Basics of Small Business Valuation
We know that successful transactions begin with fully informed sellers and buyers; it is essential that the parties understand how the value of a small business is determined. Below is an outline of methods and rationale necessary to get a fundamental understanding of valuing a small business.
IMPORTANT The information on valuation presented here is size specific. If the business net income is approaching or exceeds $1 million, substantially different methods of valuation are likely appropriate.
The valuation methods and rationale presented yield the fair market value of the business assets transferred free and clear of debt. Market value being the amount a buyer could reasonably be expected to pay and a seller could reasonably be expected to accept in an arms length transaction and within a reasonable period of time on the market, buyer and seller both being fully informed and neither being under any compulsion to act.
If the transaction includes the sale of real estate, both the real estate and the business should be viewed as separate transactions and the valuations of each must stand on there own merit. The real estate appraisal will establish a reasonable rent factor that will be used in determining the recast business earnings.
Hiring a professional to perform the valuation
What is the business worth and what will the business sell for, are very different questions. In over 20 years, we have collected countless $2,000 to $8,000 appraisals provided by “professionals”. All of these reports may answer the question what is the business worth but few are even close to identifying what it would sell for. There are many reasons why a “professional” valuation may be desirable including; determining minority shareholder interests, issuing stock options, ESOP creation and upkeep, estate tax assessment or tax returns, charitable contributions, trusts, family partnerships, insurance, private equity, initial public offering, SBA loan requirement, divorce, bankruptcy, and more.
There are an extensive number of methods acceptable to the IRS to calculate the value of a business, the values these methods generated may or may not reflect the reality of the market place. The professional evaluator must make many subjective assumptions to complete the evaluation, as such; experience shows the value reported is likely to confirm the viewpoint of the party requesting the report. The buyer’s evaluator will report a low value to please the client and the reverse is true of seller’s evaluator. We do some expert testimony work and find it amazing when the “professional evaluator” for one party in a divorce case can justify a value of $4.5 million and the “professional evaluator” for the other party can justify a value of $500,000. Fact is both may have used sound reasoning and acceptable methodology but both were wrong. If you have a valuation performed, be certain the evaluator is using real world “business sales” experience, and can demonstrate to an informed buyer a justification of market value.
The basic valuation methods and challenges they present
Asset Based Valuations: An asset-based valuation requires us to establish the “fair market value” of the assets of a business. Inventory value at cost can generally be determined relatively easily. The balance of the hard assets including furniture, fixtures, equipment, machinery, and leasehold improvements, are a challenge. The book value reflected on the financial statements of a business is not a realistic indication of current market value. Commonly we find a substantial number of the business assets never appear on the balance sheet.
The value of used business “assets” is highly subjective and it is unlikely the buyer and seller will agree on fair market asset value; both will have a defendable but different perception of value. A four year old computer used in the business for instance, the seller cannot do business without the computer and perceives its “in place value” as the cost of an immediate replacement with a new computer (say $2,000). If the old computer where offered for sale it is likely to have little if any value (maybe $200). Here the seller is justified in maintaining that the computer has a $2000 value to the business. The buyer is equally justified in valuing the computer at $200. The sale of a business is not a liquidation of used assets. It is reasonable to maintain that you would have to duplicate the assets with new replacements. Likewise, it is reasonable to maintain that the assets are used and have some minor percentage of their original value. How do we ever reach a “meeting of the minds? Because of the subjective nature of asset based valuations they rarely yield meaningful results.
Income Capitalization Based Valuations: Generally a future income stream is calculated based upon a variety of assumptions about future operations and revenue projections, and a return on investment analysis is then applied to that future income stream. Income Capitalization may be applicable for large businesses with substantial revenues ($10M+) and reasonable expectation forecasts will be realized. Market volatility; along with the arbitrary nature of assumptions made to generate future revenue, projections make this methodology inappropriate and rarely meaningful for “small” businesses.
Income Multiple Based Valuations: You will commonly hear business values expressed as “X times earnings”. This is also a method of applying a capitalization rate to income, however it is important to distinguish that it uses actual historical income data rather than future income projections.
In order to be meaningful we must also clearly define “earnings”, before establishing a multiple. We see earning defined as “after tax net income”, “earnings before interest and taxes” (EBIT), “earnings before interest, taxes, depreciation, and amortization” (EBITDA), a “modified EBITDA”, or “seller discretionary earnings” (SDE). SDE is often referred to as “seller’s cash flow”, “owner’s benefit” or some other reference to “discretionary” cash flow.
The correct earning definition is determined by the size of the specific opportunity, and the amount of discretion an owner has over business expenses. In a large publicly traded company no one is “free” to run personal expenses through the business because of the oversight by the board of directors, CFO, and company auditors, therefore “reconstructing” earnings is likely unnecessary. It is appropriate to use actual net income or EBIT definition of earnings to establish a value and we will likely be using a large multiple of those earnings. If on the other hand the owner has total unrestricted control over expenditures with no oversight, it is appropriate to “reconstruct” true earnings of the business. It is then appropriate to use a “discretionary earnings” (SDE) definition to establish a value and we are likely to be using a much smaller multiple of those earnings. This method is the most effective and widely accepted way to establish the value of a small business.
Comparable Sales: Unfortunately comparable sales data is not as readily available for business opportunities, with the exception of large transactions involving publicly traded companies; there is no public record of the transaction. A number of web sites collect data but there is little if any verification of the integrity of the data collected. Two respected sources of small business comparable sales data are Pratt’s Stats and Biz Comps; these are the largest sources of comparable sales statistics for private businesses actually sold in the country. While it is impossible to find any two businesses that are the same, we can obtain a substantial amount of data on the sale of very similar businesses. The data is most useful in establishing a reasonable range for the multiple of earnings.
Rules Of Thumb: Over the years some business types have developed a common expectation of value, often based on a multiple or percentage of gross revenue. This can be very misleading and we recommend you study additional valuation methods on any business before assuming the rule of thumb fits. It is surprising however that the results of further valuation methods often result in a value very close to the rule of thumb.