Initial Valuation: When an owner decides the time is right to sell the company (or maybe, time to begin planning for the sale), generally, the first question will be, … how much? The first step in the selling process is generally to analyze financial and operational data and conduct a fair market business valuation. The next step is to set out the price and terms along with other relevant information and format it into a series of selling presentations.
There are several generally acceptable valuation techniques, all which, by and large, can be categorized as one of, or as some combination and/or variation of three general methods.
- Asset Cost Base method, which is based on replacement cost, or fair market value of included assets.
- Income or Earnings Based method, which looks at the present value of future earnings.
- Market Comparison method, which estimates the value of one business by the comparative valuation of others.
In our view, the first two are most applicable to the valuation of small and closely held businesses, where the value is typically that amount which is equal to the value of its balance sheet plus the value of its goodwill, a calculation that combines elements of cost based and of earnings based methods.
Balance Sheet Value is simply the net value of assets minus liabilities “included in the sale.” Assets are usually valued at book value in a share sale, or at fair market value in an asset sale, and liabilities at book value.
- Share Sale: Balance Sheet Value in a share sale is generally relatively simple and non-controversial, since balance sheet represents an already booked calculation of retained earnings from the company’s past business, that has excluded depreciation from the value of the capital assets; thus “book value.”
- Asset Sale: Balance Sheet Value in an asset sale may not be so simple, where capital assets may not be considered at depreciated book value but at fair market value, which means an often arbitrary fair market valuation of such assets. Think of it this way. You have a car or pickup amongst the capital assets. You may have a blue book value, but does the vehicle fit that value? Often a matter of opinion. Similarly, fair market value of any capital asset is generally a matter of opinion and will be negotiable.
And, as mentioned above, “included in the sale” is a key. Not all assets and not all liabilities on the current balance sheet will necessarily be included in a sale, whether a share sale or an asset sale. Examples: a company vehicle that has been the personal driver by an owner will often be purchased by that owner and excluded from the balance sheet included in the sale. Or, there may be bank debt that will be excluded and retired by the seller from sale proceeds or other funds. … as stated above, Balance Sheet Value is simply the net value of assets minus liabilities “included in the sale.”
Goodwill Value is probably the most negotiable of the pricing factors. Goodwill Value is based on an anticipation (estimation) of future earnings sustained out of the Company’s past and current market business presence; from the good reputation of the Company and value of the customer base the Company built over the years, and expected to continue doing profitable business with the Company into the future. Goodwill valuation means to place a value on those sustainable earnings, which will be calculated, typically, on a multiple of *normalized ebitda. (*which means earnings before interest, taxes, depreciation, amortization, which are then normalized also to before extraordinary or non-business, non-essential and non-recurring income, costs and expenses.)
Calculating Goodwill Value on the basis of real and verifiable earnings; *ebitda, averaged in some realistic manner over some reasonable period of time prior to the sale, may help you realistically estimate the *ebitda sustainable over the next reasonable period of time, and thus a realistic Sale Price.
Cash Flow sets the limits, typically. Ultimately, the business will be expected to pay (repay) the buyer’s investment (purchase price) over a reasonable period of time following the sale. Discretionary cash flow available from normalized ebitda will impose a regulator on the valuation, based on what the cash flow can support, service and repay over that reasonable return period. As a benchmark, we’ve generally found the “reasonable” period to be 4 to 5 years, subject to various other considerations such as the mix and value of balance sheet assets and liabilities “include in the sale.” Commonly, higher than normal net working capital as a percentage of the business will often serve to increase that reasonable period (in effect), while lower will generally serve to decrease that reasonable time.
This Initial Valuation should ideally establish such reasonable period of time with regard to this particular business-for-sale, as it is being offered for sale, and also the method and manner in which selling price is established and in which the valuation will be maintained (updated) throughout the time it takes, from this point on, to sell the business. In an on-going business, value will be incrementally changed literally with every business transaction. To capture the accumulation of such changes, valuation should be updated in this same manner, just prior to an offer to purchase, and then again just prior to the close of sale, which we will talk more about later.
A realistic valuation is important. If you would like help with valuation, please contact us.
Business Valuations are more thoroughly described in the Business Valuations topic under the Resources menu. Briefly however, in analyzing and in the calculation of such business valuation, we typically use a valuation program called ValuPro, a program developed by davidsonashe, inc. In our descriptions of the valuation and presentation processes, we will refer to ValuPro from time to time because it employs the techniques and methods we deem most suited to the occasion and because it provides us with ready example and illustration.
ValuPro is designed to calculate a fair market value of a viable on-going business on the strength of its balance sheet, on the sustainability of its earnings and on the ability of a business to pay for itself over a reasonable period of time. ValuPro is also designed to generate a series of business profiles or business-for-sale presentation packages.
ValuPro is not designed to calculate the value of a ‘start-up’ or any business without earnings, unless earnings can be credibly forecast, which is often a very tall order, but there may be times, such as in a new franchise perhaps. Otherwise, no earnings are apt to mean no goodwill value and apt to limit the value of the business to simply the value of assets alone.
There may indeed be business potentials; maybe some startups, inventions, good ideas, buy-a-job, however, where there will be real but non-calculable intangible value, value that may be evident only to the eye of the beholder, …still, those are not the business valuations ValuPro was designed to calculate.