ValuAdder Business Valuation Blog

With increasing numbers of the baby boomers reaching retirement age, there is one skilled services sector that is sure to flourish - home health care.

Indeed, home health care services, classified under SIC code 8082, have been experiencing rapid growth recently. There are excellent opportunities for differentiation since a business can specialize in providing services to a targeted demographic.

With excellent earnings upside, low capital asset investment requirements, and net profit margins that can exceed 20% of revenue, mid-market home healthcare businesses are in high demand. Smaller companies need to focus on growth to reach the critical mass and establish themselves as the dominant presence in their market.

Risk factors that affect business value

While the industry prospects are good, there are some challenges that impact what a home health care business is worth:

• Intensity of competition from new market entrants.
• Exposure to litigation.
• Difficulty in attracting and retaining qualified staff.

In addition, as the industry matures, consolidation pressures may force smaller operators to merge or be acquired by larger firms.

Business valuation methods for home health care companies

As many service businesses, the typical home health care firm has a relatively low asset base. Thus, business valuation focuses on assessment of the business earning capacity and risk.  You can choose a number of income-based business valuation methods to value your company.

For smaller, owner-operator managed businesses, Multiple of Discretionary Earnings method provides a great way to appraise a business based on its earnings and 14 key financial and operational performance and risk factors.

For businesses looking to expand rapidly, Discounted Cash Flow is a proven way to determine the business value based directly on the projected income stream.

Valuation of a Business as Multiple of its Earnings

Don’t forget to check the market place for actual selling prices and valuation multiples - especially if you plan to sell or buy a home health care business.

Typical valuation multiples for the companies in this service sector are:

1. Based on gross revenues.
2. Based on discretionary cash flow.

The value of inventory is added to the estimate you get using either valuation multiple. Since home health care businesses sell often, there is plenty of  market data to compare against - and make a fact-based decision on your asking price or purchase offer terms.

Calculate business value by direct market comparison

One way to do such market-based business valuation is to use ValuAdder Rules of Thumb. ValuAdder provides coverage for over 400 industries, including home health care businesses.

You can calculate your business value based on the actual sales of similar businesses in this service sector. All you need to provide is the business revenues and inventory - ValuAdder calculates the business value range, average and median values instantly!

Business Valuation using Market Comparison

We talked about the factors that create personal goodwill in small businesses and professional practices. The key takeaway is that personal goodwill is associated with the individual practitioner, not the business organization.

In contrast, institutional business goodwill arises from the business or practice itself. This is the type of goodwill that you can transfer easily when the business or a partner’s share sell.

Increase total business value by building the institutional business goodwill

One value-enhancing strategy you can follow is to make sure that the large part of goodwill is created by the business or practice itself. This is known as the institutional goodwill. So which factors indicate this important type of business goodwill? Here is the list:

Top 8 factors that create institutional business goodwill

1. Quality and skill of employees.
2. Business reputation.
3. Business name recognition.
4. Competitive postion of the business or professional practice in its market place.
5. Location of the business premises.
6. Business referral base.
7. Stability of earnings.
8. Business marketability.

How the 8 factors affect the value of business goodwill

It goes without saying that skilled, long-term staff is the major asset in any business or professional practice. If such employees remain with the practice after key partners depart, the new owners acquire the considerable benefit of trained and assembled workforce. The result? A higher value of business goodwill and the entire business enterprise.

Focusing on building the reputation and name recognition of the business tends to attract loyal customer following. The clients come to respect and prefer the company as the product and service provider. Needless to say, this translates into higher earning potential - and higher business goodwill.

If your business or professional practice has built up a set of sustained competitive advantages, it probably enjoys superior earnings - through lower costs and greater pricing flexibility. Above average earnings are a key element in creating business goodwill over the long term.

Excellent location makes the business more visible and accessible to its target market. The result is often strong repeat and referral business. Good location also tends to help reduce the marketing expenses.

You need to understand if new client referrals come because of the business reputation, rather than an individual practitioner. Should the expert depart, the clients will likely keep coming. Such client retention is the major contributor to the business goodwill.

Stable business earnings indicate the staying power of the business or professional practice. Business people pay attention to historic earnings stability to predict what is likely to happen in the future. Again, this future earnings outlook indicates how valuable the business is.

If you find a strong market for existing businesses in some industry, buyer competition tends to increase business selling prices. Remember that the value of business goodwill is the difference between the total business value and the appraised value of its assets. Hence, strong competition among the buyers - and higher business selling prices - point to higher value of business goodwill.

Calculation of Business Goodwill

Business goodwill valuation comes up often in the context of valuing professional practices and consulting service businesses. The typical examples are medical, dental and other healthcare practices, CPA and law firms, engineering and architecture consulting businesses and other professional service companies.

A key question you may need to address is how much of the practice or business goodwill can be transferred to new ownership. In addition, legal dispute situations generally require that practice goodwill value be included in your business valuation.

Business goodwill sources: business or personal?

An important challenge you may face is how to distinguish between the business goodwill and professional goodwill. Business goodwill is created by the business or practice itself. On the other hand, professional goodwill is personal in nature - it is associated with the individual professional practitioners.

This distinction is significant because it is generally much easiler to transfer goodwill that is associated with the business, rather than an individual professional practitioner.

Elements of professional goodwill

You may need to separate the professional from business goodwill in many practice valuation situations. Here are the key elements that help you identify the professional goodwill:

• Practitioner skill and ability.
• Professional judgement.
• Practitioner age and health.
• Professional’s reputation and name recognition.
• Fee schedule commanded by the individual professional.
• Personal referral base.
• Level of client involvement.
• Work habits.

High levels of specialized skill, demonstrated ability and excellent professional judgement are strong indicators of professional goodwill. Clients tend to trust professionals that are skilled and make correct decisions.

Professionals that are in good health and have a long career horizon have excellent earnings outlook - a major element of continued professional goodwill.

A professional who is respected by peers and clients tends to be successful and enjoys excellent earning potential.

In addition, the fee schedule indicates how well the professional can translate the skill and reputation advantages into superior earnings, and greater professional goodwill.

Clients are a lifeblood of any professional practice or service business. The practitioner who has a steady, high quality referral base creates a considerable level of professional goodwill. Answer this question: do the referrals occur because of the business or individual professional’s reputation? The greater the level of professional’s involvement with the clients, the greater professional goodwill.

While it is common knowledge that professionals work long hours, how well you allocate your time among the various tasks can make a big difference to your earnings.

Predictably, professional goodwill increases as the practitioner dedicates more time to the highest value-creating tasks.

Business and Practice Goodwill Valuation

Auto tire retail stores, classified under SIC code 5531, represent around 19,000 establishments in the US alone. Over two thirds of these businesses are small, owner-run single store operations.

Check these interesting facts: while the industry as a whole generates over $77bn in revenues, the average store makes around $1,500,000 in annual gross sales, employing just 7 employees.

A well-run store offers around 6 - 12 brands of tires, with commercial dealers carrying as few as four or five. Big brand tire products are a major plus since they tend to attract repeat business from brand-loyal customers. As a result, a store which offers the right mix of top brand name products in its market tends to command valuation multiples that are 15 - 20% higher than its competitors.

Key factors that affect an auto tire store business valuation

When it comes to valuing a business or setting its selling price, not all auto tire stores are created equal. You need to consider the factors that drive business value in this industry. Here are the top ones:

1. Location
2. Established, loyal customer base
3. Availability of trained employees and strong store management, beside the owners
4. Terms of lease
5. Condition and quality of store equipment
6. Percentage of sales derived from product sales and service.

For many stores, service offerings tend to be more profitable than tire sales. In times of rapidly increasing oil prices, tire product costs tend to crimp product profit margins. Service revenues on the order of 50% of the total typically indicate a store with excellent profit potential. The result is higher business valuation and, very likely, a higher business selling price.

Business valuation methods for auto tire stores

Auto tire stores sell often, so there is plenty of business sales to compare your selling price and terms against. Such business market value comparisons can give you very accurate and compelling results. Typical valuation multiples are based on the business discretionary cash flow plus inventory levels at replacement cost.

Valuing a Business using Market Comps

Another excellent way to value a business in this industry is to use the time-tested Multiple of Discretionary Earnings valuation method. In addition to the business earnings, this business valuation methods lets you account for all the key value factors above.

Using this business valuation technique, you can determine what the business is worth today, then see what can be done to increase business value - before making critical decisions such as offering the business for sale or bringing a partner on board.

Business Valuation based on Multiple of its Earnings

If you are looking to have a business appraised hiring an appraiser is one of the ways to do it. As with any professional engagement the question of costs comes up rather quickly.

Not surprisingly, professionally prepared appraisals don’t come cheap; the average hourly rates these days are around $300. A well-done business appraisal takes about 20 hours or more. Do the math, and the price tag runs to $6,000 and up.

That’s not including any extra consulting time to present the business appraisal to partners, other professionals, prospective buyers, sellers or investors.

Instant business appraisals - too good to be true

What about those “instant” business appraisals for a few hundred dollars? Let the buyer beware: professional appraisal takes time. And time costs money. With a “minimum wage” business appraisal you quite literally get what you pay for.

So, can you get an accurate, defensible business appraisal and save?

Yes indeed! Given the right tools, you can do your business appraisal yourself - and save quite a bundle.

Most of the business appraisal cost is in the time the appraiser takes to do the work. And most of the time is spent understanding the business being valued.

Obviously, you can use your own knowledge of the business to cut down on time and costs. But what about the business valuation tools and knowledge?

A complete business valuation system

That’s where ValuAdder comes in. To make sure you can do your business appraisal yourself, ValuAdder gives you both the knowledge and tools to do it:

1. Complete business valuation software system. You can use the same valuation methods the professional appraisers use to calculate your business value.
2. A Learning and Information Center and 190-page Business Valuation Handbook. There is plenty of expert advice and guidance to get you through your business appraisal.

There is a Business Valuation Guide to introduce you to the fundamentals of business appraisal. Detailed Tutorials on valuation methods and helpful How-To Sections with examples. Every term is defined and explained in the Glossary.

To save you both time and money, ValuAdder is designed to simplify and speed up your business appraisal:

• Do split-second business market value comparisons in any of 400 industries.
• Determine business value based on its earnings and risk.
• Calculate business goodwill and total business value.
• Structure a successful business sale or purchase.
• Get tips on each input - right as you enter your numbers.
• Pick and choose the tools you want with a mouse click.
• Generate reports and share your business valuation results in the format you want: PDF, spreadsheet, Web page.

Latest word in valuation software reliability and accuracy

You may ask: how is all this possible? The short answer: state-of-the art technology and sound software engineering.

ValuAdder relies on the leading edge Java technology to give you a superior business valuation system - at a fraction of competitors’ costs:

Do your business valuation on any computer of your choice, in any currency

You can run ValuAdder on any Windows, Mac OS, Linux or Unix computer. ValuAdder naturally adapts to your computer preferences and settings - including multi-currency calculations.

Open Source technology saves you money

Java and Open Source lets us cut down dramatically on our development costs - and we pass the savings directly to you!

State of the art in security, reliability and accuracy

This technology also makes your ValuAdder an extremely stable, reliable and accurate business valuation software system. 

Less support costs for us, better price for you!

Valuing a Business based on Income, Assets, and Market Comps

One common reason business people get their businesses appraised is gift and estate taxes. Grants of business ownership interest by living owners to family members trigger gift tax liability. If the owners pass away, the business is inherited by the younger generation. One of the first tasks for the new owners is how to handle the very large estate taxes. With estate tax rates approaching 50%, the tax bite may be very painful.

Business valuation results: high or low?

Usually, business owners are interested in the highest business valuation possible. This is certainly the case if the business is to be sold to a third party. The same desire for high valuations applies if you consider partner buy-ins, and outside investment, whether venture capital or debt financing.

Gift and estate tax situations are very different. Since the tax is assessed on the current business enterprise value, business owners are interested in the lowest possible figure for their business value.

The tax authorities, for obvious reasons, are skeptical about low business valuations. Experienced tax agents expect that business people want to reduce their taxes - and often retain skilled tax lawyers and accountants to help them do so. Since gift and estate taxes are among the highest, it is natural that business owners would seek the most conservative estimate of their business value.

Tax authorities may develop their own business appraisal. Not surprisingly, the tax man’s business valuation may be quite a bit higher than the owners’ value estimate.

Business valuation: points of contention

Business owners and tax agents typically disagree on what a business is worth on the following points:

1. Total business value.
2. Discount for lack of control.
3. Lack of marketability discount.

Since any business valuation result depends upon the set of assumptions, tax authorities may challenge your business appraisal by questioning your financial forecasts, risk estimates, as well as definition and premise of business value.

Business valuation is always forward-looking. Will the business earnings continue growing at their historic pace of 10% per year? Or will the growth rate stay within 5%, as claimed by the businsess owners? Will the industry become more risky in the next 5 years? Will the business continue operating or have to exit certain markets and sell some of its assets? Depending on which position is taken, the business valuation results you get will differ considerably.

Whether the assumptions of business owners or tax agent are more accurate, only time will tell. The business valuation result needed today may become a matter of dispute between the owners and tax authorities. And if the two sides cannot develop a reasonable compromise, these situations often end up in court. To avoid the costs of litigation, it is best to work out a solution acceptable to both sides.

Marketability discount and private business sale comps

Tax authorities generally understand that private business ownership interest is less marketable than public company securities. The question often is the amount of marketability discount that applies. Again, the owners tend to argue for higher marketability discount percentages.

This is where private business sale comparable data comes in very handy -  if you can show the selling prices of similar closely held businesses, the fair market value of your business is much easier to defend.

Control premiums and minority discounts

If the value of partial business ownership interest is disputed, you can work up a reasonable minority discount by citing the control premiums paid for business acquisitions in your industry. Most sales of public company stock are minority ownership transactions. On occasion, a controlling ownership interest is acquired. The offer terms are publicly disclosed and typically state the price per share - which often includes a premium over the current share market price.

Alternatively, you can value the business ownership stake directly by using the Discounted Cash Flow method - and calculating the present value of the expected returns to the minority shareholder.

If you are looking at valuing an owner-operator managed small business, then the Multiple of Discretionary Earnings business valuation method should be high on your list of priorities.

One of the best examples of the so-called direct capitalization valuation methods, this method determines the value of a business as a multiple of its discretionary cash flow.

One of the greatest strengths of this well-known business valuation method is an excellent match it provides between the business earnings and a broad range of financial and operational performance factors.

You can get very accurate business valuation results with this method. Equally important, you can see how the business value is affected by the quality of the operation.

Balance sheet inputs that affect business value

For highly accurate results, you also need to provide several financial values from the company’s recast balance sheet.  These include:

1. Net working capital.
2. Non-operating assets.
3. Long-term liabilities.

For the purposes of your business valuation, Net Working Capital is the difference between the business current assets, less inventory; and its current liabilites, less the short-term portion of the long-term debt. Essentially, this represents the liquid capital used by the business owners for short-term financing.

Non-operating assets may include such items as business-owned real estate, excess inventory and underutilized production or distribution capacity. The idea is that the business asset base should be adequate to support its level of earnings. All assets that are not used to generate these earnings are extra - and can become additional and valuable parts of a business acquisition.

If you value a debt-free business, the long-term liabilities are zero. However, if the business uses financial leverage, then your business valuation must factor in these liabilities. The result is the value of business owners’ equity interest in the business.

If you bought or sold a small business before, you may notice that Multiple of Discretionary Earnings method measures the business value on an asset sale basis. In fact, most small business sales are asset transactions.

In these cases, the business assets, less cash and trade receivables, transfer to the buyer. The seller pays off all business liabilities to deliver these assets free and clear. Non-operating assets may be valued separately and included in the deal.

If you ever tried raising debt capital from a bank, you know that lenders base their decisions on business cash flow. In other words, the key consideration is whether the business can repay the loan in full and on time.

Lenders build in the risk into the debt service coverage ratio. This gives the bank the extra margin of safety if the business earnings dip temporarily. Typical DSCR expected by commercial lenders is in the range of 1.25 - 1.5.

Banker’s main worry: default

In addition, banks expect that some loans may go sour. To address the risk of default, your bank will look for some collateral. Business owners can expect that only a fraction of their business asset values can be pledged as a loan collateral.

Typical business asset values as loan collateral

Accounts receivable, adjusted for uncollectible bad debt may fetch close to 75% of their book value, the finished goods inventory around 50-60%. Hard business assets such as furniture, fixtures and equipment (FF&E) are likely to be worth about 50% of their fair market value when offered as collateral.

Some banks may even be willing to accept certain intangible assets, especially the readily marketable trademarks, copyrights and patents. If a licensing agreement is in place, you can use the Discounted Cash Flow method to determine the value of such assets. Otherwise, you will need to research typical royalty rates and prepare a defensible income forecast for your intangible asset valuation.

Lenders: what are the business assets worth in a liquidation

Business owners and lenders often disagree on the value of business assets used as business loan collateral. The reasons are obvious: from the lender’s perspective a low-risk loan is one offered to a business with plenty of stable cash flow backed by a valuable, highly marketable asset base.

If the loan goes bad, the bank will look to dispose of these assets quickly. Hence, your lender is likely to use the so-called liquidation premise when valuing your business assets.

Business owners: what is the cost to replace business assets?

The fair market value of these assets can be considerably higher. Business owners often object to the lender’s business valuation results - after all, they know what their inventory is worth when sold in the normal course of business. Besides, it seems far more reasonable to value the FF&E on a replacement cost, value in use or going concern basis.

Different assumptions lead to differences in business valuation results!

Whose valuation is right? Actually, both sides are correct! As is the case with any business valuation, the assumptions drive the results. Put differently, the business owners and the lender use different premises of value - each based on their respective position.

Both the lender and business owners need to understand that this business value spread is normal, then work together to find an acceptable compromise.

Perhaps the greatest advantage of the renowned Discounted Cash Flow business valuation method is its flexibility. You can choose any stream of business income and discount it to determine the business value today. However, to get accurate business valuation results, you need to match your earnings and the discount rate carefully.

Net cash flow and build-up discount rate formula

Most business appraisal experts recommend the net cash flow as the earnings basis for use with the Discounted Cash Flow method. The widely accepted rationale is this:

The discount rate, which captures your business risk, is typically derived from the public capital markets. The investors in these markets generally obtain the economic benefits equivalent to the net cash flow. Hence, the use of net cash flow to ensure that the earnings basis and discount rate are matched.

That said, you can make an adjustment to the discount rate and then use it to discount a different income stream, such as the seller’s discretionary earnings.

In this case the discount rate will need to account for the additional opportunity cost of owning and operating the business. This cost is not included in the Build-Up cost of capital formula directly - since typical investors do not work in their portfolio businesses.

Once matched, the two sets of income streams and discount rates should provide you with comparable results.

Discretionary earnings and capitalization rate that match well

In comparison, the Multiple of Discretionary Earnings, a widely used direct-capitalization method, uses the seller’s discretionary cash flow as the earnings basis. The capitalization rate is developed from the 14 business financial and operational factors you specify.

This cap rate is matched specifically to the seller’s discretionary cash flow as the earnings basis. An important difference from the net cash flow is that SDCF includes the single owner-operator compensation and non-recurring business expenses as addbacks.

Companies large and small often realize that they cannot be all things to all people. A business may excel at product development but have little experience in providing specialized services to its customers. A company may have an established position in a regional market place, but lack resources to enter a larger national or international markets.

In such cases, business owners can decide to form a joint venture with another firm that has the capabilities they lack in their own organization.

Joining forces together has advantages in that each partner in the venture brings the right and complementary set of skills and abilities to the table. Given the synergies that may result, such combination can do very well indeed.

Whenever a joint venture is considered, a couple of important questions arise:

1. What is the overall business value of such an enterprise?
2. How is the business ownership allocated among the venture partners?

Most of the time these business valuation issues arise in the planning phase, before the business combination is finalized. Hence, there is no track record of the joint venture’s financial performance. Under these circumstances the income approach to valuing the business is the best choice.

Business valuation of a joint venture - methods

Using the income-based business valuation methods makes sense because they let you determine the value of the joint venture directly from your financial forecasts and risk assessment.

Assuming that your venture partners buy into the financial projections, you can determine the business value of the entire enterprise by using such well known valuation methods as Discounted Cash Flow.

Valuing a Business based on Cash Flow and Risk

This agreement on the expected financial performance of the joint venture is essential to determine what the entire business is worth - and address the first question above.

Determining the value of business ownership interest in a joint venture

Allocation of the business ownership interest depends upon the relative contribution each partner makes to the joint venture.

Example

Let’s say that the combined company will design and market a new product. One of the partners has the research and development expertise while the other has experience in marketing, sales and distribution of similar products. Each brings considerable value to the venture. What are their interests in this business worth?

Assume that your financial projections were used to calculate the total business value of the venture to be $10,000,000. The partner will provide the product and technology for the venture. The value of such business contribution can be estimated using the asset approach to valuing businesses. Your goal here is to estimate the costs of creating a suitable alternative.

If you were to develop the product by yourself from scratch, the costs associated with this effort can be estimated. In addition, there is an opportunity cost incurred due to sales lost while the product is being developed. Let’s say that you estimate these costs to be $4,500,000.

This provides the estimate of your partner’s share of the venture, which in this case equals 45% of the total business value. If no adjustments are made, you would wind up with 55% of the company which gives you the controlling ownership interest in the venture.

If your partner insists on having an equal stake in the joint enterprise, a balancing payment of $1,000,000 would need to be made.

Construction companies are frequent business acquisition targets. The volume of business sales is largely due to the industry size - there are over 346,000 firms in the single-family housing construction alone, classified under SIC 1521.

While this construction industry segment generates over $196 billion in annual sales, the average construction company is small - employing just 3 people and generating around $600,000 in annual revenues.

There is a sizable pool of business buyers looking for construction companies, especially in the mid-market segment - with the profitable firms topping $5,000,000 in gross revenues.

If you own a business in this industry or plan to buy one, knowing the value of your construction company is essential. While standard business valuation methods under the income, market and asset approaches work well for construction business valuation, there are 5 key factors you need to keep in mind:

Construction company worth: 5 key factors

1. Longevity, name and reputation of the business make a big difference to what the company is worth.
2. Value of a construction company is affected by the expected level of repeat business. Established sales and marketing function that does not depend on the current ownership translates to higher business value.
3. Current contract pipeline and billing practices.
4. Accounts receivable collection. Slow collection calls for higher working capital which increases business risk and leads to lower valuation multiples.
5. Availability and retention of key skilled employees.

Often, higher business selling prices are achieved when a company sells to a competitor or a larger firm looking to enter the market.

Construction business valuation methods

Since construction firms sell often, there is plenty of market comps to detemine the construction company worth. Market-derived Rules of Thumb for construction companies under the SIC 15, 16 and 17 are generally based on the business discretionary cash flow or EBITDA.

For owner-operator managed businesses, the Multiple of Discretionary Earnings business valuation method is an outstanding choice. In addition to the business earnings, this method lets you account for the 5 factors above when valuing a construction company.

Well-established construction businesses may have considerable goodwill. Consider using the time-tested Capitalized Excess Earnings method to measure the worth of your construction company, as a sum of its tangible assets and business goodwill.

If you are buying a business or selling your business, estimating the business selling price by market comparison is a good idea. Recent business sales in your industry offer an excellent way to develop your asking price or check your offer price and terms.

A number of business pricing multiples to choose from

As we discussed in the Business Valuation using Market Comps post, you have a number of valuation or pricing multiples to do your comparisons. Which ones work best?

How to pick your pricing multiples

The answer depends on your business valuation situation. Your choice of the valuation multiples needs to address these important questions:

1. Which pricing multiples give the most accurate prediction of business market value?
2. Which valuation multiple gives the best estimate of what my business is worth?

In the market, business selling prices are set by the business sellers and buyers. So what do these players use as their basis to determine the business value?

Valuation formula multiples are developed by statistical analysis of the actual business sales. Let’s say that in your industry the Price to Gross Revenue valuation multiples cluster around the average value. In other words, business values determined using such pricing multiples fall within a narrow range.

This means that your business peers tend to rely on the business gross revenues to determine the business selling price. Knowing this, you can use the Price to Gross Revenue valuation multiple to get a good idea of what your business is worth.

Obviously, such pricing trends can differ by industry. ValuAdder market-based Rules of Thumb Pricing Formulas use advanced technology to help you make the most accurate choice of the valuation multiple for your business.

Business valuation multiples - making strategic choices

You can use a number of other business valuation multiples as a strategic choice to demonstrate your business value.

For example, the business may be exceptionally profitable compared to its industry peers. In such a case, you may decide to use the Price to Net Income or EBITDA valuation multiples which will show how profitability translates into superior business market value.

If the business is asset rich, business Price to Tangible Assets or Total Asset base may be a good choice of a pricing multiple.

Alternatively, you can pick the Price to Gross Profit valuation multiples. This may be a good fit if the business shows outstanding operational efficiencies which keep its direct costs low compared to the competition.

Take a peek at ValuAdder Business Market Value Reports to see how a number of business valuation multiples can be used to estimate your business market value.

Perhaps the most misunderstood part of valuing a business is that business valuation results may differ depending on the assumptions you make, namely:

• Who needs to know what the business is worth?
• What are the circumstances surrounding your company valuation?

Business appraisers use the formal term business value standard to address this situation. You have a choice of several business value standards that are well known:

• Fair market value
• Investment value
• Intrinsic value
• Fair value

Fair market value is used most often in valuing small businesses and professional practices.
It is an excellent fit when a business is valued for sale or purchase - after all the fair market value is established by business buyers and sellers themselves.

If you are valuing your business by comparing it to recent sales of similar businesses, the fair market value is the typical choice. The assumption here is that, by and large, business buyers and sellers act in their best interests, have taken pains to educate themselves about the market, and are not forced into a deal by circumstances.

Business fair market value and fair value may differ

Enter a deceptively similar definition of business value: fair value. Watch out - this is most often seen in legal disputes and is subject to interpretation by courts.

The assumption often made in this situation is that business owners may be involuntarily deprived of their ownership interest and need to be fairly compensated for their loss.

This is hardly the same as the business owners who freely bargain to get the fair market value for their business!

If business valuation is done for investment reasons, the investment business value definition is common. Each investor seeks to determine the expected returns and risks associated with the business of interest. Since each investor’s perception of risk and required returns is different, their business valuation results for the same business can differ considerably.

Business investment value is unique to each investor

Truly, business value defined under the investment standard is in the eyes of the beholder! This is one reason that business brokers often suggest targeting specific business buyers - those that look for synergistic benefits in a business acquisition - and are willing to pay the price.

Business value definition - a strategic choice

Giving a bit of thought to your choice of business value has strategic implications:

1. Fair market value standard is easily defensible. You can use this to justify your business asking price or offer price to buy a business.

Market-based business valuation methods are typically used to establish your business fair market value.

2. Fair value standard can be very helpful in a legal dispute such as divorce, shareholder disagreements or ownership rights infringement.

3. If you invest in a business or look to attract the right investors, investment business value should be your choice.

Income-based business valuation methods such as the Discounted Cash Flow give you an excellent way to value businesses under the investment business value standard. Each target business is valued based on its specific risk and return profile.

Even if you keep your company’s financial records in accordance with the Generally Accepted Accounting Principles (GAAP), the value of key intangible assets may not be clear.

Unless, that is, these assets were acquired as part of another business purchase. In fact, GAAP rules state that business owners can’t record the value of internally developed intangibles on their financial statements!

Yet for many businesses the value of these “home-grown” intangible assets far exceeds the worth of the assets shown on their cost-basis balance sheet.

Think about the key vendor and distribution agreements, customer lists, brand names and intellectual property the business has developed.

Lumping the value of all business intangible assets into goodwill may not be a good idea. If you buy a business and plan to reduce the tax burden by asset depreciation quickly, allocate part of the business purchase price to the assets that have a short life.

However, under GAAP, business goodwill is not amortized over a fixed time period. Instead, it is handled by the so-called impairment rules as described in SFAS 141 and 142. Allocating much of your business purchase price to goodwill can slow down your cost recovery through depreciation considerably.

Valuing Business Goodwill

Valuing your business intangibles is worth the effort

Knowing the value of your business intangible assets is important for a number of reasons:

• To determine the overall value of the business.
• To allocate the business purchase price in a tax-advantaged way.
• To identify opportunities for additional royalty income.
• To determine the value of business partner contributions in a joint venture, merger or business spin-off.

It is a good idea to estimate the value of your business intangibles and keep this important information in separate records, in addition to your financial statements.

If you are looking to appraise a business, you have two basic choices:

1. Hiring a professional business appraiser.
2. Doing your business appraisal yourself.

Obviously, professional help comes at a price. What can you expect to spend
to get your business appraised?

Business appraisers charge by the hour, with average hourly fees being $250 to $300. A professionaly done business appraisal takes around 20 hours or more to complete. You will receive a business appraisal report detailing the work done and business valuation results expressed as the professional’s opinion of business value.

If you do the math, a professionally prepared business appraisal will set you back $5,000 or more.

Most business appraisals are done on a “limited scope” basis. This means that the business appraiser accepts your company’s financial statements and operational data as true and accurate. Typically, no site visits are involved.

If you need a full scope, comprehensive business valuation, the business appraiser will audit the financials, review the business operating and marketing documents and conduct extensive site visits. The costs of such a business appraisal can easily run upwards of $30,000.

Be wary of “cheap substitutions”

While there is wiggle room on professional fees, you don’t get a reliable, quality business appraisal for a minimum wage. To put things in perspective: $300 buys about 1 hour of professional’s time. This is barely enough to review your financial statements, let alone do a proper business appraisal.

Where are the costs?

In a typical assignment, most of the business appraiser’s time is spent on:

• Understanding your business and its economic prospects.
• Analyzing your financial and operational records. The appraiser then “recasts” your financials for use in business appraisal.
• Communicating with the client.

The actual “appraisal number crunching” and business appraisal report preparation are relatively quick.

Some additional costs: regular business re-appraisals and consulting fees

Many business appraisals need to be repeated on a regular basis. An example is a partner buy-sell agreement - business is typically re-valued at least yearly. Needless to say, you will incur additional costs for each business appraisal prepared for you.

Business appraisal is not worth much unless the client understands it and can use it. Often, business appraisers act as consultants to interpret their results - to the client’s partners, tax authorities, courts and parties to a business sale transaction. Again, the client bears the additional costs every time.

Appraising your business yourself - the benefits of knowledge

There are several reasons you can save a bundle by appraising your business yourself:

1. You use your knowledge of the business and its market - no need to educate the appraiser.

2. You can calculate your business value by using the same well-known business valuation methods the professionals use. All you need is the right tools.

3. You eliminate the costs of having the appraiser communicate and interpret your business valuation results. The knowledge of what your busines is worth - and why - is yours.

Even more importantly, knowing what your business is worth puts you in a strong position in a number of situations:

I. You can negotiate with business partners and lenders, prove your point to an investor, and make your case to tax authorities.

II. You can spot opportunities to increase the business value before making a critical decision, such as buying or selling the business.

Business Valuation Tools

Appraising your business - tools for the job

Business appraisers use standard methods in their work. So can you. Well-designed business appraisal tools, such as ValuAdder business valuation software and Report Builder help you in 4 essential ways:

1. Organization: You can get through your business appraisal easily by following a well-established business valuation process.

2. Information: Learning & Info Center and Business Valuation Handbook give you the essential know-how on choosing and applying the business valuation tools effectively. Making informed choices is critical to an accurate business appraisal.

3. Time-saving tools: You can calculate your business worth using the standards-compliant business valuation methods the professional appraisers use.

For example, using such well-known methods as Discounted Cash Flow and Multiple of Discretionary Earnings gives your results considerable credibility.

4. Standard reporting format: You can present your business valuation results in a professional report format. Compliance with important standards such as USPAP and AICPA SSVS is expected from any serious business appraisal report.

Preparing Appraisal Reports

When it comes to valuing a business, the business value number you get is always in today’s dollars. In other words, all business appraisals are done in the present.

Yet the key goal of business valuation is to assess the company’s earning potential and risk going forward. In this sense, your business appraisal is always forward looking.

No two business types stretch the dimension of business earning upside and risk more than these:

A “cash cow” business which produces steady income year over year. The company does so with minimial risk but shows moderate growth.

A high growth company that promises excellent growth and great returns in the future. At present though, the business may be unprofitable.

So which business is worth more money today?

Let’s see how the well-known Discounted Cash Flow business valuation method lets you answer this question precisely.

Example: business valuation of a cash cow and a rising star

For our “cash cow” business, we have the following net cash flow forecast in the next 5 years:

• Year 1: $100,000
• Year 2: $103,000
• Year 3: $106,090
• Year 4: $109,273
• Year 5: $112,551

The earnings growth rate is an uninspiring 3% per year. However, because the company operates in a well-protected niche and stable industry, you estimate the risk to be quite low and calculate the company’s discount rate at just 15%. Beyond year 5, the long-term terminal value of the business is capitalized at $966,062.

Our “rising star” high growth company shows a very different cash flow forecast. In the first year the company is unprofitable. It breaks even in year 2 and starts producing good earnings starting in year 3.

• Year 1: ($100,000)
• Year 2: $0
• Year 3: $100,000
• Year 4: $125,000
• Year 5: $156,250

This is done at a very high earnings growth rate of 25% per year. However, this growth is achieved at considerable operational and market risk. Hence, you estimate the discount rate for this company to be around 35%.

Given the long-term growth and year 5 earnings, you determine the long-term (terminal) business value to be $1,953,125. Five years from now, the high growth business would be worth about twice as much as the company with the steady income!

Business valuation calculation: which business is worth more today?

You can calculate both scenarios using ValuAdder Discounted Cash Flow business valuation.

The value of each business is based on the respective earnings forecast, discount rate and long-term value. Remember that we are interested in what each company is worth today. The results:

Cash cow business value: $833,334.

High growth business value: $474,623.

Business value conclusion: high growth comes at a price

What this example demonstrates is that high business growth that defers business earnings may be worth less than a low-risk stable income stream.

In fact, our high growth business will have to demonstrate about twice the business earnings in year 5 to be worth the same as the “cash cow” company. Getting to that level of earnings fast may require considerable amount of additional capital and stretch the company’s ability to grow.

A strategy to maximize your business worth

Knowing this, you can combine the two extremes into a winning business value-creating strategy:

1. Develop a steady, low risk income stream first. Early positive cash flow and stability of earnings translate into superior business value.

2. Focus on high growth opportunities going forward. Their risk may be justified by higher returns at a later time.

Businesses use a wide range of assets, both tangible and intangible, to produce income. One way you can create business value is to use specialized business assets.

A well organized kitchen makes a big difference to a restaurant. A manufacturing firm has production equipment that is fine-tuned to reduce costs and output quality products.

Needless to say, such special-purpose assets are very valuable because of their essential contribution to business earnings.

Challenges in valuing specialized business assets: highest and best use

Yet valuing such business assets may be harder than it seems. The need to value business assets often arises when the business comes up for sale. The key question then is whether the business buyer intends to continue using the specialized assets for the same purpose.

If, for example, the business buyer plans to make operational changes, some special-purpose assets may require additional investment. If the buyer uses the cost approach to valuing these assets, their business value will be adjusted net of the expected additional outlays.

Put differently, the business buyer may not be putting the specialized assets to their ”highest and best use”.

Fair market value of special-purpose business assets

Since savvy business sellers and buyers tend to act in their best interests, specialized business assets do have fair market value. The reason: in the business market, there are alternatives.

What this means is that you are unlikely to spend more on an asset than the cost of a suitable alternative. If you are selling a business, you would consider several offers before making a decision.

Alternatives, business value and the principle of substitution

This principle of substitution is a powerful economic force that influences the value of businesses and their assets.

Unique assets and amazing valuations

If the asset is truly unique, the principle no longer applies. That’s one reason why works of art can command such unexpectedly high valuations.

Business assets and commercial property are not really unique - there is always the next best thing that will do. Existence of reasonable alternatives explains why values of business assets tend to gravitate toward the fair market value equilibrium.

Insurance brokerage is a growing business. In the US, for example, there are nearly 220,000 insurance brokerage firms.

The industry employs some 1,232,000 people and generates total annual sales of over $355 billion. Most insurance agencies are small businesses with an average staff of 6 and annual revenues of around $1.8 million.

These businesses continue to provide excellent financial rewards to agency owners in return for investment in modern financial management systems, client management and new business development.

Insurance brokers tend to have highly recurring income stream. Attracting and retaining long-term growth clients is very important.

If you are valuing an insurance agency, consider these key business value drivers:

1. Product mix

Insurance agents can offer products in a wide range of markets. Among these are the property and casualty commercial lines, personal, health insurance, and life insurance products.

Group health and consumer insurance lines are frequently more profitable than commercial contracts. Agencies that specialize in health benefits often show good, steady cash flow which drives their business value.

2. Whether the policies are direct or agent-billed

Direct-billed policies tend to have higher client retention rates. As a result, your will find that insurance agencies with high direct-bill rates often command higher business valuations.

3. Contract renewal rates

Existing client policy renewals are critical to the insurance agency’s ability to generate stable cash flow. Renewal rates may be affected by the client base characteristics and client concentration. Agencies whose income stream depends on a few large clients are likely to have business value below the peers with diversified customer base.

4. Licensed employee percentage and tenure

Professional insurance agents are in great demand. If you are looking at an agency whose staff is largely composed of highly skilled, long-term insurance professionals, the valuation multiples tend higher.

This is due to both the expectation of better client retention and ability to develop new business.

5. Independent or captive insurance agencies

Independent agents frequently command higher valuation multiples. This is because some major carriers limit the product choices that their captive agents can offer.

Independent insurance brokers can capitalize on this reduced competition by offering profitable products that are highly customized to meet their clients’ needs. This leads to better client retention, steady profit growth and higher business valuations.

Business valuation techniques for insurance brokerages

You have a number of solid choices to determine the value of an insurance agency. Some guidelines:

Market approach to valuing insurance agencies

Multiples of gross sales commissions are the preferred way to determine business market value in this industry. Again, valuation multiples for agencies with high client retention rates tend to be at the top of the range.

Agency valuation under the Income approach

Because many smaller insurance agencies are acquisition targets for larger firms, business valuations should factor in the potential synergies. The Discounted Cash Flow business valuation method, which enables you to account for key business value drivers directly, is an excellent choice here.

Asset approach to business valuation

Insurance agencies tend to have a large intangible asset base and business goodwill in the form of established clients and carrier relationships. The method of choice here is the Capitalized Excess Earnings - it lets you calculate the business value as the sum of its tangible assets and business goodwill.

There are over 50,000 bars, pubs, microbreweries and night clubs in the US alone. These businesses tend to generate good cash flow and attract loyal customer following, especially if the bar concept is well-focused on a particular demographic.

With health benefits of moderate wine drinking planted in the public subconscious, and popularity of local microbrews, many pubs and bars are enjoying solid growth and steady earnings.

Valuing a bar is all about earnings

Business value of a bar or pub is driven by its profitability. A key measure of the bar value is how much discretionary cash flow it throws off.

A number of factors affect how profitable, and therefore, valuable a bar is. The top hitters to check:

1. Location

Bars and microbreweries often are a gathering place for the locals. If you target a specific market demographic, the bar should be located where these people like to spend their time. Ample parking is very important.

2. Rental expenses

Lease expenses and terms are a big factor affecting bar values. Successful bars keep theirs under 8% of sales.

3. Liquor license

Liquor license is a requirement to generate sales, produce profits and build a bar’s value. A liquor license is especially valuable if the number of licenses in the area is limited, deterring competition.

4. Whether drinks are measured or free poured

How the drinks are served affects the bar’s cost of goods and its cash flow. A rule of thumb is to keep the drink costs under 30% of the price.

5. Additional profit centers such as on-premises vending

On-premises vending of products and games is a frequent addition to the bar’s revenue. This also helps keep the customers in longer, often increasing the drink sales volume.

6. Payroll expenses

Payroll expenses within 25% of the bar sales are the industry norm.

Business valuation methods for bars and pubs

Business valuation based on income is the typical choice for valuing bars and pubs. The Multiple of Discretionary Earnings method is an excellent choice because it lets you figure out the effects of various financial and operational factors into the bar value.

Since bars sell often, you can value a bar by direct market comparisons. Multiples of discretionary cash flow are the preferred choice. You can also price a bar based on its revenues. Even then it is a good idea to check your business valuation results by using the cash flow based multiples.

You will find extensive coverage of business values for bars and pubs in the ValuAdder Business Valuation Rules of Thumb. Based on the current business sales, the Rules of Thumb give you an instant estimate of the business selling price range, average and median values.

Bars are rarely valued based on assets. This is because many business buyers change the bar concept and invest heavily into upgrading the assets, such as furniture, fixtures and equipment. By convention, the business-owned real estate is broken out and valued separately.

While business valuation is hardly black magic, 3 common myths do need dispelling:

Myth 1: There is only one way to appraise a business.

Not so. In fact, there are three ways, known as approaches, to determine the value of a business. Each has strengths and drawbacks. That’s why a well-prepared business appraisal uses a number of business valuation methods to get accurate results.

Myth 2: Valuing a business involves filling out a couple of forms.

You wish! Business valuation is part art and part science. It requires that you make a number of important decisions about why and how you value your business. This way you get reliable business valuation results that you can interpret - and defend in any situation.

Properly prepared business appraisals account for this and get very accurate results. You can do this by analyzing the business carefully, choosing the appropriate business valuation methods, and drawing a well-considered business value conclusion.

Myth 3: Once my business is appraised, I am done.

In fact, a business valuation is valid only on the date it is completed. A business is like a living and breathing thing - its situation changes all the time. So does its value.

Re-appraising your business regularly is an excellent strategic management tool - it lets you see how your business value evolves in response to financial and operational changes in your business.