The Eight Most Common Methods of Valuing A Business
Which Value/Price Method To Use?
There are many methods of valuing/pricing a business. The Business Valuation Industry uses a large number of different methodologies. Business owners and buyers may have opinions of their own, driven by their own interests, about the value of a business. Business Brokers use many of the same methodologies as Business Valuation Companies, and some brokers also have developed their own approaches to value/price. Some of the various valuation methods are discussed in the Small Business Administration’s Standard Operating Procedures Guideline SOP 50-10. The SBA permits lenders to use any method, as long as it produces a “reasonable” value.
Below is a description of the eight most common methods of valuing/pricing a business.
(1) Rules Of Thumb
Rules Of Thumb (ROT) can be useful tools for appraising small and medium size businesses. But, there is no one, universally acceptable, “Rules Of Thumb” method. All of them are only rough descriptions of reality. They are all gross simplifications, and can be as inappropriate as they are appropriate. Some are based primarily on “comps” (comparables with the sale of similar types of businesses), some are based on standard accounting approaches, some are based on the experience of the compiler/publisher of the ROT, and can be in conflict with ROT’s available, on the same business, from a different compiler/publisher. So, Rules Of Thumb can be a useful guide, but, should not be considered “the only answer” if you wish to have an objective opinion of value/price of a business.
(2) Book Method
The Book Method is based on an adjustment of the book value, to reflect the current market price of the assets. Under accounting principles, using the Book Method, the assets acquired are valued at current “fair market value”.
Commonly, when the acquirer is acquiring the corporate stock of a company, the transfer of ownership is of the stock certificates, with the new owner of the stock becoming also, therefore, the “turn key” owner of all the assets and liabilities of the acquired company. In some stock sales the seller may retain some of the assets and/or liabilities, or the seller may deliver the stock to the buyer after the seller has first “cleared” (paid off) some or all of the company’s liabilities. These issues are negotiable, and vary from one transaction to another. But, in many stock sales the acquirer acquires everything. So, in a stock sale, using the “Book Method” of valuation, the parties will settle on a “Fair Market Price” for the assets, including the intangibles (good will, non compete from the seller, etc).
In an Asset Sale, generally, the owner/seller keeps ownership of any cash assets, and gets to keep the accounts receivable of the business (those receivables generated up to the date of the buyer’s take over). The seller also keeps ownership of all accounts payable and notes payable of the company, and/or pays off those liabilities prior to the buyer’s take over. In any case, commonly in an Asset Sale, the assets are conveyed to the buyer in a debt free condition. The seller also keeps ownership of the selling company stock certificates, and retains ownership of the corporation or LLC, and of it’s balance sheet. In those cases, the owner/seller keeps ownership of the selling entity and the buyer/acquirer forms a new entity, and the buyer’s new entity purchases the assets owned by the seller’s entity, allowing the buyer to depreciate the tangible assets (furniture, fixtures, equipment), and amortize the intangibles (good will, non compete, etc.). The seller is left with a selling corporation or LLC that owns nothing but cash, receivables and payables. The seller commonly changes the name of the selling entity, as the name familiar to the public is sold to the buyer as part of the assets being transferred. The buyer gets all the other assets of the company, which are folded into the buyer’s new corporation or LLC, including the buyer receiving the name of the business, the inventory, the furniture, fixtures and equipment, the employees, the systems, the good will and other intangibles, etc. The buyer also commonly gets from the seller a Non-Compete Agreement. So, in an asset sale, using the “Book Method” of valuation, the parties will settle on a “Fair Market Price” for the assets, including the intangibles.
Going Concern Value
Because of the “going concern” benefits (compared to starting a similar business from scratch), the business price/value will almost always be greater than the Fair Market Value of the assets alone.
Work In Progress (WIP)
In transactions whereby there are unfinished, unshipped, un-invoiced orders on hand (Work In Process), the value/price of the WIP is negotiated by the parties, with the seller receiving from the buyer some payment after the WIP orders are completed by the buyer, after the buyer’s take over, and those orders have been shipped and invoiced by the buyer, and the receivable collected by the buyer. In many cases, the negotiated amount eventually paid the seller for WIP is the amount the seller had invested in the parts and labor in each WIP prior to selling the business, with the buyer keeping the rest of the money received from the business’ customers, including the buyer receiving the profit margin on the WIP orders.
In the case of construction related company ownership transfers, there is also an adjustment to the seller’s compensation for any deposits or advance payments on WIP the seller might have received prior to transfer of the company to the buyer. And/or sellers might transfer to the buyer at closing any customer deposits on hand.
(3) Capitalization Of Historical Earnings
In this method the historical earnings of the business to be acquired are analyzed to determine the expected earnings in the future. Within the analysis, adjustments are usually made for the owner’s compensation. These adjustments presume amounts expensed for management salaries (for the buyer’s anticipated salary if the buyer is going to be an owner-operator/manager, or for a manager if the business is going to be operated absentee). This analysis commonly “normalizes” the historical earnings, meaning the earnings for multiple past years are averaged. Then, a reasonable Return On Investment on the Book Value of the selling company’s Net Worth is subtracted from the adjusted earnings. The remaining earnings are called “excess earnings” and represent the earning power of the assets.
These “excess earnings” are capitalized at an appropriate rate, related to the risk of owning the business. The fair return on the net worth is a rate that the owner/buyer could perhaps get if invested instead in a secure, safe alternative investment (CD’s, etc). A common guideline is the rate one might earn on a 5 to 10 year Treasury security is considered the rate to determine a fair return. The amount determined is subtracted from the “excess earnings”. The remaining “excess earnings” are capitalized at a rate related to the type of risk, and the risk of the business generating “excess earnings” in the future by operation by the buyer.
Large public businesses command a capitalization rate of Prime minus two to Prime plus two. Small and medium size businesses are usually privately held, may be more risky, and allowances for risk should be made for the lack of marketability of the securities (stock) of the small or medium size business.
Small and medium size businesses commonly have capitalization rates from Prime plus 10 to Prime plus 25. The value of the capitalized “excess earnings” is then added to the book value of the equity.
Net Income 22,000 (average, last 3 years)
Add: Seller’s Salary 70,000
Less Buyer’s Anticipated Salary (50,000)
Equals Adjusted Earnings 42,000
Net Book Value Of Assets 60,000 (furniture, fixtures & equipment)
Goal of Fair Return On Assets 3,600 (ROI of 6%)
Excess Earnings 38,400 (42,000 – 3600)
Capitalization of Excess Earnings 174,545 (38,400/.22) (22% Cap Rate)
Add Book Value Of Assets 60,000
Value of Business 234,545 (Using this method)
(4) Capitalization Of Seller’s Discretionary Cash Flow
This method relies on a commonly accepted analysis of the business’ historical financial records, called EBITDA, which is the Earnings (Net Profit) of the Business being purchased, plus any Interest, plus any business income Taxes, plus any Depreciation and Amortization expenses paid by the business, for the periods being analyzed.
Example (Average last 3 year’s Income & Expenses & Cash Flow):
Business Income 500,000
Less Cost of Goods Sold (250,000)
Gross Profit 250,000
Owner’s Salary 50,000
Employee Wages 55,000
Accounting & Legal 3,000
Other Expenses 10,000
Total Expenses 208,000
Net Profit 42,000
Seller’s Discretionary Cash Flow 93,000
The Seller’s Discretionary Cash Flow (SDCF) is the amount the buyer would have available from the business after paying the buyer a management salary of $50,000 per year, and, after adding back to the Net Profit the “add-backs” (Discretionary expenses), resulting in the $93,000 SDCF (the amount from the business’ operations that the buyer would have available to pay the principal and interest on the buyer’s acquisition loan). The remainder after paying the loan payments would be the funds available to the buyer to replace equipment, and to provide the buyer’s Return On Investment.
The SDCF is then multiplied by factors and represents the Fair market Value of the non-real estate fixed assets (assuming the business is located in leased premises), the inventory and the good will, that typically transfer in the transaction.
In this example, the business might be valued/priced at 2.5 times $93,000 or $232,500.
“Valuing Small Businesses and Professional Practices, by Shannon F Pratt, 3rd edition, McGraw Hill 1998, states:
“A large proportion of pricing multiples fall in the range of 0.75 to 2.75 times, and sometimes range all the way from .4 to 5.5 times SDCF..”
“Handbook of Business Valuation” By Thomas L West, John Wiley and Sons, states:
“Selecting the multiple is unquestionably the most difficult step in applying the Multiple of Discretionary Earnings Method.”
The multiplier generally excludes the seller’s cash on hand, accounts receivable, prepaid expenses, real estate, non-operating assets and liabilities of the company. If any of these elements are included in the purchase, the value must be adjusted accordingly.
Most small and medium size businesses that are successfully sold will sell for a multiple of 1 to 3 times the SDCF (generally these are businesses that have SDCF of less than $500,000 per year). Some larger businesses might sell for 4 to 5 times SDCF.
The variables that affect whether a business is priced at 1 or 2 or 3 or 4 or 5 times SDCF are determined by (a) the SDCF involved (businesses with smaller SDCF usually sell for lower multiples), and/or (b) assets included in the sale, and/or (c) the appearance of the premises, and/or (d) the trend in sales/profits in recent years, and/or (e) the customer mix of the seller's business, and/or (f) the strength/weakness of the business' staff, and/or (g) the availability of seller financing for some of the purchase price, and/or (h) any number of other factors that might impact on value/price.
ABMI, having successfully brokered the sale of thousands of different businesses over the last almost 30 years, has a keen understanding of all these issues, and offers to consult with buyers or sellers, by appointment, to help you understand these facts, that are so important to entrepreneurs who wish to buy, sell or finance a business.
(5) Capitalization of Latest Years Adjusted Earnings
This method utilizes the latest years adjusted earnings, capitalized at the rate determined for the risk. So, if a “cap rate” of 22% would be used, of the latest year’s earnings ($42,000), in the example shown above, the value/price of this business might be $190,909.
(6) Purchase of Years Adjusted Earnings
With this method, the value/price is determined by (a) determining a base price of, for example, 5 times “excess earning”, plus (b) the Net Book Value of the Assets being conveyed. In this example, 5 x $42,000 = $210,000 plus $60,000 = $270,000.
(7) PFA Method of Value/Price
Unfortunately, too often, a business owner or buyer will choose to use the “PFA Method”, which is the Plucked From Air approach. In other words, someone simply guesses at a value/price, with little consideration for commonly accepted valuation methods.
For a business owner, one danger of using an arbitrary guess at value is that many owners undervalue the value of their business, and risk selling the business for too little.
Or, an owner might undervalue the business and, because the perceived price is lower than the seller wants, the owner leaves the business unsold, too often for the wrong reason (undervalued).
Or, sometimes an owner chooses a value that is not consistent with “the realities of the market-place”, and prices the business at an unrealistic value that makes it impossible to sell the business or for a buyer to obtain the financing needed for the acquisition.
Buyers, too, who ignore commonly accepted valuation methods run the risk of paying too much for a business, if they are not operating from an informed position.
Or, a buyer might, by insisting on purchasing a business at an under-the-market price, simply under-price themselves out of being able to make an acquisition.
(8) The ABMI Method
ABMI, having brokered the sale of thousands of different businesses over the last 28 years, has a high level of understanding about business values and pricing, as well as considerable experience in consulting with business owners about the various acquisitions terms that might be offered to buyers.
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