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 for Valuing a Business
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 Methods for Business Valuations 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.
HOW TO VALUE A SMALL BUSINESS FOR PURCHASE
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.