, you should be relying on the professionals.

To calculate the discounted cash flow, 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).

To help clarify, here’s an example using simple, round figures:

A company makes a profit of $10k annually, which is forecast to remain steady for the next 10 years.

Let’s assume our potential buyer wants to achieve a 10% rate of return.

$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, $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 they should pay now to receive the returns from the business in the future.

Multiplier valuation by sales

The above valuation applies the multiplier method to estimate how much a business is worth.

Average sales figures in a particular industry may be used to arrive at a standard multiplier factor. Trade or financial publications, industry associations and business brokers can usually provide current multiples used per industry.

The basic formula is a company's gross sales times the multiplier; for example, $50,000 gross sales x 0.25 multiplier = $12,500 value of the business.

The formula may be modified by adding other components to the equation. For a retail business, the value of its inventory is added to gross sales before multiplying it by the industry multiple.

These adjustments require experience and current knowledge if they’re going to effectively reflect the real value of the assets in question.

For instance, the stock of a retail store may be overpriced at the moment, as in the case of fashion merchandise whose value declines at the end of the season. In this case, the timing of the sale has a huge bearing on the valuation.

The validity of the industry standard multiplier is questionable because this basis alone does not give the complete financial picture.

Companies across an industry vary by size, scope of operations, production output, market share or brand value. Moreover, a host of other differentiating factors, such as cash flow and profitability, are not taken into account.

Multiplier valuation by profits

Alternatively, the multiplier number may be based on a company's profits. The price to earnings ratio can range from five to 10 times the after-tax profit.

Small businesses will fall into the lower range, while enterprises with better prospects will be assigned a higher multiple.

Business income valuation seems straightforward and easy to understand, since it uses recent profitability numbers as the benchmark. However, the reported return on investment may not reflect an accurate financial status or looming external threats.

For example, earnings can be overstated by deliberately pending a necessary capital investment.

The actual profit margin may not be as high as claimed if the owner has drawn a salary for managing the business. A rival business may set up shop in town, lure customers away and take a big bite of the profit pie.

This is part 2 of our Ultimate Guide to Business Valuation.

Part 1: Get the Maximum value

Part 3: Boosting the Value of Your Business

The Ultimate Guide to Business Valuation: Part 3

After reviewing all of the different methods of business valuation, you’ve likely picked out some things you can do to improve the value of your own business before putting it up for sale

How to boost the value of your business

By reviewing all these different methods of business valuation, you’ve likely picked out some things you can do to improve the value of your own business before putting it up for sale.

Likewise, if you’re considering buying a business, you can probably identify some fairly inexpensive improvements you could make to the company you’re investigating in order to improve the return on your investment and/or negotiate a better deal.

Here’s some pro tips that can help you accomplish this:

Stay with the company

If you or your colleagues are clearly a 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. Alternately, buyers may offer to pay a second sum at the end of that period, but this is a risky route if they already own companies that are not entirely solvent.

Grow first

Whatever the sector, buyers tend to regard bigger businesses as more secure.

Larger organizations are perceived as having greater resources with which to weather any unforeseen economic storms. Buyers will pay more for such reliability.

If you’re planning to sell, look at the current situation and see if it may be possible (and profitable) to merge with or acquire one or more companies before putting the business on the market.

Patents, trademarks, and copyrights

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.

Just consider if the famous Coca-Cola Co. went up for sale.

Without a doubt, its value on the market would be far more than the combined value of all their physical assets because the secret recipe of their iconic soft drink and the unequaled brand recognition they’ve created are worth more than all their factories and bottling plants combined.

Different buyer types

Finally, the value of a business will also depend on the nature of the buyer.

Buyers will generally fall into two categories: financial and strategic.

A financial buyer, such as a venture capitalist, will typically look at your business in isolation, analyze the viability of its profits, and examine whether he could increase them streamlining the company.

A strategic buyer, on the other hand, will likely be in the same or a related sector: a direct competitor, a supplier or vendor, or the owner of a tangentially related business.

Combining your business with theirs, might enable them to cut costs in a way not possible for the financial buyer.

They could centralize 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.

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

Approaches from competitors can also be dangerous. Do you really want to divulge the mechanics of your business to a potential buyer, only for them to abort the sale and remain a competitor?

In that instance they would be equipped with knowledge of your weak points, which they could then exploit. And also, your strengths which they could then replicate.

Clearly, the best option for a motivated business owner looking to sell their business is to get professional help arriving at a reasonable valuation.

Business valuation pros will be able to look at the big picture of each unique company’s situation to determine which valuation method is going to be the most effective to carry out.

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Next steps

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.

Here are four areas to consider once you have a legitimate valuation in your hand.

With the right actions and investments, you can likely boost the value of your company in preparation for putting it on the market.

1. Finance

Financial factors are likely to be key to the value of your business.

They include your past, current and projected profits and cash flow, and whether or not there is need to capital investment in the business in the future.

Tip: Review all your current holdings, including equipment, supplies, facilities, licenses, and anything else you can reasonably predict, then ask yourself whether you will need to upgrade or replace them anytime.

If so, would it boost your valuation to do so prior to trying to sell?

2. Intangible factors

These are harder to measure than concrete factors, but they’re still capable of influencing your profitability.

For example, do you hold key patents that can prevent competition? Do you have a key process or methodology that’s able to be trademarked?

Tip: Ask yourself tough questions and concentrate on improving the answers before selling.

Some examples are: How strong are my customer relationships? Is my company’s unique selling proposition obvious to an outsider? Can I rely on my staff to run things flawlessly without me here?

3. Assets and liabilities

Obviously, your company’s assets and liabilities play a huge role in determining its value. Anything you can do to increase the value of your assets and/or lessen your liabilities can have a positive impact on business value.

Tip: Focus on debt reduction prior to putting your company on the market. Undertake “low hanging fruit” investments to boost the value of your assets as well, such as inexpensive facility repairs and upgrades, renew equipment warranties or service contracts, software upgrades, and the like.

4. Staff

The people your business employs (especially their achievements and experience) are important to the value of your business.

This includes your contribution - you should make clear to potential buyers whether the business depends on you, and if it will require your input in future.

Tip: In most cases, it’s best for the seller to arrange affairs to ensure you are not integral to the running of the business.

Psychologically, this makes it far easier for prospective buyers to envision themselves successfully filling your shoes. However, the business value can increase even more if you’re willing to stay on in a consultative role through an initial transition period (unsalaried, of course).

5. The Market

Finally, no matter how well your business is doing, the state of the wider market will affect its value and how likely it is to sell.

If there are a lot of similar businesses for sale at the same time, this could negatively impact your business value. Likewise, if there is high demand from potential purchasers, your business could be worth a lot more. Market factors include the state of the economy, inflation and interest rates.

Tip: If you’re not being forced to sell due to circumstances outside your control and have the luxury of choosing when you put your company up for sale, spend at least two years investigating the market with your sale in mind.

Discuss the situation with local professionals who can advise you. Then, pull the trigger when market conditions appear optimal.

After reading this in-depth guide to business valuation, you’re in an excellent position to determine a realistic value for the company you currently own or you’re currently interested in purchasing.

Be sure to rely on valuation professionals to help you, especially when handling the more complex valuation methods.

And if you’re ready to buy a business or sell a business, let BusinessesForSale help too!

This is part 3 of our Ultimate Guide to Business Valuation.

Part 1: Get the Maximum value

Part 2: The Methods of Business Valuation


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