If you turn to a commercial lender for a business loan, expect the focus to be on the company’s cash flow. In other words, the lender wants to know whether the business will be able to repay the loan from its profits and cash flow.

Lender’s view of value: ability to repay plus valuable collateral

Just in case this assumption does not work out, the lender will want the business owners to put up sufficient collateral - typically in the form of valuable business assets. Should the loan repayment become a problem, the lender will lay a claim on these assets.

Loan to value depends on how quickly the assets can be converted into cash

For a lender it is important to establish the marketability and values of the business assets pledged against the loan. The more easily the asset can be converted into cash, the higher the loan to value figure.

You can expect the bank to offer around 80% of the value of current accounts receivable. On the other hand, most lenders will likely offer just around 50% of the value of business furniture, fixtures and equipment (FF&E) assets.

Inventory is another business asset that the lenders scrutinize carefully. For a manufacturing company, the bank is likely to lend against the values of raw materials and finished goods inventory. In the event of default, the finished goods can be sold off to a jobber, while the raw materials usually can be returned to the supplier or sold at a discount to a competitor.

Since the bank is not in a position to complete the production, the work-in-progress inventory is usually not a good collateral.

Experienced lenders are well aware that some inventory may be slow moving. In the event of default, this type of inventory is much harder to convert into cash quickly.

Good inventory control records are very important if you are to get high loan to value figures for inventory. Writing off obsolete inventory has the additional advantages of reducing your property taxes and insurance costs.

Conservative commercial lenders are also likely to apply a haircut to inventory levels in excess of the industry average. The assumption here is that the business inventory value is likely overstated or partially unmarketable.

Business valuation results depend on the premise of value!

A major cause of disagreements between business owners and lenders is how the value of pledged business assets is determined. Business appraisal can be done under several premises of value. Depending on the choice of premise, the business valuation results and, therefore, the amount of business loan, can vary dramatically.

Lender’s position: liquidation premise of business value

Expect the lender to take a conservative position and use the so-called liquidation premise of business value. This establishes the worst case scenario in the event the business fails to repay the loan and the collateral needs to be liquidated quickly.

Business owners’ view: going concern

For the owners of a going concern business, the typical premise is value in use. The resulting business valuation is considerably higher than under the liquidation assumption.

Both the business owners and the lender are right. However, each party is viewing the business value from a very different perspective!

Despite the current economic headwinds, many building maintenance service companies with established client contracts continue to thrive. There are some 92,300 such firms in the US alone, classified under the SIC code 7349.

The industry segment contributes an impressive $28B in annual revenues to the economy employing just under 840,000 people. The typical janitorial services company is quite small - generating around $300,000 in gross annual sales with a staff of 9.

Business valuation methods for janitorial service companies

Given the size of the market and the recurring need to clean and maintain office buildings, the janitorial companies tend to be “recession-resistant”.

Companies with stable earnings from long-term commercial contracts are bought and sold regularly. This is very good news: business selling prices and terms from such deals offer you an excellent way to estimate the value of your janitorial service company.

The typical tools are valuation multiples that relate the actual selling prices of similar companies to their financial performance. You can apply these valuation multiples to estimate the value of your company based on its revenues, profits, EBITDA, cash flow, asset base and owners equity.

Example: valuing a building maintenance business using valuation multiples

To demonstrate this market approach to valuing a business, let’s pick a typical private janitorial service company with the following current financials:

• Gross revenue: $300,000.
• Net sales: $290,000.
• Net income: $60,000.
• EBITDA: $75,000.
• Seller’s discretionary cash flow (SDCF): $110,500.
• Furniture, fixtures and equipment (FF&E) assets: 55,000.
• Inventory: $10,000.
• Book value of owners’ equity: $35,000.

To calculate the fair market value of this business, we choose a set of sensible valuation multiples as follows:

Note that this averages to about 0.86 times the business gross revenues.

Other business valuation methods for janitorial service companies

To supplement the market-based valuation and check your results, consider using the Multiple of Discretionary Earnings method. This well-known technique lets you assess business value from a totally different point of view: based on the company’s earning power and 14 key financial and operational performance factors.

Companies with a long history of success in their market may have built up significant business goodwill. As a result, they may be worth well above the value of the business tangible assets. The Treasury Method is a great choice to calculate the value of business goodwill and total value for such firms.

With a global focus on sustainable manufacturing, scrap metal recycling is a key growth industry segment. Classified under the SIC code 5093, there are just under 8,200 metal recycling companies in the US alone. The industry as a whole generates some $21.1B in annual revenues and employs close to 75,600 people.

Yet an average metal recycling firm is quite small - with around $3,000,000 in annual sales and a staff of  9.

Business valuation methods for metal recycling companies

Being in a growth segment usually means there is considerable investor appetite for business acquisitions. Indeed, scrap metal recycling businesses sell quite often.

The recent sales of similar businesses offer you an excellent way to determine you company value. Valuation multiples that relate the actual business selling prices to key financial performance measures are the typical valuation tools.

Using valuation multiples derived from recent recycling business sales, you can develop an accurate estimate of value for firm in this industry segment. The most common valuation multiples used for valuing metal recycling businesses are these:

• Business selling price to business gross revenues or net sales.
• Price to gross profit.
• Price to net income.
• Price to EBIT and EBITDA.
• Price to seller’s discretionary cash flow.
• Price to business assets.
• Price to owners’ equity.

Example - valuing a metal recycling company using valuation multiples.

To demonstrate how the value of a business in this industry can be determined, let’s select a firm with the typical financial performance as follows:

• Gross annual revenue: $3,000,000.
• Net sales: $2,900,000.
• Gross profit: $1,000,000.
• Net income: $250,000.
• EBIT: $145,000.
• EBITDA: $282,500.
• Seller’s discretionary cash flow (SDCF): $750,000.
• Furniture, fixtures and equipment (FF&E) assets: $400,000.
• Inventory: $355,200.
• Total business assets: $950,000.
• Book value of owners’ equity: $600,000.

Next, we apply a set of reasonable valuation multiples and come with the following business valuation results:

Fair market value or investment value?

Market based valuation as this example illustrates tends to be a great way to determine the fair market value of your business. This is because the valuation multiples are derived from a large number of comparable business sales, establishing the “going rate” for similar business investments.

Exceptional companies may attract very strong investor interest. Professional investors that are looking for synergies to enhance their portfolio in your market segment may be willing to pay a premium for the right business opportunity. As a result, your actual investment business value may well exceed the fair market value estimate.

Business people often ask us: “Are different business valuation methods used to value companies in different industries?” It is a very sensible question - after all the differences between, say, a manufacturing firm and a dental practice are profound.

Professional business appraisers have developed an elegant, powerful framework to deal with this challenge. At the core of this framework are a set of universal business valuation methods that can be applied to valuing any business.

All these methods are grouped under the three major approaches to business valuation:

• Asset - based on the values of individual business assets and liabilities.
• Income - based on the company’s earnings outlook and risk profile.
• Market - by comparing the subject business to similar companies, in the same industry segment, that have recently been sold.

There are several reasons why this business appraisal framework can handle any business:

• All standard business valuation methods consider the industry-specific value drivers.
• These valuation methods provide a consistent way to measure business value while accounting for the unique attributes of your business and its industry.
• Each standard valuation method offers a different way of measuring the business worth, complementing the results you get from other methods.

Support by major business appraisal standards

The power and flexibility of this business valuation framework have made it the de-facto standard in all professionally conducted business appraisals. In addition, the multi-method business valuation is supported by the key appraisal standards such as the USPAP, AICPA SSVS No 1, and the IRS Revenue Ruling 59-60.

Let’s take a quick look at the typical valuation methods that are used to value companies in just about any industry:

Asset based valuation methods

The Asset Accumulation method lets you determine the overall business value based on the valuation of individual business assets and liabilities.

Current market values of these assets and liabilities are used to create the appraisal of a business. Needless to say, these market values are defined by the industry-specific factors. Examples are prices paid for similar equipment, royalty rates charged for customer lists or licenses and property rental costs.

Capitalized Excess Earnings method is another asset based valuation technique that is especially useful in measuring the value of business goodwill. Again, the industry conditions affect the market value assessment of individual business assets along with the capitalization rates used by this method.

Income based valuation methods

This group of appraisal techniques is perhaps the best example of how the industry factors affect the business value. Both capitalization methods, such as Multiple of Discretionary Earnings, and discounting techniques, such as the Discounted Cash Flow method, require business risk assessment. The industry-specific risk is one element of the discount and cap rates used by these valuation methods.

Income based valuation also requires that you forecast business earnings. This will most certainly be affected by the trends in your industry segment.

Market based valuation methods

These appraisal techniques rely on comparison to sold businesses in your industry segment. As a result, the business value estimates reflect the industry conditions such as investor demand for similar companies.

As a rule, business investment requires careful assessment of industry-specific growth prospects and risk. Hence, by using the market-based valuation multiples derived from similar business sales, you are effectively relying on the judgment of other business people about what a company in a specific industry is worth.

Since each method takes a different view of business value, throwing several standard methods into the mix is a very good idea. In fact, the use of multiple valuation methods is expected of all professionally prepared business appraisals.

Continuing our discussion about valuation of software services companies, let’s focus on the market valuation approach.

A central technique under this approach is the comparative transaction method. It is especially useful for valuing private software firms. In a nutshell, the method lets you determine the value of your software firm in comparison to similar companies that have recently sold.

Privately owned software companies with a solid track record of profitability are frequent acquisition targets. You can study the selling prices of successfully closed deals in relation to the financial performance of such companies.

Valuation multiples

Valuation multiples are the usual tools to estimate the fair market value of your software company using the market approach. For example, you can calculate your company value in relation to its revenues, gross profit, net income, EBIT, EBITDA, discretionary cash flow or business assets.

One of the main advantages of using such valuation multiples is that they are based on actual sales thus offering a highly objective and defensible way to estimate what your software company is worth. This is especially useful if you need to prove your business value to a skeptical investor, or defend your valuation in court or before the tax authorities.

Example - valuing a custom software development company using valuation multiples

We will take a typical contract software development firm with the following financials:

• Gross revenue: $1,300,000.
• Net sales: $1,200,000.
• Gross profit: $1,000,000.
• Net income: $230,000.
• EBIT: $370,000.
• EBITDA: $385,000.
• Seller’s discretionary cash flow (SDCF): $400,000.
• Furniture, fixtures and equipment (FF&E) assets: $450,000.
• Total business assets: $500,000.
• Book value of owners’ equity: $225,500.

We pick a set of reasonable valuation multiples and estimate the value of this software company as follows:

Each business value estimate can shed a different light on what drives the value of your software company. For example, a high business valuation result based on EBITDA may point out that the company manages its profitability better than the industry average.

An asset rich firm will likely show a higher business value estimate based on the value of its total assets, both tangible and intangible, such as internally developed technology or business processes.

Using business valuation as a strategic tool

Showing how business value depends on your company performance in this way can help you in strategic planning and decision making.

A key question: what value factors can be improved to increase the overall business value? You can focus on the areas that can enhance the value of your company, then measure the result by repeating your business appraisal.

If you own a private mailing business or need to appraise one for a client, here are some interesting statistics to consider:

Mail box rental and shipping companies are classified under the SIC code 7389 and NAICS 561. This business services sector has just under 1,500,000 firms that generate over $301B in annual revenues.

The business services industry segment employs some 3,639,000 people. Yet the average firm is definitely small business: with annual sales of $200,000 and a staff of just 2.

Business valuation methods for mail box rental and shipping firms

Successful private mailing companies sell quite often. You can develop a very good idea of your business value by comparing it to the companies that sold recently. Using the valuation multiples derived from such business sales, you can calculate the fair market value of your business based on its revenues, gross profit, net income, EBIT and EBITDA, the business asset base and owners’ equity.

Example: valuing a mail box rental business using valuation multiples

To demonstrate this market approach to valuing a business, let’s take a typical mail box rental and shipping firm with the following financials:

• Annual gross revenue: $200,000.
• Net sales: $185,000.
• Gross profit: $120,500.
• Net income: $17,000.
• EBIT: $18,900.
• EBITDA: $19,250.
• Seller’s discretionary cash flow (SDCF): $75,000.
• Furniture, fixtures and equipment assets (FF&E): $50,000.
• Inventory: $4,500.
• Total business assets: $61,500.
• Book value of owners’ equity: $44,000.

We next pick a set of sensible valuation multiples to calculate the value of our example business as its potential selling price:

Other business valuation methods for private mailing service companies

No business valuation is complete without the use of several methods under each approach: Asset, Income and Market. Since many mail box rental and shipping businesses are owner operated, the Multiple of Discretionary Earnings method is an excellent complement to verify your market value assessment.

Using this well-known income-based valuation method, you can create a comprehensive appraisal based on the business earnings and 14 critical financial and operational performance factors.

If the business has established itself in its market place over many years, chances are there is considerable goodwill. To determine the value of business goodwill, consider using the classical Capitalized Excess Earnings method. Known as the Treasury Method, this valuation technique lets you calculate the value of business goodwill and total company value.

One of the key factors that affects the value of a company is the industry in which it operates. The question is why and by how much?

The answer is risk. In fact, the industry-specific risk premium is one of the elements that make up the discount and capitalization rates for your business. Here are the key factors that define the industry-specific risk:

• Overall industry growth prospects.
• Barriers to competitive entry such as initial capital investment, licensure requirements or unique know-how.
• Consolidation trends and degree to which large competitors dominate the industry segment.
• Technological changes that may require considerable investment to stay competitive.
• Regulatory compliance requirements that can suddenly drive up the costs of doing business in the industry.
• Emergence of new competitive threats domestically and internationally.

How much can the industry-specific risk affect the company valuation?

In 2009 the lowest risk industries such as the educational services under the SIC code 82 showed negative industry specific risk premia of around -4%. This means that the companies in this industry sector faced risks below the overall market!

On the other hand, the high risk industry segments, for example the transportation services under SIC code 47, called for the risk premia on the order of 4.3%.

Given the typical discount rates of some 25% for privately owned firms, this could make a difference of more than 8% and greatly affect the valuations of companies in these industries.

Example: effect of industry specific risk on company valuation

To demonstrate the effect of industry risk on company valuations, we will pick two firms with identical earnings forecasts for the next 5 years.

One of the firms is in the educational services sector, the other is a transportation company. To make the comparison easier, we will assume that both firms have the same company-specific risk profile that adds another 4.1% to their discount rates.

Here is the earnings forecast:

• Year 1: $150,000.
• Year 2: $175,000.
• Year 3: 185,000.
• Year 4: 200,000.
• Year 5: $225,000.

Using the well-known Build-Up model, we calculate the discount rates for the two companies as follows:

• Educational services: 18.94%
• Transportation services: 27.47%

We apply the Discounted Cash Flow business valuation method to calculate the value of both companies. Here are the results:

The business value difference is amazing: with the same earnings prospects the educational services firm is worth almost twice as much as its transportation industry counterpart!

Do you own a lanscaping services company? Need to determine the value of your own business or prepare an appraisal for a client? Here are some interesting industry statistics to consider:

Key landscaping industry statistics

Classified under SIC code 0781, there are over 49,370 landscaping planning, design and counseling establishments in the US alone. The industry as a whole generates $10.9B in annual revenues and employs over 205,000 people. Yet an average landscaping company is a typical small business: it produces around $200,000 in annual sales with a staff of 4.

Business valuation of landscaping companies

By far the most objective evidence of what a landscaping company is worth is recent sales of similar businesses. Business appraisers refer to this business valuation technique as the Comparative Transaction Method.

Valuation multiples derived from such business sales offer you an excellent tool to estimate your business value. Here are the typical multiples used for landscaping business appraisals:

• Multiple of gross revenues or net sales.
• Multiple of gross profit.
• Multiple of net income.
• EBIT and EBITDA based valuation multiples.
• Multiples relating your business value to its fixed or total assets.
• Business value as a multiple of owners’ equity.

Example: valuing a landscaping company using multiples

Let’s take a typical landscaping services firm with the following financial parameters:

• Annual net sales: $600,000.
• Gross profit: $410,500.
• Net income: $56,250.
• EBIT: $57,000.
• EBITDA: $59,600.
• Total business assets: $195,000.
• Book value of owners’ equity: $102,500.

We next pick a set of reasonable valuation multiples to calculate the company value as follows:

Asset and income methods for valuing a landscaping business

To complement your market-based valuation,  consider the the well-known Multiple of Discretionary Earnings method. This income-based business valuation technique is especially suitable for valuing owner-operator managed landscaping service companies.

For a business that has excellent reputation in its marketplace, the value of business goodwill can be considerable. To appraise the value of business goodwill, consider using the Capitalized Excess Earnings method, known as the Treasury Method. Many professional business appraisals use this asset-based method to value goodwill as well as determine the total business value.

If you talk with professional business investors or business brokers, soon enough you will hear them mention business valuation ratios. Business appraisers refer to these tools as valuation multiples.

Basically, the ratios are a technique to estimate the value of a business based on comparable business sales. Such market-based valuation tools are very useful in a number of situations that call for a defensible, objective business appraisal:

• Business sale or purchase. Buyer and seller can justify their valuations based on the objective, empirical evidence.
• Legal disputes which often require that the fair market value of a business be determined. Again, objective market proof of business value is a great way to resolve disagreements.
• Tax issues such as gift, estate and income taxes. Tax authorities are very keen on checking the market data to verify the business appraisal results submitted by tax payers.

Typical ratios used in business valuation

Since no two businesses are the same, the actual business selling prices will differ from one transaction to another. Relating the selling prices to the business financial performance measures is the best way to develop reliable ratios for your business valuation.

As you can expect, the business income statement and balance sheet items are the usual choice of basis to calculate the business valuation ratios. Here are the most common ones:

1. Business selling price to gross revenues or net sales
2. Price to gross profit
3. Price to net income
4. Price to EBT, EBIT and EBITDA
5. Price to seller’s discretionary cash flow or net cash flow
6. Price to fixed business assets or total asset base
7. Price to owners’ equity.

The accuracy of each business valuation ratio varies by industry, company size, and the time frame when the business sale comps have been selected. The best ratios are those showing the smallest spread of values, from low to high. This indicates that business people rely on some business valuation ratios more when pricing the actual business acquisitions.

Choosing the ratios for your business appraisal: best practice

One way to develop a highly defensible market-based assessment of your business value is to use several ratios or valuation multiples at once. Each will produce a result indicating what your company may be worth based on the specific financial performance measure.

You can then use these valuation results to come up with a solid estimate of business value. Let’s say that the lowest business value for your company as determined by the price to gross revenue valuation ratio is $1,000,000; the intermediate value based on the discretionary cash flow is $1,100,000; while the highest is $1,250,000 as indicated by the price to net income ratio.

You can conclude that the market value of the business will fall somewhere in the range established by these numbers, in this case $1,000,000 - $1,250,000.

On the other hand, the numbers can be averaged to give a single number for the business value: $1,116,667.

In fact, both the range and a single value number reporting is industry-standard for professional business appraisals.

Privately owned and operated florists are a major part of the retail industry. Classified under the SIC code 5992, there are around 35,650 such establishments in the US alone. The industry as a whole generates an impressive $6.6B in annual revenues and employs over 135,000 people.

Yet an average flower shop is a classical small business: producing around $200,000 in annual sales with a staff of 4.The industry is highly fragmented with the top 5 companies accounting for less than 2.5% of the total industry revenues.

Key value drivers for retail florists

The product for flower shops is arranged cut flowers that usually account for over 50% of a store’s revenues.  Florists with significant commercial accounts that tend to result in stable recurring revenues are valued above the average.

Another key value driver is an attractive store location with the rent expenses below 6% of the shop’s gross revenue. The highest valued flower shops are located away from the major “big box” competitors such as do-it-yourself home improvement or grocery chain stores.

The florists that focus on the special event and gift market segments tend to command higher business valuations. Essentially, such flower shops differentiate on superior service that leads to customer loyalty, higher profitability and, not surprisingly higher business value.

Sales from an online presence or phone orders tend to be more cost-effective ways to generate sales. Some of the most valuable flower shops achieve close to 80% of their revenues through these channels.

Business valuation methods for flower shops

Florists with a track record of highly stable, above average earnings are very desirable and sell often. If you study such business sale comparables, you can develop a very good idea of what your business is worth.

The typical tools to estimate your business value is to use the valuation multiples derived from such business sales. The multiples relate the actual flower shop selling prices to their financial performance.

Thus, you can calculate your business value in relation to its revenues, profits, EBIT, EBITDA, cash flow, assets or owners equity.

Here are the typical valuation multiples used to estimate the value of a flower shop:

• Business value based on gross revenue or net sales.
• Business value based on net income.
• Business value based on EBIT and EBITDA earnings.
• Business value based on the seller’s discretionary cash flow.
• Business value based on the furniture, fixtures and equipment assets.

Example: valuing a flower shop using valuation multiples

To demonstrate the idea, let’s pick a typical retail florist business with the following financials:

• Business gross revenue: $250,000.
• Business net sales: $225,000.
• Net income: $35,553.
• EBIT: $36,000.
• EBITDA: $39,500.
• Seller’s discretionary cash flow: $154,247.
• Furniture, fixtures and equipment assets: $25,307.
• Inventory: $4,601.

We pick a set of reasonable valuation multiples to calculate the value of the business as follows:

Other methods to use for valuing a florist business

You can value an established owner-operator run flower shop by the well-known Multiple of Discretionary Earnings method. This income-based business valuation technique lets you determine the value of the business based on its earnings outlook and a set of key financial and operational performance factors.

Since many privately owned florists are lifestyle businesses, the Multiple of Discretionary Earnings is particularly well suited for their business valuation.

For a florist that has created an solid reputation in its market, the value of business goodwill can be considerable. To appraise such a business, consider using the Capitalized Excess Earnings method, known as the Treasury Method. This technique is specifically intended to help you determine the value of business goodwill and total business value.