Valuation how to:
No-nonsense small business valuation
The valuation process requires an in-depth examination of income statements, balance sheets, and tax returns of the business, as well as a basic understanding of the industry and specific operation of the business. While many valuations are subjective, this process will permit you to quickly recognize a value as legitimate or unreasonable.
The sale of assets is predominant in the marketplace. Therefore, this valuation presupposes the sale of the business assets free and clear of debt. Seller will generally retain its cash in banks and retire all outstanding debt. The size and nature of the business will determine if it is appropriate to include or excluded accounts receivable, an assumption of the accounts payable is generally a prerequisite to the inclusion of the accounts receivable.
First, attain a basic understanding of business operations. Become familiar with and understand the general business operations, its employees, their duties and pay, the customer base, supplier relations, marketing methods, and sellers rational for the sale. In particular note:
- a) Owners role in management and additional family members or partners involved.
- b) Percentage of revenue major customers contribute and the total number of customers.
- c) Specific terms and conditions of any contractual obligations and/or ongoing lease commitments.
- d) Determine and understand what is and is not included in the sale.
- e) Examine the overall quality of the data provided, if you have any questions get answers.
Next, review the financial history. Complete an overview of the company financial statements and tax returns for a minimum of three years. In particular note:
- a) The gross revenue and gross profit percentage trends year to year. Look for changes in cost of goods and major expense categories on the profit and loss statements.
- b) The balance sheet changes year to year look at the cash, inventory, A/R, A/P, hard assets, liabilities, and owner’s equity balances and changes.
- c) The depreciation schedules will help determine a “best guess” as to the value of hard assets including furniture, fixtures, equipment, machinery, vehicles, etc. consider the cost of replacement with new, replacement with like kind and condition (an educated guess) and the likely liquidation value.
- d) Identify current working capital requirements and likely capital expenditure necessary in the future.
THEN THE MOST IMPORTANT STEP IN VALUING A SMALL BUSINESS
Calculate the true business earnings. Analyze the profit and loss statements identifying any adjustments necessary to establish the seller’s discretionary earnings (SDE) each year over a minimum of three years. SDE is determined by adding specified expense items considered nonessential or discretionary to the stated net profit (see SDE worksheet).
Determine if the stated net profit before tax is free from non-operating “other” income. Look for income the seller is receiving that will not continue after the sale such as interest, investment, rentals, or sale of assets, deduct any non-recurring income from net income before taxes.
To the actual net profit before taxes from business operations, add
- a) The total Salary of one owner (from W2’s) and any salaries in excess of market, paid to family members and or partners. Be certain you understand the real costs necessary to replace family members and/or partners involved, it could be that the current salaries paid to related parties are less than what you will have to pay to replace them. If appropriate to apply a deduction from owner’s salary. In larger businesses, it may be appropriate to substitute reasonable management salary comparable with industry standards for the salary drawn by the owner.
- b) Depreciation and Amortization are expense items that are not actual cash transactions. If however the business makes extensive use of rolling stock (trucks/tractors/etc.) and/or the renting or leasing of equipment, tools, electronics, or other property, the stated depreciation may be a very real cost or even understate the required annual capital expenditure. It is critical to determine that there is not an annual capital expenditure larger than the depreciation expense, and you need to understand the future capital expenditure requirements of the business.
- c) Interest expense is discretionary, as business owners have different philosophies on business borrowing. Furthermore, our valuation assumes the sale of assets free and clear of debt, therefore the buyer will have use of the funds seller is using in financing activities. Understand that there are certain types of interest expenses that are ongoing and would not be a legitimate add back to SDE. These include floor plan interest in dealerships and/or interest on lines or letters of credit necessitated by large, sometimes-seasonal swings in inventories or prepaid costs. Equipment lease payments may also be considered discretionary and added to earnings. Be certain that if the equipment lease expense is added back to determine SDE that the business value indicated is free and clear of these lease liabilities.
- d) Small business owners often take advantage of the opportunity to have the business provide them certain Fringe Benefits. These expenses often personal in nature, do not relate to or are not essential to the business operations and are therefore a legitimate addition to SDE. We commonly see auto, travel, entertainment, and insurance expenses that are for the owners benefit or paid on behalf of family members and/or partners. Be certain you understand that there may be some real business costs involved in some of these expense items, and add backs that include one hundred percent of auto expense or travel for example are likely not legitimate if some auto or travel expense is necessary to operate the business. These items must be clearly identifiable in the expenses on the profit and loss, and justifiable through documentation from the seller.
- e) Other adjustment possibilities include rent normalization, non-recurring, or one-time expense items. There are very few legitimate adjustments in this category; it is legitimate to adjust the rent an owner is paying himself for real estate owned by seller to reflect actual market rent or add back a specific identifiable non-recurring expense. Any adjustments to inventory, revenues, or cost of goods should be carefully scrutinized; if legitimate it is likely these adjustments are better allocated over a number of years rather than a one-year period.
Completing step three results in an understanding of seller’s discretionary earnings SDE, this is the amount available to the purchaser after acquisition of the business to satisfy purchasers need for a reasonable salary, payment of debt service, realize a return on investment, pay taxes, and fund future expenditures. This calculation is relatively objective in nature; given a reasonable purchaser and a reasonable seller each should arrive at approximately the same SDE for any given business. Basing the valuation on an objectively arrived at SDE figure will go a long way towards helping the parties reach an agreement on value.