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De-Mystifying Business Valuation

I. Terminology:

A. Appraisal -

An appraisal is an opinion as to the market value of hard assets or real property and is certified by a licensed appraiser. Appraisals are normally used for estimating the value of real estate of large items of capital equipment. The author is not an appraiser.

B. Valuation -

A valuation is an opinion as to the market value of a going concern and considers both tangible and intangible assets. Valuations can be conducted for many different purposes, such as litigation, divorces, ESOP formation, and partnership dissolutions.

II. "Realism":

Some of the common unrealistic expectations of Buyers and Sellers are:

A. Buyers -

1. Undervaluing the cost of starting a similar business from scratch.

2. Undervaluing the importance of having cash flow and an operating business.

3. Undervaluing the goodwill and transition assistance of the Seller.

4. Expecting no money down deals and substantially more generous terms from the Seller than are available from an outside lender.

5. Assuming "everything is negotiable".

B. Sellers -

1. Overvaluing hard assets.

2. Overvaluing customer "goodwill."

3. Overvaluing the cost of starting a competing business from scratch, or buying a cheaper competing business and building it.

4. Believing that time in business = value, ie. 10 years in business = 10 million dollars in sales price.

5. Expecting an all-cash price.

III. Valuation Steps:

A. Net Liquidation Value -

This approach considers:

1. Hard assets valued at "fire sale" prices.

2. Value of Receivables.

3. Value of customer list, trade secrets, contracts, tradenames, trademarks, contracts, patents, product lines, special software, operating systems, etc.

4. Subtract Payables, Selling and Transaction Costs, Moving Costs, Lease Obligations and other obligations at close of business.

Liquidation Value is probably the lowest price you should accept.

B. Cost of Entry / Replacement Cost -

This approach considers that there is a cost in time and money to starting a business from scratch. No one could enter your business without incurring expense and accepting risk. General considerations are:

1. Organizational Costs, Licenses, R&D, Legal, Accounting, Printing, Design Fees, Furniture, Fixtures and Equipment, Inventory, Supplies, Advertising, Deferred Owner's Salaries, Net Operating Losses, etc.

2. Value of Time.

3. Risk Avoidance. In general, going concerns are safer than start-ups.

Assuming a Buyer wants to be in this type of business, the cost of entry method may reflect the highest price the Buyer will pay. Realism is essential on the part of both Buyer and Seller!

C. Industry Norms and Rules of Thumb -

1. Comparable sales are almost impossible to find. Any "comparable" should only be used as a sanity check.

2. Small Business General Rules of Thumb:
   Price = 1 to 3 Times Seller's Discretionary Cash (SDC) plus Earnings Before Interest, Taxes and Depreciation (EBITD) plus owner's compensation plus owners "Perks".

IV. Buyer's Objectives:

• What might a Buyer be trying to accomplish with this acquisition?

• As a Seller, what could a Buyer realistically accomplish with your business?

• Who might be a likely Buyer and what might they be trying to accomplish?

• What a Buyer is Buying?
  1. Viable, Ongoing Business with Existing Cash Flow.
  2. Customer Base.
  3. Market Share.
  4. Market Penetration.

• What are you Selling?
  1. Hard Assets.
  2. Cash Flow.
  3. Business Design, Organization and Start-up.
  4. Strategic Positioning for the Future.

What to Buy or Sell?

Because a going concern has both tangible and intangible assets, Buyer and Seller must decide what the value of the company is to be based upon...the value of the net tangible assets, or the cash flow produced by the assets. Regardless of what assets are bought and sold, in the final analysis on the Buyer's part, it will all come back to an evaluation of the return he expects to achieve on his investment.

The value of any asset (including inventory and equipment) is ultimately determined by it's productivity.

The key question is: How much profit has the collective assets generated historically, and how much can they be expected to generate when owned by the Buyer?

Note

The above information is only general in nature and should not be acted upon to address your specific situation unless a professional is consulted first to determine its application to your situation.

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Money Talk

Investing in USA

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