What's it Worth?
If you don’t know how much your company is worth, it may be time for a valuation.
BY FRANK JOSSI
As the great wave of baby boom entrepreneurs begin retiring, many of them will have to decide whether to sell their businesses or hand them off to family members. But first, they must answer a quintessential question: How much is my company worth?
Many owners of privately held small and medium-sized businesses have little true idea of what their enterprise might fetch in the open market, says David Stene, a partner in the Minneapolis office of Eide Bailly and an occasional presenter at Minnesota Technology, Inc.’s (MTI) business events.
“With many small-business owners, the largest asset they have is their business, and they don’t know how much it is worth, and the number they believe is correct is often inflated,” he says. “A lot of people ask me how you value a private business and I tell them, ‘You ask the owner and then divide by two.’”
Of course, selling a business isn’t the only reason to get a valuation, says Stene. A business owner may need a valuation for the IRS, especially when gifting a portion of the business to a family member, he says. A business making charitable contributions usually needs one as well.
Valuations are also used to create an employee stock ownership plan, to fulfill certain accounting procedures, to provide information to a new investor or for dispute resolution in matters such as marital dissolution of the owner and his or her spouse, he says. “In general, I recommend a business owner understand what his or her business is worth periodically and to understand what those value drivers are,” says Stene.
Assessing Values
To unravel the mystery of a company’s worth, start the process by hiring an accredited valuation professional. With the help of outside experts you can establish a date for determining the value of a company, a requirement of the process. The value can change significantly in a year, Stene points out.
Every aspect of a business plays into a valuation, from ownership to customer mix. A business owned by several people might have a lower price because a new owner has to potentially deal with several sellers — or one owner will have to buy out partners for a cleaner final sale.
A business with 80 percent of its revenues coming from one customer will be a riskier proposition than one with many customers. A small business where the owner is the only operating officer carries a greater risk of failure, too. The firm’s marketability also is a factor in the value of the appraisal, he says.
Many clients Stene deals with are passing the business to family members, one of the clearest reasons for a valuation. In this case, the family’s discounts might be considered, which may result in a lower value.
Three Approaches to Valuation
Consultants take three approaches to valuation — asset, income and market. For an operating business, the asset approach may not be applicable. “We would look at the fair value, not the book value,” he says. If a company owns real estate, for instance, the book value may be well below the market value and that asset will receive a boost in the valuation.
This method has been used for real estate companies, large construction firms with valuable equipment and even golf courses. For service companies, the asset method does not work because the assets are often the employees themselves or the client list, he says.
Generally, the most appropriate approach is to look at income. Boiled down to the basics, a valuation reveals a business’s return on investment. If the return on investment is less than bonds or the stock market, the investor might use those investments instead. “In a private company, you have to look at getting a higher return based on the income stream,” he says.
Finally, the market method looks at other sales of comparable businesses. A number of databases exist that appraisers can use to determine what like-sized businesses in a particular field are fetching in similar markets. “If we can find enough businesses that are comparable, that can be an indicator of value,” says Stene. “We use data based on revenue or net income.”
A valuation expert will help a client decide which of the approaches fits his or her situation. “We decide what’s appropriate and we do some weighting on that,” Stene says. “Often for an operating business, the income method would have a higher weight, the asset method little weight, and we might look at the market approach to see if that would influence the overall value.”
The final result is a report that comes in two types — a calculation analysis or valuation analysis. A calculation analysis, the less expensive of the two, uses only those valuation approaches or methods agreed upon by the client and the appraiser. “The report is limited to use by specified parties,” he says.
Meanwhile, a valuation analysis is a much more comprehensive valuation and considers all potential approaches in determining the worth of a business. Any IRS matters generally require a valuation analysis report, notes Stene.
The Sale
Buyers purchase private businesses in two ways — asset purchase or stock purchase. An owner might prefer a stock sale because it comes with tax advantages, but such a move comes with complexities for the new owner. The buyer generally prefers an asset purchase, says Stene.
Sales proceed in a variety of different ways. Offering an example, Stene says a small firm with $5 million in sales and $1 million in earnings before interest, taxation, depreciation and a mortization (EBITDA), a frequently used measure of value, might be worth $3 million to $4 million on the open market. Contrast that with a mid-sized business of $60 million in sales that has a much stronger management team in place, annual audits, good employee benefit plans and diversity of products.
Stene imagines a scenario where the second, richer company buys the first. “The owner might well have a larger EBITDA multiple than the first company — of six, rather than three,” he says. “She might look at the first business, buy it out at $4 million, reduce waste, eliminate duplicate functions and other things. She can improve the EBITDA of his business to $2 million and increase the value of her business in the process. That’s a good day for her.”
The two examples point to a few truths concerning sales. If the first owner knew how much the second owner would increase her EBITDA, he might have asked for more money. And had he known a few years before the sale how much his low EBITDA would affect the selling price, he may have cleaned up problem areas of the business, diversified and made other changes to increase the value.
There are other things to consider. To maximize the sale you have to have a good story to sell, good solutions, limited risk areas and an outstanding staff, says Stene. A business that gets a valuation a few years before a sale can move to improve operations in preparation for a better price. And a growing business is almost always easier to sell than a shrinking one, or one with flat sales, says Stene.
Stene recommends owners start exit planning early. “You start your planning for exit of the business the day you start [the business],” he says. “You have to have a long-term view of increasing value and making sure you have a good business model at the time you start.”