Valuing Your Business
Knowing the value of your business ought to be self-evident. It is absolutely essential if you are considering selling it or looking for fresh investment. Ultimately, the value of any business winds up being what all interested parties agree it is worth. A company that has shares listed on a stock exchange has a clear value, namely, the number of shares outstanding multiplied by their value set by the exchange at a given time. The value of a small business, however, can be much harder to calculate, and depends on such factors as assets, liabilities, earnings, cash flow, annual sales and revenues, its customer base, even its reputation and standing in its community.
This article provides some long-accepted rules of thumb on how to value your business, and how to affirm that it has been properly and accurately valued by someone else.
Valuation is hardly an exact science. Arriving at a single figure is difficult, because so many factors should be considered. First are the "hard" figures like assets, liabilities, historical earnings, and cash flow. Next, are more subjective figures, such as projected earnings, the experience, expertise and quality of management; a firm's reputation (or "goodwill") has value, too. Then there are external factors to judge, such as: current market conditions, the sector a business competes in, and the long-term viability of that sector. Yet, even when all these factors are evaluated, the final value you derive from them still may differ considerably from the value a prospective buyer or investor may arrive at—even after looking at the same figures.
Yes, indeed. A final price of a business can also depend on the circumstances surrounding a sale or additional investment. For example, is a buyer eager to buy quickly? Is there an urgent need to sell? Is there more than one investor or buyer interested? How will the purchase or investment be financed? What is the level of risk involved for the buyer or investor? Are there tax matters that could affect a sale or investment—such as inheritance taxes that a family selling a business are trying to minimize?
If you're using a business broker or an accountant in advance of a sale or attracting investors, valuing your business is part of the basic responsibility. However, it still is wise to set your own value, so that you can compare whatever price the outside expert recommends. And whatever price the broker or accountant does recommend, you need to establish how it was determined, so you can judge whether or not the price is fair—and challenge it if you do disagree.
Determining your own value of your business also should leave you satisfied that your expert has reached a fair and reasonable value. After all, who knows your business better than you do?
Of course, you could decide to value the business alone, without the assistance of professionals; however, independent third-party input usually adds valuable credibility when it comes to, say, negotiating a final price and terms with a prospective buyer or investor.
Yes, again. Before proceeding with a valuation effort, you should try to compare the financial results of your business with those of competitors or similar organizations within your business sector. Obtaining the data for this comparison can be challenging but also revealing, for it can put in perspective the determined value of your business. Financial comparisons should be made using such measures as: sales growth; gross margins; earnings before taxes as a percentage of sales; return on assets; return on equity, return on investment, and the debt-to-equity ratio.
You also can compare your business to your market's performance—and those numbers are typically easier to obtain. What is the growth rate of your business compared with the overall market? Compared with competitors' growth? Is your business gaining or losing market share?
There's no substitute for gathering data and calculating. Your final valuation figure will depend on the technique adopted. There are any number of generally accepted methods of valuing a business, but three of the more popular ones are: net assets, multiple of earnings, and standard formulas.
Valuing a business by calculating its net assets is the most easily understood method, and the one most commonly used for small businesses. The net assets—or net worth of the business—appear on the balance sheet. If everything was sold at the value shown on the balance sheet, the amount of money realized would be equal to the net assets. Sometimes buyers are reluctant to pay much more than net asset value, since it is very difficult to put a market price on intangible assets such as goodwill—that is, reputation and perceived value of a brand. The value of other intangibles can also be considered, such as ownership of patents, trademarks, and copyrights, and the value of long-term contracts, license agreements and similar relationships that can generate revenue.
The net-assets figure may need to be adjusted to reflect their aggregate true worth. Buildings, for example, may be worth more than the balance sheet shows. Equipment—computers, in particular—may be worth far less, especially if they're older models. You may need to negotiate a method for valuing assets, one that takes into account replacement value and realizable value.
The multiple of earnings calculation for valuing a business is based on the price/earnings ratio, or simply P/E ratio. The P/E ratio compares the current price of one share to the earnings (net profit) attributable to that share. The P/E ratio indicates how much investors are prepared to pay to buy the shares.
If, for example, a company has an earnings per share of 18.5 cents and one share costs $5 then it has a P/E ratio of 27 (500 divided by 18.5). You can apply this to any business. Take the net profit, then apply a reasonable multiplier—the sum is the value of the business. Determine a suitable multiplier by looking at the P/E ratios of publicly traded companies, which can be found in the stocks tables of a newspaper's business section. However, you likely will need to apply a discount to account for the smaller size, greater risk, and the difficulty investors subsequently will have selling shares in private companies. Typically, you should apply a discount of 30–40%, though if your profit is less than $1 million, the discount should probably be at least 50%.
For example, assume you have achieved annual earnings of $100,000 over a number of years and can show that this trend is likely to continue. If the average P/E ratio in your business sector is 12, you then need to apply a discount of 50%, which produces a multiplier of 6. The final calculation, 6 x $100,000, indicates the business is worth $600,000. You should remember to exclude non-recurring expenditures (such as unusual one-time purchases) when you calculate the earnings for a particular year.
Some business sectors use well-established and accepts standard methods to value a business. Call them simply rules of thumb that offer a quick look at a firm's health and vitality. For example, the valuation of a courier service depends on the number of average daily deliveries, while insurance brokers often multiply their gross commissions one to two times to derive the value of their businesses. Your business sector may rely on a similar accepted formula, and it is probably is worth investigating this further before committing yourself to any valuation process.
Valuing the business only gives you a starting point. If you are seeking fresh investment, your next task is negotiating the percentage of shares to be exchanged for the dollars invested. The owners of a business will have invested their own funds—though this should be reflected in the valuation in some way. The owners also will have invested considerable time and effort to grow the business to the point where they are seeking additional equity. This, too, should be recognized and rewarded.
One approach is to add an amount to the net asset valuation that represents the "sweat equity"—the hard work, effort and "intellectual capital" that also has been invested to build the business to its current position but which is not reflected in its valuation. If, for example, a business has a net asset valuation of $50,000, another $50,000 could be added as sweat equity, for a total of $100,000. An investor providing an additional $50,000 would then receive 33% of the outstanding shares.
Whatever method you use to determine the value you place on your business, don't expect that figure to be the price that you receive in any sale: it only serves as the basis for negotiations. In turn, it's wise to further boost your preferred price by, say, 5–10%, for you can assume a buyer will try to negotiate a lower price even if he or she feels your asking price is a bargain.
No serious buyer will value a business until after first studying it inside and out—and then calling in an accountant or business broker to help negotiate what they hope will be the final value for your business. Assume that a prospective buyer will use a different valuation method than the one you used. Buyers typically will try to compute a value that compensates for the expected return they hope to receive by investing in the business. And they will almost always focus on a business's future performance and profitability. Therefore, you should prepare to be offered an amount that reflects how profitable your business is expected to be in the future—not how profitable it is at the time of a sale.
In short, you have to acknowledge a cardinal rule of valuation: a business is worth what someone is willing to pay for it, no more, no less.
Your goal is, or should be, an achievable and realistic valuation of your business—a figure that both parties can agree on. So you need to be realistic, too. If you're using the P/E ratio as the basis of your valuation, make sure you select a realistic ratio and discount it by an amount which is appropriate for the size of your business. If you decided to include "sweat equity" and goodwill, be equally reasonable in assigning them values.
Mistake No. 1 is hiring the wrong adviser. For example, many sellers decide to hire a lawyer and often will be attracted to the first one they find. Consequently, they overlook more qualified and experienced individuals. This leads to poor decisions and bad advice being made at crucial phases in the selling process. The same mistake can be made in seeking business brokers and accountants.
Bethel, Stephen.
National Association of Certified Valuation Analysts: www.nacva.com