If you are buying or selling, or adding or removing a partner from a business partnership, you may know that the business needs to be valued. In very generic terms, this means creating a financial model of your business and estimating a value. Business evaluators use three business valuation approaches to value different businesses. But how do you know which valuation approach is best for your small business?
Here are the basics on the 3 approaches to business valuation, and which businesses they work best for.
The market approach uses substitution of market sales.
The market approach is the primary way to value small and very small businesses. The valuator will substitute comparable market sales from similar companies that have recently been sold to the company being valued. This calculation includes comparing cash flows and financial information with information about how the company is structured, the industry, and overall economy. For example, if a small government services provider is looking to determine their value for the SBA, a valuator would compare their size, management team, cash flow, and financials to a group similarly sized business in the same industry. For more information on this approach click here.
An income approach is based on cash flow.
When valuators use the income approach to find the value of a small business, they focus primarily on cash flow. The income approaches estimate the business value to an investor who could invest in anything from a government bond to a small business. This means looking at how much money a business is making and the business risk compared to other investment risks. Because most people who are buying or selling a business are interested in knowing how this business compares to other businesses this approach is the most used approach. By looking at the historic cash flow and income of a business along with many other business factors, valuators estimate future cash flow and the risk of obtaining the cash flow. From those inputs, they can estimate a value. For more information click to ….
The asset approach estimates the business’s value through assets.
For some small businesses, their value may lie in the assets they have. For a construction company, this could include equipment; for a commercial real estate company, it could include their properties; and for a tech company, it could include intellectual property. The asset approach is often used when there is not sufficient cash flow to use the income or market approach and basing the value on cash flow would not adequately estimate the value of a business. For more information on this approach click here.
The reality is that a professional valuator looks at your small business and all the available information, and uses the approach (or combination of approaches) best suited for your business. Each of these three models can be useful and each can be used in a misleading way. This is why all the models are helpful but none are perfect. As valuators, we impartially use valuation models to help business owners understand their value, whether it is for an SBA 7(a) loan approval, dissolution of the business, or establishing a partnership.
Business owners often feel it is not worth making changes once they have decided to exit. “After all, I’m just selling it.” But time and time again those owners who prepare for a sale sell their business faster and obtain a higher price.
While each business is unique, these approaches apply to every business.
A. Be highly profitable.
High profitability will increase your business value more than any other one thing you can do. Cash flow, largely a reflection of profitability, is half of any valuation equation. In addition, high profitability is viewed to reduce risk. So, high profitability improves both sides of the valuation equation. Here are some things you can do to increase profitability.
Reduce expenses. Almost every business can cut expenses 10% by looking closely at expenses and weeding out the redundant or unnecessary costs such as software subscriptions that are no longer needed. This is also a time to critically review staffing and identify employees who consistently underperform or do not have a full workload.
Sell more high margin products and services. Most businesses have a range of profitability across their products and services. Prepare a gross margin, or contribution analysis and to the extent possible and then focus on selling more of the high margin products.
Grow, if profitability can be maintained. Growth can be expensive. Do not grow at the expense of profitability if you expect to take your business to market in the next three years.
Do not over-invest in capital items like a new warehouse, large major machinery, etc. that will lower profits and take a long time to absorb if you are within five years of going to market. However, continue making normal periodic equipment investments like trucks.
Refinance debt to lower rates if they can be obtained.
Keep your company lean. Remember, the last two or three years and the current period through your closing date are going to determine your business exit or succession value. During this period focus on profits.
B. Reduce risk
The other half of the valuation equation is the multiplier or discount rate which is an adjustment that factors in business risk. Reduce business risk to increase your business exit value wherever possible. Examples are:
Contracts: Obtain long term contracts instead of working with no contracts. Obtain service contracts when possible. Develop backlog and bid waterfalls to estimate (and later show) potential work.
Liability Insurance: If you have a professional practice make sure you have professional liability insurance.
Legal Resolutions: Resolve lawsuits that are not covered by insurance if possible before beginning the sales process.
Safety Ratings: Maintain a good safety rating in dangerous industries.
Balance Sheet: Build a strong balance sheet. Strong balance sheets demonstrate long term profitability and the ability to overcome short term difficulties.
Joint Venture Options: If you have a preferred buyer, try to joint venture or otherwise work for them. Knowing you, assuming things go well, reduces risk at least to that buyer.
Training: Develop other salespeople besides yourself. In fact, develop systems and train people to solve problems to reduce reliance on yourself.
C. Become Expendable
In most small businesses, the loss of the owner is the biggest risk because every major decision leads to the owner. Therefore, when you sell your business much of the decision making and intellectual property leaves with you. A prospective buyer will view this as a serious liability.
Start training your staff now to make decisions and share the day-to-day responsibilities. Granted, this process is challenging and in some cases may mean additional training for current employees and/or hiring a higher caliber staff. Work towards being able to take a two week vacation and not call in.
This effort will not only reduce risk but also create increased business value. Of course, if you don’t have to work so hard, you might now want to sell at all.
D. Lock in Key Players
As you develop systems, train key people, and start taking time off, the risk of losing of key people increases. Create a “golden handcuff” plan to keep your key people now and through a transition. If you have a high year end bonus culture you can pay
Conclusion:
If you are considering an exit plan, you need to make sure you get it right. The area is complex and many things from tax laws to negotiating strategies are not always intuitive. Don’t learn on yourself.
The book, “The Art of Business Valuation, Accurately Valuing a Small Business” has over 75 of its 400 pages covering many aspects of small business market sales including working with business brokers, increasing sales value, descriptions of a well-run sales process, due diligence including a checklist and guidance on SBA loans. If you are selling a business with revenues under $10 million, you need this book on your desk. The book published by Wiley is available through your favorite bookseller. More information can be found at www.theartofbusinessvaluation.com
Finally the author, Greg Caruso, JD, CPA, CVA, is always available to assist with exit planning, brokerage, and to prepare or review business valuations with an emphasis on increasing value and likely transaction values and terms.
Asset Approaches in business valuation compares the value of the assets less the value of the liabilities (debts) of the company and the difference is the company value. The formula is Assets – Liabilities = Value.
For small businesses this tends to be limited to the physical tangible assets. Intangible assets such as the value of the customer list, value of systems and processes, etc. tend to be lumped into goodwill and are not independently valued under the asset approach.
The assets and liabilities are often valued to different standards of value. An easy way to think of standard of value is it answers “who is establishing this value”. Another way to look at it is “who is the buyer and who is the seller.” Also, in the case of asset methods, standard of value may include time available to sell on the market.
Book Value is the value the asset are carried in the accounting records. This is the purchase price less depreciation. This may or may not reflect a market value. This is a value to the seller for accounting and/or tax purposes.
Market Value tends to value assets at the current value, near what might be considered dealer or distributor prices. Namely what the company would have to spend to acquire assets in similar condition or what they might sell a few assets for under normal operations.
Liquidation Value is the sale price for the assets under assumptions about the timing of the sale. Orderly liquidation means perhaps 90 days to sell (a bad situation but not dire). Forced liquidation means auction value.
Clearly each of these assumptions will change the value found dramatically.
Below is a simple example without estimating a value for intangible assets or goodwill:
Note the range of values found under the asset method depending on the standard of value applied. Choosing which value is most appropriate will depend on the underlying fact pattern of the subject company.
If you own a business, or prepare business valuations, or advise business owners based on business valuations (i.e. attorneys, CPA’s, financial planners, lenders, business brokers, etc.) you owe yourself and your clients the peace of mind of really understanding small business valuation.
“The Art of Business Valuation, Accurately Valuing a Small Business”, written by Greg Caruso will be published by Wiley in Fall 2020. The book is geared for valuating businesses with revenues under $10 million. This resource is easy to understand yet addresses the technical side of valuing small and very small businesses. In addition, the related website has sample reports, checklists and working Excel files of many calculations.
