Cashing Out: What is my business worth?
Before reading this article, we suggest you read our article, “Dollars and Sense: Why is it Important to Know the Value of My Business?”
The simple answer to this entire article is - a business is worth what someone is willing to pay for it. This is certainly a straightforward response, but as you will begin to understand, this small statement holds a lot of weight when determining the value of your business.
Here are a few things to know in determining what your business is worth:
Be Realistic With Your Expectations
It is a simple fact that almost every small business owner thinks their business is worth more than it is. Our goal at Viros Group is to help you in every way to maximize the value of your business. The reality is most businesses rely so heavily on the ideas, knowledge and relationships built by you, the current owner, that losing the intangible goodwill value that you bring to the company immediately reduces its value when you leave. Your goal in maximizing the value is to put yourself in the buyer’s shoes and ask yourself what they are going to purchase. Ask yourself, “how do I make this the most valuable to my buyer?” Doing so will allow you to bring your own valuation to a more realistic starting point in order to help you better strategize on how to make the company more valuable in the years leading up to your succession plan. Identifying weaknesses in the value and turning those into strengths just might end up bringing the valuation more in line with your expectations.
Barriers to Entry Significantly Affect a Valuation
The most common reason business owners feel their company is worth more than the actual value is based on very significant business terminology known as “barriers to entry.” Every business has market share, strengths and opportunities that make it valuable. Ultimately, the true value of a business comes when competitors or new entrants to the market have a difficult time entering your business space and reducing your value. As an example, if you own a profitable construction company with some newer equipment and a loyal repeat customer base, you might think you have a very valuable business. But, if anyone wanting to get into the construction business can simply buy a piece of equipment and start servicing your customers better than you, they would have no need to pay a high valuation for your business. In effect, there are no barriers to them entering your market and slowly draining your profits and your business valuation. To combat this, you as a business owner can put some safeguards in place such as customer contacts, strategic pricing models, employees, and other intrinsic strategies that would make someone want to buy your business before they would consider starting their own. Again, the overall value of the business is what someone is willing to pay for it, so recognizing that the barriers to entry philosophy exists is an important component when completing a valuation.
Three Different Valuation Methods Can Yield Three Different Values
Typically there are 3 different overlaying fundamentals to valuing a business. Within that, there are a lot of variations on how to explain the valuation methods. We choose to simplify the methods into three categories: Current earnings multiplier, future earnings forecast and asset acquisition model. Depending on the type, size and scope of the business, one or a combination of all three methods may ultimately be used. The highest of the values determined is usually what represents the fair market value of the company.
Current Earnings Multiplier
If you have a stable, profitable and simple business structure most likely it will be valued based on the current earnings multiplier method. A prospective buyer will scrutinize the current and past three to five years of income statements to determine the average annual earnings for the business. From this, the earnings are normalized to account for both personal/owner specific items you run through your company like travel, auto, and management wages, as well as non-operational expenses such as interest, taxes, depreciation, and amortization. Determining a normalized income will allow the prospective buyer to truly understand how much money they can expect to continue to earn from the business after you are gone. This profit equates to their own personal return on investment. How confident they are on achieving that ROI ultimately determines what the buyer is willing to pay for your business. The average company sells between two to four and even sometimes up to six times normalized earnings. Meaning, if your business earned a normalized annual net income of $300,000, you can expect a valuation to be in the area of $600,000 to $1,200,000 plus or minus some discretionary adjustments. The intent of this valuation is that the new owner will be able to pay their investment off in three to five years which coincides with most financing arrangements and general market investment returns.
Future Earnings Forecast
Have you ever wondered why some public companies can lose millions of dollars and yet still have soaring stock prices considered extremely valuable? The concept is based around analyst expectations that the decisions the company is making today will have positive effects on the profitability of the company tomorrow. Therefore, the company has strong value based on future earnings and not necessarily current or historical earnings like the previous example. It is important to really understand that profitability is not the only driver to the value of a company. A company like Netflix can lose money in a quarter, but if they increase their subscriber base, the value goes up. They might not be making money, but more people are signing up and that yields the expectation that more subscribers will generate more future profitability. As a business owner, it is important to understand your valuation metrics and how your decisions today will positively or negatively affect future earnings and ultimately how much a prospective buyer will pay for that future forecast.
Asset Acquisition Model
Earnings are a speculative valuation model as they take so many unknown factors into consideration. The easiest way to value a company is the asset acquisition model. A buyer can forget earnings and profitability and instead simply focus on the overall fair market value of the company’s assets. Assets obviously include cash, accounts receivable, inventory, and equipment. Additionally, assets can include customer lists, patents, trademarks, goodwill, brand recognition, licensing agreements, intellectual property, and even research and development work. Many of the intangible assets eliminate the barriers to entry risk of a valuation and make the company worth someone buying it to acquire the assets that they cannot simply build, purchase or develop themselves. More often than not, asset valuation becomes a significant component to a business valuation and eventual sale. Knowing and building the value of these assets is an important part of the development stage as you work towards your succession plan and sale.
Finding the Right Buyer
As mentioned in the opening, a business is worth what someone is willing to pay for it. Outside of understanding the valuation techniques and ways to make your business more valuable, the ultimate catalyst to obtaining maximum value for your business is to find the right buyer. The right buyer is someone who sees value in purchasing your business versus starting their own. They see value in what you have built and welcome the opportunity to grow the future earnings and they see value in your assets and overall position in the market.
To continue the discussion on how to find the right buyer, we suggest you read our article, “Buyer Aware: Where Do I Find a Buyer for My Business?”
Jared Burwell is the author of this article. He is the founder and director of Viros Group, a capital investment and financial management firm focused on business growth and succession planning. He has spent the last 20 years in public accounting with a primary focus on providing advisory services and financial oversight to a wide sector of small and medium-sized owner managed businesses.
