Archive for April, 2008

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 Valuation 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 Valuation Market Comps Tool to see how a number of business valuation multiples can be used to estimate your business market value.

If you need a bullet-proof way to show what your business is worth, compare it to similar businesses that sold recently. In fact, such business market value comparisons are widely used by business people and professional business appraisers. So much so, that they deserve an official name: Comparative Transaction business valuation method.

Market comps and business fair market value

One of the greatest strengths of valuing a business by the Comparative Transaction method is that it establishes the business fair market value. This is perhaps the best known standard of business value.

Done correctly, such business valuation results are compelling and defensible. Many business people believe that the market ultimately decides what businesses and their assets are worth.

Business valuation mechanics: pricing multiples

To make an apples-to-apples comparison, you can use a number of pricing multiples – ratios which relate the likely business selling price to its financial performance. Examples of commonly used business pricing multiples are:

  • Business selling price to discretionary cash flow or net cash flow.
  • Business selling price to gross or net revenue.
  • Business selling price to net income, EBITDA, EBIT, EBT.
  • Price to total assets, tangible assets or business book value.

To make the comparison accurate, you can pick a number of actual business sales in a specific industry. Some questions that come up often:

1. My business generates income from several profit centers. How do I do my business market value comparisons?

2. My business is very specialized. Are there enough similar business sales to compare against?

Business market value comparisons, such as those offered in ValuAdder Market Comps are organized by industry. If your business is pure play, deriving all or most of its income from one industry, you can make your business value comparison directly against your industry group.

For multiple profit center businesses, you can estimate your business fair market value as follows:

  1. Check the business values in each industry group of interest.
  2. Assign a weight to the business market value result from each industry in proportion to its revenue contribution to your business.
  3. Sum up the results to get a business value estimate for your company.

Valuing a Business with Market Comps

Example

We are looking at a business with $1,000,000 annual sales.

Let’s assume that the business generates 70% of its revenues from retail product sales. The remaining 30% are derived from its client consulting services.

We check comparable business sales using the pricing multiples for retail sales and consulting services. The first comparison uses the $700,000 revenue as the basis and indicates that this part of the business is worth around $550,000.

The second comparison, using the $300,000 revenue basis, shows an additional business value of $250,000.

Combining the two results, we get the business market value estimate of $800,000.

Note that this estimate does not account for the synergies among the business profit centers. That is why it is a good idea to value your business several ways – including the income-based business valuation methods such as Discounted Cash Flow and Multiple of Discretionary Earnings.

Fair market value estimation for specialized businesses

If your business is very specialized, chances are there are not enough comparable business sales. In this case, you can choose a broader industry group to do your business value comparison. 

Standard industrial classification systems, such as SIC and NAICS, are very helpful to locate the relevant industry groups.

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 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 professionally 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