Business valuation 102

William McGinnis recently contributed an article of operational insight to Small Business Times on the selection criteria for a business valuation specialist. I would like to elaborate on the topic of how the value for a business can be determined.
We have found no scientific approach that provides a definitive value. Our approach is to use several methodologies and then through a triangulation process provide a "range" that the business should sell within.
For example, the range of value for a commercial printer we’ve recently assessed was between $2.9 and $3.2 Million. The variables affecting the value were:
1. Land/building
2. Gross margins
3. Sales trends
4. Cash flow
5. Overhead assumptions after the sale
6. Business loan availability
It is our experience that the first buyers who look at a business are the best candidates, because they are usually most motivated. Therefore, the selling price must be realistic, or these buyers will be turned off. Asking $5 million initially and then reducing the price to $3.2 million scares the would-be buyers because they wonder what is wrong.
Let’s address how we do an assessment. Note, I said assessment, not appraisal. We are not licensed appraisers and do not charge for this assessment. In fact, we strongly recommend you enlist the services of a business valuation specialist if you feel uncomfortable with our approach.
First, we start with a meeting of the owner(s) to gain an understanding of the business. Topics covered are:
1. Organizational structure.
2. Trends in the industry.
3. Fair market value of assets and equipment replacement cycle.
4. Customer sale distribution.
5. Products and processes.
6. Inventory value, age, accuracy.
7. Competition.
8. Reason for selling.
Based on this information, we next review the financials, preferably for a minimum of three years. At the risk of being redundant, we consider: sales, margins and overhead trends; cash flow; equipment lease/hold improvements; inventory, building lease/buy options; and add-backs such as depreciation, interest expense and owner’s compensation.
Typically, businesses sell for either multiples of cash flow (current or perceived) or debt the business can support after allowing for new owner’s compensation. With these many variables, you can appreciate why we provide a range for determining the selling price of a business.
For example, consider a company with sales of $1.2 million, net profits of $100,000 and an owner’s salary of $100,000. If the appropriate industry multiple was 2.5, a possible value could be (2.5 X 100,000) or $250,000. Using the debt approach and assuring the buyer will assume the owner’s salary, the amount available for debt reduction is $100,000. Assuming a four-year payoff
of debt at 7 percent and a yearly "average" cash flow of $80,000, the value could be $270,000. Add-backs, inventory and equipment also would be factored into these values.
Besides these approaches, a return on investment or straight percentage of sales could be used. These approaches plus other variables make determining a finite value for business difficult. That is why we suggest multiple approaches that provides a range which can be discussed with the seller to determine the selling price.
In conclusion, there is a difference between "value" and "price." Value refers to the worth of something. Value is determined by the use of the formulas, assumptions, and data available.
"Price," on the other hand, is the final consideration that is needed to acquire something. An example would be the sale of a convertible sports car valued at $10,000. Because it’s the middle of winter with snow on the ground and the owner needs quick cash, he accepts a price of $7,500. It has been said that price is what you pay, and value is what you hope to get.
Finally, every business is unique. Placing one "right" figure on a business is impossible. No formulas or rules of thumb are foolproof. No one equation can deal with all the factors that must be considered.
Most buyers don’t have complicated formulas or methods for buying a business. Many don’t have any methods or formulas at all. But they do have common sense.
The best advice I can give is to use common sense when placing a value on your business. A good question to ask yourself is, "If I were the buyer or investor, how much would I pay for this business?"
The only "right" number is the one that convinces all parties that they are coming out ahead and have gotten a fair deal.
James Schwai is a member of Metropolitan Business Brokers LLC, which is based in Milwaukee. The company can be reached at (414) 453-1111 or through the company’s Web site as www.busbroker.com.
August 6, 2004, Small Business Times, Milwaukee, WI