Understanding Business Valuation
There is confusion about the rationale and justification for a formal business valuation prior to taking a business to market, i.e., the value of a valuation. Selling a business is far different from selling a house or other tangible asset where there exists comparable sales information sufficient to support a value. Unlike real estate, it is not unusual for 50% or more of an operating business’s value to be based on intangible assets such as goodwill, intellectual property, licenses, location, etc.
Two businesses both netting $250,000 can have considerably different market values due to such comparative considerations as revenue growth rate, equipment condition, customer concentration, intellectual property, barriers to entry, competitive situation, owner’s role, administrative systems, labor and capital intensity, etc. One business may be operating below capacity and the other might require significant capital investment in order to grow. One may have an absentee owner with strong operating management while the other could be highly owner dependent. There can be myriad valuation variances for companies that on the surface are quite alike. Attempting to value a business based strictly on market comparables results in an average valuation that is insensitive to distinguishing characteristics and hidden aspects of the business.
The valuation of intangible assets relies on income-based methods. Accurate discernment of earnings and seller’s discretionary cash flow (SDCF) is essential if the value is to be true. The business valuation process begins with a detailed examination of the company’s revenue and expenses to accurately determine the true earnings performance of the business. Is the brother-in-law earning $50,000 really needed? Is a Porsche Cabriolet necessary for delivery purposes? If the seller owns the building, is the rent at market rate? How much business is being conducted in the addition to the owner’s house that the company’s maintenance crew built? What about stockholder compensation mystique in S versus C corporations? Inventory pricing creativity? Such typifies the discovery challenge of the appraiser and the rationale for a formal valuation if a business is to be fully valued.
Another major reason for a valuation is to avoid surprises in the due diligence process, which can quickly kill a deal. Full financial disclosure upfront to a buyer is extremely important. Bad news if fully disclosed might have an impact on price but at least the deal is far more likely to survive with upfront disclosure.
With precise earnings information in hand, the appraiser employs several valuation methodologies and weights the various results according to their pertinence to the business in question. For a business with significant tangible assets, the appraiser incorporates those asset values with the intangibles through methods such as Capitalization of Excess Earnings to arrive at a fully integrated value.
Finally, the appraiser subjects the valuation to an extensive set of qualification criteria from over 100 SBA lenders for further validation of the value. If the value withstands the SBA’s requirements standards, there is added basis for its validity.
Every business has a range of fair market value—the valuation process is not totally scientific. The challenge of the business valuation process is to determine a business’s true earnings, to assign fair value to its intangible assets and to uncover the hidden value drivers of the business that reside below the radar of superficial valuation techniques.
At FLORIDA Business Appraisals., we have found that businesses for which we have done formal valuations sell considerably closer to asking price than those without valuations. It appears that both sellers and buyers become better informed as a result of a formal valuation resulting in a more enlightened process for all concerned.
- Company Asset Valuation
Asset valuation is used when a company is asset-intensive. Retail businesses and manufacturing companies fall into this category. This process takes into account the following figures, the sum of which determines the market value:
- Fair market value of fixed assets and equipment (FMV/FA) - This is the price you would pay on the open market to purchase the assets
- Leasehold improvements (LI) - These are the changes to the physical property that would be considered part of the property if you were to sell it or not renew a lease.
- Owner benefit (OB) - This is the seller's discretionary cash for one year; you can get this from the adjusted income statement.
- Inventory (I) - Wholesale value of inventory, including raw materials, work-in-progress, and finished goods or products.
Capitalization of income valuation
Capitalization of income valuation method places no value on fixed assets such as equipment, and takes into account a greater number of intangibles. This valuation method is best used for non-asset intensive businesses such as service companies.
In his book "The Complete Guide to Buying a Business" (Amacom, 1994), Richard Snowden cites a dozen factors that should be considered when using Capitalization of Income Valuation. He recommends giving each factor a rating of 0-5, with 5 being the most positive score. The average of these factors will be the "capitalization rate" which is multiplied by the buyer's discretionary cash to determine the market value of the business.
The factors are:
Owner's reason for selling
- Length of time the company has been in business
- Length of time current owner has owned the business
- Degree of risk
- Growth history
- Entry barriers
- Future potential for the industry
- Customer base
Owner benefit valuation
This formula focuses on the seller's discretionary cashflow, and is used most often for valuing businesses whose value comes from their ability to generate cash flow and profit. It uses a fairly simple formula: you multiply the owner benefit times a multiple consistent with the industry to get the market value.
Multiplier or market valuation
This approach finds the value of the a business by using an "industry average" sales figure as a multiplier. This industry average number is based on the price at which comparable businesses have sold recently. As a result, an industry-specific formula is devised, usually based on a multiple of gross sales. These formulae can be troublesome, because they may not focus on bottom line profits, cash flow, or take into account how different two businesses in the same industry can be.
To find the right multiplier for your industry, please contact FLORIDA Business Appraisals
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