- IMPORTANT: The following explanation is meant to offer a general understanding and not as a set of instructions as how-to conduct a Business Valuation. The considerations and complexities that may become involved in a valuation process are too numerous to mention and explain here in a page or two. Books have been written on the subject matter. If you would like help with a Business Valuation, please Contact Us.
In our experience, the price at which good and profitable businesses have sold have been that amount equal to balance sheet value plus goodwill value.
That being the case, in our view, a business valuation conducted for the purpose of determining the price at which the business is apt to be bought and sold between a reasonable and motivated buyer and seller, would be calculated on the combined values of the Balance Sheet and Goodwill, with the value components being calculated and developed approximately as follows.
The calculation of Balance Sheet Value is simply “the value all assets intended to be included in the sale price, minus the total of all liabilities intended to be included the sale price” and thereby, the opening assets and liabilities of the business post sale. The company’s balance sheet is a reflection of “what the company has earned and retained from yesterday’s business.” At book value, Balance Sheet Value is a known quantity since it is reported in the company’s financials, and is thus generally not a particularly contentious calculation. When capital assets are revalued at a market or replacement value, that portion of Balance Sheet Value can become contentious because it becomes a value opinion.
In a closely held business, often, certain assets and/or liabilities will be excluded from the valuation (and from the sale and from the sale price). Examples: Related party assets or liabilities such as a loan to or from a related party, or a vehicle driven by the business owner who may decide to retain the vehicle personally, or perhaps the business premises owned by the company but excluded from the sale and retained by the seller, and then generally offered to the business post sale in form of a lease. So, in this explanation, Balance Sheet Value means the net value of Balance Sheet items (assets minus liabilities) included in the valuation and to be included in the sale and sale price.
The calculation of Goodwill Value is firstly a calculation as to what are anticipated will be sustainable post sale earnings of the business; a predictable post-sale continuation of pre-sale sales and earnings which will NOT be a known quantity but an estimate or opinion as to what the company “will earn” from tomorrows’ business compared to what it “has earned” from yesterdays’ business. Goodwill implies that “the good business experience developed in the past will continue into the future” with a level of earnings that are considered sustainable into the future, and a goodwill valuation must predict or estimate the amount of those sustainable earnings.
As a rule of thumb, in our opinion, one developing such an estimate would probably first look at past and current sales revenues and earnings. In doing so, one should take a particular look at non-business sales, costs and expenses as to adjust out such that which are non-business related and/or normalize to market rates those which have been recorded at non-market rates. Examples: adjust out personal perks paid by the business, such as a vehicle expenses, travel, entertainment, etc., and normalize related party expenses that may have been paid at over or under market rates; such as wages, salaries, bonuses, dividends, leases, rents, etc.
The sustainable earnings number you are looking for will typically be an average (be it a flat average or a weighted average) of the last 4 or 5 years of the above described adjusted earnings. Again, this is meant to suggest a general rule of thumb. All sorts of factors may come to play; such as changing economic trends, industry trends, the trends of this particular business or its markets or suppliers, and other factors that might impact the next few years in any predictable manner, including what might be the impact from the sale of the business to new ownership and perhaps new management.
And, since no one knows the future, sustainable earnings and goodwill value will both be based on a forecast and thus arbitrary, but nevertheless, the best anyone will be able to provide with regard to that sustainable earnings number, will be a reasoned and explainable estimate based on its history.
So, in our view, a business valuation will be the combination of Balance Sheet value plus Goodwill value, with Goodwill value based on what are considered to be the sustainable level of earnings and selling price will be a derivative of those calculations.
Selling Price should be calculated on the basis that the sustainable level of sales and earnings must be such that will be sufficient to pay all business related cost and expenses of the business over several years; commonly 4 or 5 years, and ALSO sufficient to repay (or return), over a reasonable period of time following the purchase; commonly a 4 or 5 year period, the buyer’s investment in the acquisition of the business.
Any Business Valuation with any arbitrary component, such as goodwill value, is a matter of opinion, BUT this is your business and you get to set the Selling Price, or at least the Asking Price that emerges from that valuation. Of course the person being asked to pay the Asking Price will determine willingness to pay such a Price, and what is reasonable value and reasonable time to one may not be to another. Purpose, motivations and compulsions of seller and buyer, and the type and degree and the value of strategic fit (if any) that may exist for either are factors that may bring unique and legitimate weighting and suasion, and in the end, different opinion.
So, the reasonable assumptions involved in the calculation of the valuation and the Selling Price should be logical, explainable, defensible and REAL, which takes us back to the value in the balance sheet and value in the business earnings. Those base values to begin with must be REAL.
Whether a business valuation is conducted in order to price the business ‘for sale‘ or ‘for purchase,’ the objective of the valuation should be the same; … to calculate a FAIR MARKET VALUE. That’s where agreement between reasonable buyers and reasonable sellers, in our experience, has be found, and where good profitable businesses have been and will be bought and sold, and I think, in a few words, the following defines FAIR MARKET VALUE.
Fair Market Value is the amount at which business ownership will change hands …
- from a reasonable Seller who is motivated, but not compelled to sell
- to a reasonable Buyer who is motivated, but not compelled to buy
- under terms and conditions acceptable to both
- and when both parties are in possession of and have understanding of the relevant facts.
Seller Motivations: If the business is being valued for sale by a seller urgent to sell the business for personal reasons; reasons other than non-viability or non-sustainability, that urgency should probably NOT be calculated into the valuation. If the seller’s urgency is going to impact the price, it should impact the price later in the process, such as when the seller might decide to take less just to get a deal done in order to satisfy the personal urgency. Thus, in conducting a fair market valuation, one should assume the seller is motivated, but not compelled to sell.
Buyer Motivations: There are many different types of buyers, who generally fall into one of two groups; those who are just looking for a good profitable business to buy and operate on its own; and those who are industry buyers with a business already in the same industry looking to grow their current business through the strategic acquisition of another with synergy.
- Fair Market Value, in our opinion, is typically that calculated on a standalone business operating on its own, just as it has been until today.
- When one business is merged into another, combined sales to a combined customer base will often result in greater overall sales, while combined expenses will often result in lesser overall expenses, and thus result in increased overall earnings, and in such case the business might indeed be more valuable to a buyer working on a merger than to one looking for a business to own and operate on its own.
There can be real price advantages in selling your business into a merger within the industry, but there may be real risk as well while attempting to find the right buyer within the industry. There may be many more interested in looking than in buying, but those will be left to another discussion. Fair Market valuation of a business for sale, in our opinion, typically means pricing it for sale as the same stand alone business it is today, to a yet unknown buyer with yet unknown motivations and levels of compulsion.
Terms and Conditions may include a host of considerations, but two primaries will be Payment Terms and Due Diligence.
Will the purchase price be an all cash payment, or will the seller be prepared to carry a portion of the selling price; if so how much, over what period, at what interest rate and supported by what form of security. And, when it comes time for due diligence with respect to books and records, employees, customers, suppliers, etc., what level of access will be available to the buyer (or buyer representatives), and when and when.
Relevant Facts: An absolute key to a Fair Market Valuation, in our view, will be the valuator’s access to all of the relevant facts pertaining to the business. These will include, and probably begin with the financial facts; the value of the hard or tangible assets of the business that are to be included in the sale, as well as the value of the soft or intangible assets of the business. Other considerations will include equipment condition and/or cost to rebuild or replace, continued availability of current location or availability of alternate facilities and cost to relocate, market conditions, economic conditions, transfer-ability of the business to new ownership, employee relations and retention of key employees, customer and supplier relations and future probabilities, and more.
Some can and should be factored into the valuation. Some cannot, but will simply become part of the overall considerations of the buyer. And, the seller will have considerations as well and will want to know that the buyer is serious and capable and that ‘full payment’ will be received in due course, and will want to see facts in support of those matters, and all should be considered as a part of the ‘relevant factual’ requirements, although not necessarily a calculable consideration of the business valuation.
Of course, there will be times when relevant facts may not be available, and times when much detail may not be required. But in our experience, other than very small businesses, or maybe start-ups or life style business, the occasions where neither buyer nor seller will care about these kinds of facts will be very few and far between. Thus, in conducting the valuation, one should assume that both buyer and seller will require access to all the facts and information material to the decision, and that they will understand the information or find help that does.