Learn How Transaction Prices Are Determined

If you own a business, you should have a current and accurate valuation of your company. Even if you don’t plan to sell, you may need a valuation if you need debt or equity financing for business expansion, or you may want to add or subtract shareholders depending on your needs and your relationship with existing shareholders.

Valuing a business is both an art and a science. You should have a third party do the valuation. Your M&A Advisor or investment banker can give you a preliminary valuation and an educated opinion on what your business is worth. If you want a detailed and more precise calculation, then you should pay for a detailed analysis from a business valuation expert. The American Society of Appraisers can provide you with a list of accredited business appraisers in your area.

You should be familiar with how a business valuation is computed and the methodology selected to value your business. Make sure the methodology chosen is appropriate for your business based on your industry, size, and overall financial health.

There are six potential methods for business valuation:

  1. Value of assets

If you have an unprofitable business but still have cash available to run the business (going concern), then the value of the assets is the net balance sheet value of its assets minus the value of the liabilities.

If your business is bleeding cash and close to insolvent where you must sell quickly, then the liquidation asset-based approach determines the net cash that would be received if all assets were sold and liabilities were paid.

The asset approach should only be used for unprofitable businesses that are either out of cash or will have a hard time becoming profitable in the foreseeable future.

  1. Historical earnings method

This is appropriate if you have a profitable business, but it is not growing. The assumption is that future earnings will be consistent with the past.

The starting point is to recast historical financials that add back excess owner compensation and perks over and above what a nonowner manager would be paid to run the business. The next step is to average historical earnings over either three or five years to normalize any abnormalities (positive or negative) in one given year. The final step is to divide the desired capitalization rate (what the buyer wants to earn as a rate of return each year). If the buyer wants to earn a 20 percent annual return and recast average historical earnings are $500,000 per year, then the value of the business to this buyer would be $2.5 million.

This method is ideal if a buyer is borrowing to fund the purchase because then it will compute whether historical cash flows are adequate to service the debt. Once again, do not use this method if your business is growing. This method gives no credit for growth in future earnings or cash flows.

  1. Combination of assets and earnings valuation (excess earnings method)

This method takes both assets and historical earnings into consideration in determining the value of the business. This approach is endorsed by the IRS for estate and gift tax situations if other methods are not appropriate.

Historical earnings are normalized to add back excess owner compensation, and typically a five-year average is computed.  The current balance sheet is then used to calculate net value of the current assets. Net asset value fails to include the goodwill or intangible value of the business that should be factored into the calculation.

To determine this intangible value, the appraiser will determine what portion of your historical earnings is attributable to the physical assets on the balance sheet. One method would be if the assets were sold today and the money was invested at market rates, then what is the monetary value of these physical assets? Another method is how much is the market paying today for similar assets at a similar risk level?

Once the earnings from physical assets are determined, this number is compared with the overall average of historical earnings. If the historical figure is higher, then the difference is called “excess earnings.” The excess earnings are then divided by a capitalization rate (usually 20 to 25 percent) to determine their value. This is the value of your intangible assets. Adding this value to your physical assets will give you the total value of your business.

  1. Comparable sales of similar businesses

This method is often used in commercial real estate or for main street businesses with annual revenue less than $1 million.  It is not recommended for businesses with over $1 million in annual sales. It is very difficult to get accurate data on private transactions since for the most part this information is never made public. In addition, no two businesses are alike, which makes the exercise of comparing them very difficult.

For larger transactions ($50 million +), public company valuations (price to earning [P/E] ratios) are sometimes used as a ballpark to estimate value. This can be misleading, however, since public companies may incur expenses not required in a private company (accounting, legal, or investor relations) that could underestimate the earnings potential of a similar company with a private capital structure.

  1. Future earnings potential

If your company is profitable and growing, this is the best method to use. It takes into account the future earnings potential of the business. Buyers like successful businesses (growing and profitable) and they are willing to pay a premium based on the company’s expected earnings in the future if the future is better than the present.

The key is to establish future projections that are based on facts and can be supported with real data. They cannot be “pie in the sky” or “wishful thinking.” For example, if historically a business has 5 percent annual earnings growth, then it is difficult to support an assumption that the earnings will grow 20 percent annually in the future unless the business owner can support the accelerated growth with tangible evidence such as investments in additional sales staff or the launch of a new product line. Projections must be realistic and based on data and facts. If the projections are far off, then the business valuation will not be accurate.

Business buyers feel most comfortable when future projections are consistent with past performance. If the seller takes a hard position on higher projections, then the only way the deal may get done is to factor the difference not in the price at closing but in the form of an earn-out (where the sellers must “earn” part of the purchase price based on the performance of the business following the acquisition).

The future earnings valuation is based on agreed-upon future earnings projections discounted back to arrive at their net present value (NPV). The key is the discount rate. The higher the rate is, the lower the valuation. The discount rate must be the appraiser’s best guess as to what the market rate will be for investments of a similar nature over the next five years.

 

The next step is to determine the residual value that the company will have after five years of the financial statements. Assume that the company will have that level of cash flow indefinitely into the future. Take the last year’s free cash flow, divide it by the discount rate, and arrive at the company’s perpetuity earnings value. This residual value is then discounted to find its NPV. Finally, the NPV of cash flow from each of the projection years plus the NPV of the company’s residual value after all these years will add up to the present value of the business.

 

  1. Seller’s discretionary earnings (SDE) or earnings before interest, taxes, depreciation, and amortization (EBITDA) multiples

If you have a successful business that is growing and profitable, your business valuation can be based on a multiple of SDE or EBITDA. This is the true cash flow of the business when excess owner’s compensation and owner perks are added back to net income reported on tax returns. This gives a more accurate barometer of the cash flow of the business. SDE is often used for businesses with positive cash flow that is less than $1 million per year.

If the cash flow exceeds $1 million per year, EBITDA is often used as the basis for the valuation multiple. Depreciation is the annual non-cash write-down of physical assets on your balance sheet. Amortization is the annual non-cash write-down of intangible assets on your balance sheet. EBITDA is sometimes considered a proxy for the operating cash flow of the business.

SDE and EBITDA multiples tend to vary by industry and size of the business. The 2015 Capital Markets Report produced by the Pepperdine Private Capital Markets Project gives a chart showing these multiples by industry and by the size of the company. For SDE and EBITDA between $1 million and $10 million, the range of multiples is fairly wide, between 3.3x to 8x. The average ranges from 4.5x to 6.5x.

Keep in mind these are averages and benchmarks. Your business could be evaluated higher or lower based on other factors such as strength of management team, customer retention, customer diversity, recurring versus project revenue, proven operating leverage, and intellectual property.

It is a good idea to have a formal appraisal of your business every two to three years, even if you are not selling your company. You need to know what it is worth. Make sure the appraiser chooses the right valuation methodology for your business.

If your business is not profitable, your business is probably worth no more than the value of your net assets on the balance sheet. If your business is profitable but not growing, then the historical earnings method is probably the right one. But if your business is profitable and you can demonstrate consistent earnings growth in the past, then use the net present value method of future expected earnings. Make sure you can justify your projections and any accelerated growth rates with facts and hard data.

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