Recently I presented “Valuing Micro and Small Businesses in the Shadow of COVID-19″ as a webinar training for Business Valuation Resource members. As always, I provided time at the end of the session for questions from attendees. This group had some very thoughtful questions. I thought perhaps others would benefit from our discussion.
What do you mean by “poor financials?” Do you mean a lot of personal stuff is run through the business? Or a general ledger that doesn’t balance and off balance sheet assets / liabilities?
Each of those issues creates poor financials plus many more. Many micro and small business owners manage by walking around. They have a few leading indicators they watch (maybe sales, collections, production). From those, plus being in the middle of the business, they know how they are doing. This knowledge does not translate well for us, as we are not in the middle. Therefore, we have to work harder to really understand what is going on and how to adjust the deficient financials so they are reasonable and workable.
What sources of data do I use for the local economy?
I use the Federal Reserve Beige Book, published for each district. It is anecdotal information but I find it useful.
Another one I will use for cyclical and real estate related is State Board of Realtors sales data. Often this can be obtained at a local level, if that is more meaningful for your company. The data here impacts everything from construction, remodeling, furniture sales, equipment sales, etc. in a local or state market.
Also, the quarterly BizBuySell Insight Report offers data on many market areas with prior reports available for many years to allow comparisons. The number of sales can be used as an indicator of the difficulty or ease of selling a small business.
Local information can be gleaned from many sources. Many federal agencies, states, universities, and state oriented non-profits publish data that might be indicated for the Company and industry you are valuing.
I have been spending more time analyzing debt service (for example: Can they pay back the debt? If so when will they achieve a profit given high debt levels? Will they need more debt to stay afloat?). Do you have any thoughts on that?
Certainly for high debt companies, or companies with lumpy cash flows, (i.e. a few large clients or projects that have endpoints like construction contractors that do a few large projects each year) understanding the balance sheet is very important. Current assets on the balance sheet (particularly cash reserves) provide resiliency and the ability to meet payments when times are tough.
Another thing that needs to be reviewed with companies with debt is the terms of the debt. Many small companies use lines of credit like long term financing. Also, even long term loans often contain clauses allowing the lender to recall the entire amount due, if covenants like minimum earnings are not met. The result can be a company that is meeting minimum cash flows to survive falls into default on their loans creating serious going concern issues.
In most cases (but not all), we do not have data to make a final determination on going concern issues. But a company that has a reasonable level of going concern issues is going to have a steep discount versus companies with a clear path forward.
I saw a few companies with low, negative earnings (-30% to 50% and high revenues multiples in the range of 3-4x. This looks funny for a service company. Since I don’t have historic data or projected data how can I make sense of the pricing relationship?
Without more data, I’m not sure. And perhaps you can’t. Some technology codes do have the types of companies desired by Google, Apple and the like and these may contain synergies that frankly I don’t completely understand how to assess.
Assuming there are enough comparables, I recommend several things though before you throw up your arms in defeat.
Try sorting the data several ways. Use different cash flow minimums and minimum and maximum revenues and see if the results look different. Sometimes I get an understanding of the data doing this and it is easy within the DealStats .
Assuming your firm is profitable sort with a minimum cash flow that is somewhat near your cash flow (i.e. if your company as a 15% SDE profitability (SDE/Revenues) and a minimum revenue sort of $1,000,000 then perhaps you require an SDE of $75,000. Since your company is profitable, these comparables will be more like your company.
Always chart the companies by cash flow profitability (Cash flow being used/Revenues). This will usually provide clear trends that are different from what might be implied by the charts shown in the various databases.
Three more webinars on the “Valuing Small Businesses in the Shadow of COVID-19″ topic are scheduled in the upcoming weeks.
“The Art of Business Valuation, Accurately Valuing a Small Business” covers many aspects of small business valuation and 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 value or use valuations of businesses with revenues under $10 million, you need this book on your desk. The book published by Wiley is available through your favorite bookseller.
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.
I am grateful to my friend and colleague, Ron Rudich, for writing the Foreword to “The Art of Business Valuation: Accurately Valuing a Small Business”.
FOREWORD
This book, The Art of Business Valuation: Accurately Valuing a Small Business is an important guide and desk reference for valuing small businesses under $10 million in revenues. The vast majority of businesses are this size, yet most business valuation books, even the ones claiming to be for small businesses, do not address the unique factors impacting these small and very small businesses.
The author’s business broker and valuation background provides a practical view of technical valuation issues from someone who has had to then “find the number” in the market. Yet this is not a book about price. It is about business valuation, namely, finding a business value for a specified interest as of a specified date to a specified standard of value.
My contribution to this work has been to provide insight and modification as an experienced practitioner, instructor, and mentor from a more technical accounting business valuation view.
The book’s focus on small businesses does not mean that methods or techniques have been simplified or ignored. What has been provided is a thorough examination of how valuation methods really work with the data that is really available for these businesses. Things like,
how to work with less than perfect financial information
how to find a highly supportable multiplier using available data
when to use the market or the income method
how to meet valuation standards
and more.
Included in the book are detailed figures, tables, explanations, and on the related website working Excel files and even sample reports that provide a framework that can be adapted to most business valuation needs.
Lastly, while an exact “opinion” may only be supportable and not be accurate, our methods, work product, and reports can and should be accurate. That is the standard we all must strive for every day in every engagement. That is why accurate is in the sub-title.
Clearly, the best a valuator can do is issue an “opinion.” Therefore, there will be varying viewpoints on the topics and methods presented here. In fact, there will be situations where the facts and assumptions would dictate that we use different techniques than the ones recommended here. That illustrates the importance of professional judgment.
That is the Art of Business Valuation.
We find this variety of viewpoints and challenges to our thoughts to be exciting and invigorating. It makes business valuation better. With this view in mind, please contact us at with your thoughts on the book and the valuation of small businesses. We also would be pleased to receive additional reports, studies, techniques and other viewpoints that can be posted on our related website www.theartofbusinessvaluation.com.
This way, we can all continue to learn, grow, and improve together.
The book, “The Art of Business Valuation, Accurately Valuing a Small Business” has over 400 pages covering many aspects of small business valuation and 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 value or use valuations of businesses with revenues under $10 million, you need this book on your desk. The book, published by Wiley, is available through your favorite bookseller.
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.
Greg is also available for interviews, podcasts, quotes, presentations and more. Contact Greg at or 609-664-7955.
Standard of value is a shorthand for describing who is the buyer and who is the seller and what is the framework for the transaction in a business valuation.
For instance a race car has a very different value to a race car driver than it would to a family of six looking for a safe car. The value is also likely to be different if the seller must sell in a week or has three months to make a deal.
While this distinction can be subtle, it can shift the found value significantly. For instance a Fair market value and fair value valuations regularly have a 15-30% or more value variance. A brief explanation of the primary (but not all inclusive) standards of value follow.
Fair Market Value
“The amount at which the property would change hands between a willing buyer and willing seller, when the former is not under any compulsion to buy, and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.” Rev. Ruling 59-60.
Other important points that, while not in the above definition, are agreed upon by the valuation community:
This payment is in cash or immediately available funds (which means it will be cash within three days). Basically this is a typical buyer and a typical seller transaction at an all cash price.
The buyer and seller are hypothetical not the actual parties.
Finally fair market value is often not the highest price that might be obtained. It is a likely price by a financial buyer with no synergies unless many buyers have the synergies.
The fair market value standard, when used to value minority and lack of control interests, will require discounting or other adjustments. The owner’s of these lack of control interests do not have the ability to control the company, (the difference between being the driver of the car and in the passenger seat) hence their shares are difficult to sell and garner much lower prices than control owners. Discounting is, in effect, a second valuation that reduces the value found from company value to the specific minority owner’s interest value.
Fair Value
Definitions vary, but for litigation and state law purposes, it is usually the fair market value of 100% the equity interests in the enterprise that are then divided pro-rata based on ownership percentage. There are no discounts for minority interest or discounts for lack of marketability for lack of control shareholders. Again, these are the discounts that arise from being “along for the ride” instead of in control of the company. State statutes and in litigation by courts of equity frequently use Fair Value to protect minority shareholders. (Please Note: Fair Value in GAAP public accounting has a different definition but that is rarely applicable to small and very small businesses and will not be addressed here.)
Synergistic Value
Synergistic Value is the value to a buyer where the buyer can make more money from the acquired company than the acquired company could on its own. Consider two delivery companies with half empty trucks going on the same routes. Surely if one acquired the other the successor would be more efficient and profitable. This is Synergistic Value.
If there are many synergistic buyers, then synergistic value may actually equal fair market value. If synergistic buyers are rare, then fair market value will be below synergistic value.
Investment Value
Investment Value is a market value where the buyer and seller are known. This valuation would attempt to use actual revenues and expenses to determine cash flows from the two companies. Investment value may be synergistic or not.
Remember fair market value is NOT the actual buyer and seller but a representative hypothetical typical buyer and seller.
Liquidation Value
Liquidation Value is the value of the assets that must be sold in a defined time frame. Orderly liquidation assumes about a 90 day sales window. Assets must be sold promptly but there is some time to make a market. Forced liquidation is also known as auction value, the price when the asset will be sold on a set date.
Clearly the standard of value selected will greatly impact the value found in a business valuation.
Do you need a valuation for your business or for your clients?
Do you prepare or review business valuations?
Do you advise business owners based on business valuations as their attorney, accountant, or financial planner?
Do you ever refer your clients to a Certified Valuation Analyst?
Small Business Valuation 101 explains estimating your business value or worth.
Business valuation at the rule of thumb level is very simple like the summary shown immediately below. Yet formulating an opinion of value can be endlessly complex. Part of the complexity comes because business valuation is forward looking. Likely foreseeable cash flows, not past cash flows are the basis of the value. That alone brings many assumptions into play and room for disagreement.
So here it is – Business Valuation at it’s simplest:
The subject company or company being valued iscomparedto something else to determine value. For instance:
Under the asset approach the comparison is the cumulative total asset value less total liability value. (Add up the current “market” value of all your assets. Subtract all your debts. What is left is the business value under the asset method. For instance, Cash is $100,000 plus Trucks $50,000 plus Inventory of $200,000 equals $350,000 less accounts payable and debt of $100,000 means the business value using the asset approach would be $250,000.
Under the market approach you are comparing market sale comparables to the subject company. Find “comparable companies” that sold. Determine how much they sold for compared to their “cash flows”. This ratio is called a multiplier. Multiply that multiplier times your company cash flow to get a value. For example Joe’s garage sold for $300,000. Joe’s garage had cash flow of $150,000. The multiplier is 2 estimated as $300,000/$150,000. Your garage has cash flow of $125,000. Your garage’s indication of value is $250,000 estimated as $125,000 * 2.
Under the income approach it is comparing all investment opportunities to the subject company. One way to do this is to come up with a required return to obtain an investment in the subject company based on risk. Divide your cash flow by the required return. For example Cleaning Supply Distributor has cash flow of $500,000. The capitalization rate is estimated at 20%. $500,000/.2=$2,500,000.
That’s it at the simplest level. But life and businesses are not so simple. In fact each of these simple steps above combines many other steps, research, assumptions etc. Therefore, business valuation is not really quite so simple either. What is shown above is an useful place to start but certainly not the place to stop. Keep reading if you want to know more.
Three Main Valuation Approaches
The Asset Approach, the Market Approach, and the Income Approach.
One of the most important decisions a valuation analyst makes is which approach and then which method under the approach to use. Methods are subsets of an approach. Methods under an approach often share key elements of the approach but have different details and can result in very different values for the business.
Asset Approaches
The asset approach 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. The assets and liabilities are often valued to different standards. A few of these standards are; book value defined as what it is on the accounting books, market value or what the asset would cost from a dealer, or various liquidation values depending on how fast the assets need to be sold. For small and very small businesses this analysis tends to leave off the value of intangible assets and is often used for liquidating companies. Going concerns or companies expected to continue operations use the next two approaches.
Market Approaches
The Market Approach compares market prices, either public stock prices or sales of comparable private companies to the company being valued. The underlying principal is Cash Flow times a Multiplier which is derived from the comparable data equals Value.
Cash flow for the future is estimated from past adjusted cash flows. Normalization adjustments are made so the cash flow is an apples to apples comparison with the comparables’ cash flows used to determine the multiplier.
The multiplier is calculated as Sales price / cash flow. For example a sales price of $1,000,000 / a cash flow of $350,000 = a multiplier of 2.85. This ratio is called a multiplier. Each comparable transaction will have a different multiplier. This multiplier is further adjusted based on similarities and differences between the comparables and the company being valued. The final selected multiplier is multiplied by the subject company estimated cash flow to calculate a value. Cash flows typically used include revenues, EBITDA (earnings before interest, taxes, depreciation, and amortization) and SDE (seller’s discretionary earnings or EBITDA + all the ways one owner makes money from the business). The analyses for both cash flow and selecting the correct multiplier can become quite multifaceted.
Income Approaches
The Income Approach estimates a rate of financial return called a discount rate that investors will require in order to invest in the subject company. In the simplest shorthand the normalized future cash flows are divided by the discount rate to calculate value. These investors are generally assumed to not be owner operators but true investors.
Data about required returns for investors is used to “build up” a discount rate which is in effect a required rate of return for investors. For instance Federal treasury bills are considered the risk free rate, then the increase in required return for large company stocks is added and so on until a risk rate equal to the risk in the subject company is calculated. Again, this is an estimate of the return that will be required by an investor to invest in the company.
Under the discounted cash flow method each years future cash flows are forecast, discounted, present valued and added together to perpetuity. Because perpetuity would be hard to calculate this usually includes a terminal value calculation to address the period between the end of the forecast and perpetuity. This terminal value is added to the value from the discrete years.
Under the capitalization of earnings approach historic cash flows are reviewed and adjusted to reflect likely future cash flows. Then the discount rate is reduced by a long term growth rate to develop a capitalization rate. Finally the next year’s cash flow is divided by the capitalization rate to determine the value.
Please note: this article is a simplified overview, estimating and normalizing cash flows and estimating the discount and capitalization rates quickly becomes quite complex.
Two other major factors may provide a huge swing in value found: determining what interest is being valued and deciding the standard of value
Interest being valued – Often the value of the entire business is being valued. This is the enterprise value which includes both long term interest bearing debt and stock or equity in the capital structure. If the debt is subtracted or otherwise adjusted for the stock or equity value is calculated. Those are two interests. Discounts can be used to adjust for variances between the comparable set and the subject company. More often discounts are used to adjust for differences between majority control owners of a company and minority non-control shares in private companies.
Minority non-control shareholders are shareholders who cannot directly influence company policy and procedures. Because these shareholders are “along for the ride” there tends to be no market to sell these shares. Therefore under a fair market value standard of value (essentially a transaction price) they have far less value than the majority or control shareholders stock. Where a lack of control minority interest is being valued discounts for lack of control and discounts for lack of marketability (DLOM) are estimated and used to reduce the enterprise value found. Stock options, debt, convertible debt are all interests in businesses that can also be valued. Finally goodwill and personal goodwill are intangible interests that may be valued. Valuing each interest involves additional methods and comparisons.
Standard of Value – this is shorthand for who is the buyer and who is the seller. For instance a race car will have very different values to a family looking for a safe car and a race car driver.
Fair Market Value – “The amount at which the property would change hands between a willing buyer and willing seller, when the former is not under any compulsion to buy, and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.” Rev. Ruling 59-60.
Basically this is a typical buyer and a typical seller making a market. The buyer and seller are hypothetical not the actual parties.
Fair Value – is the same as the fair market value of 100% equity ownership in the enterprise divided prorata based on percentage ownership. There are no discounts for minority interest or discounts for lack of marketability for lack of control shareholders. This is frequently used in state statutes to protect minority shareholders.
Synergistic Value – This is the value to a buyer where the buyer can make more money from the acquired company than the acquired company could on its own. For instance two delivery companies with half empty trucks going on the same routes. Surely if one acquired the other the successor would be more efficient and profitable. Therefore the target company can be worth more to the synergistic buyer than other buyers.
Investment Value – this is a market value where the buyer and seller are known and the valuator attempts to use actual revenues and expenses from the two companies. Remember fair market value is NOT the actual buyer and seller but a representative typical buyer and seller.
To Summarize
The subject company or company being valued future cash flows are estimated and is compared to a comparison set to determine value.
Under the asset method it is the cumulative total asset value less total liability value.
Under the market method it is comparing market sale comparables to the subject company.
Under the income method it is comparing all investment opportunities to the subject company.
These methods are used to determine the enterprise value. This enterprise value will be influenced by the standard of value or definition of who the buyer and seller are. Finally discounts may be applied for minority or other interests. The results are an indication of value.
Greg Caruso J.D., C.P.A., C.V.A. is the author of “The Art of Business Valuations: Accurately Valuing a Small Business” (to be published by Wiley in late 2020), an easy to understand yet technical guide about on valuing small (under $10 million revenues) and very small (under $5 million revenues) businesses. In addition, sample reports, checklists and working Excel files of many calculations are provided as resources
