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Business Valuation Techniques

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Last updated: 21 Sep, 2014
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By Jason Watson ()
Posted September 2, 2014

Are you considering buying or selling a business? It can be exciting, but the biggest problem is determining a value. If you are Mark Cuban from Shark Tank, you have money to burn and can take risks on pricing mishaps. But if you are like most people, the value of what you are buying or selling becomes a sensitive issue.

Large corporations that are traded on the New York Stock Exchange or are listed with the NASDAQ are easily valued. If you wanted to buy Apple, you would simply buy all the outstanding shares at market price. While that is an over-simplification, small business are way more complicated in terms of valuation.

Here are the basic techniques-

  • Market-Based- business brokers in a certain geographic area have a good feel for what a business is worth based on historical information, trends, and their ability to add value to the business being sold. But are you comfortable taking someone else’ word for it? Perhaps.

  • Asset-Based- this technique looks at the market value, book value and liquidation value of the company’s assets. These values will all be different of course with liquidating probably being less than book (depending on prior depreciation), and with book being less than market.

  • Earnings-Based- this takes into account past performance of the company from a cash flow and taxable earnings perspective.

The important thing to remember is that these techniques are not independent of each other. Often they are used in conjunctions with each other. For example and as alluded to earlier, a jumping off point is three times net earnings plus book value. So if your business earned $300,000 per year and had $500,000 in assets, you might be able to justify $1.4M.

Control Premium
There is a concept you should be aware called control premium. It can add significant value to your business during a sale. Let’s say you own 30% of a market and your competitor who is also buying your business owns 40% of the market. Comparable in size, but when combined the singular company has control of the market at 70%.

The ability to control the market allows a company to perhaps raise prices, or lower prices temporarily to drive out remaining competition or dictate better terms to vendors. Sure some of this is business school theoretical stuff, but glimmers of these issues are observed in real life, every day.

There are other control premium examples that might include location, key employees, clients, etc. So giving a new buyer more control demands a control premium to the value of the business.

Earnings and Cash Flow Based
This is the most common focus for buyers. For service industries such as law, medical, accounting and information technology, the earnings based valuation technique will be used the most. For example, accountants will sell their practice for a factor of 1.1 to 1.5 of gross revenue. How does a factor get determined?

Simple actually, and we’ll use an accounting firm for illustration. First, when you are considering the net earnings of any business you need to back out the officer compensation to determine potential earnings. Here is a quick table showing some of the math-

Gross Revenue 500,000
Expenses 325,000
Officer Wage 75,000
Taxable Earnings 100,000
Earnings, Officer Wages 175,000
Profit Percentage 35%
Three Years of 35% 1.05
Gross Revenue x 1.05 525,000
Earnings x 3 Years 525,000

So this table is suggesting that if your business profits are 35% including your compensation, then 3 x 0.35 equals a factor of 1.05. And since service industries such as our accounting firm example have very little assets, the earnings based technique is usually all a seller and buyer need to reach an agreement.

Assets and Market
Aside from earnings and cash flow valuations, some businesses are attractive because of other reasons. Perhaps a target business has a monopolistic government contract. Or perhaps the target business has some key employees that you want to assume and add to your core competencies. Or channel experience. The list goes on. So while cash is nice, and earnings are nice, not everything is easy to put a value on. These softer assets or intrinsic value can actually be a much larger and smarter reason for an acquisition.

Depreciation, Amortization, Personal Expenses
Other considerations when reviewing a seller’s financials are non-cash deductions and personal expenses. When a seller is depreciating assets or amortizing purchases, those expenses only affect the seller’s financials. So a careful analysis of cash flow versus taxable income must be performed.

Personal expenses include items such as travel, meals, mileage, home office and family-member wages. Let’s be frank- business owners have been known to deduct personal expenses through the business. A buyer might not get a straight answer from the seller, but these activities should be reviewed and perhaps added back into the statement of cash flows when evaluating a transaction.

Valuation techniques are just conversation starters. There are CPAs and other experts who do nothing but business valuations and appraisals. And if you purchase a business with a Small Business Administration (SBA) or other bank loan, you will undoubtedly have to an appraisal done on the business you are buying.

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Chap yy - Business Valuations, Sale, Exit Planning       Purchase Price Allocation