Business valuation tips, updates and advice. Pick up a few suggestions on how to value a business. Feel free to browse the contents or share your thoughts by leaving a comment.
Do you own a small engineering firm or are looking to acquire a consulting company? Here are some interesting industry statistics and company valuation tips that you may find useful:
Private engineering firms are a typical small professional service business. Of some 58,300 engineering firms classified under SIC code 8711 and NAICS 54133 in the US, fewer than 8% have more than 25 employees.
While the engineering consulting industry as a whole generates over $208B in annual revenues, the average engineering company does about $3.5M in gross revenues annually and employs a staff of 16 to 17. Revenue per employee is about $211,000.
Privately owned engineering companies cover a number of disciplines, the most common being:
Civil and structural engineers
Mechanical engineering and industrial automation
Electrical engineers
Environmental and chemical engineering consultants
Information technology services and systems engineering
The market for engineering service businesses remains highly fragmented with the top 4 consulting firms accounting for about 15% of the industry revenue. Most engineering companies are locally owned and operated and address the needs of specific market niches in their target geographies.
Professional engineering license requirements tend to limit competition and contribute to relatively consistent billing rates and stable business earnings across the industry.
Valuation multiples for engineering companies
Smaller firms with gross annual sales under $10,000,000 are typically valued on their earnings, most often seller’s discretionary cash flow. Business sale price to gross revenues is the second most common formula multiple used in valuing an engineering company.
Interestingly, the historic coefficient of variation for the business selling price to EBITDA valuation multiple is almost 4 times greater than the discretionary earnings based figures.
Why is this important? The smaller coefficient of variation tells us that the valuation multiples based on discretionary cash flow tend to cluster around the mean. You can estimate your engineering company’s fair market value with greater precision if you use such valuation multiples.
This points to the need to adjust your engineering company financial statements in order to establish the business earning power – typically based on the discretionary cash flow, not the accounting profit multiples.
Other business valuation methods for engineering firms
Depending upon your business valuation needs, you can resort to a number of standard business appraisal methods.
What is your business goodwill?
For established engineering companies the value of business goodwill may be considerable. The Capitalized Excess Earnings business valuation method is an excellent choice for valuing such companies.
Equally important, you will need to separate the overall goodwill into the personal and business goodwill parts. While the personal goodwill is generated by the skilled employees, the business goodwill belongs to the company itself, and is highly transferable in case the business sells.
Valuing an engineering firm based on its cash flow
The Discounted Cash Flow business valuation method is the usual choice when valuing a young or rapidly growing engineering firm. This method is widely used by the venture capital industry and requires no introduction when talking to business appraisal professionals.
If you require a precise, defensible business valuation of your company, the discounted cash flow valuation should be on your list of priorities.
Earnings multiple valuation
If you are valuing a smaller owner-operator managed engineering firm, consider using the Multiple of Discretionary Earnings method. The method offers a very intuitive link between the business earnings, key financial and operational performance factors and business value.
If you own a small business or plan to buy one these days you may be wondering – how is the current economic downturn affecting the small business selling prices?
If you are tempted to check the public company stock market for guidance on private business sales – do be careful. The truth is that small business sales are nothing like trading public company stock.
Here are the top 5 reasons for this:
1. Small businesses take a while to sell – 180 days on average
Selling a small business takes quite a bit more time and effort than unloading public company stock.
What this means is that we will see reliable evidence of how the current credit markets turmoil has impacted small business sales months from now.
2. Small business sales are usually closed by experienced business people
Small business buying and selling is a high stakes activity. If your livelihood is at risk, you would approach the business acquisition a bit differently than a part-time stock picker.
To avoid costly mistakes, small business people must understand the business thoroughly before they buy or sell. As a result, successful business people price their deals much better than the typical public company investor.
Before the transaction is closed, there is extensive due diligence. By the time the business sale is concluded, the business buyer has a very good idea of what the business is really worth.
3. Private businesses sell in a private market that moves slower that public capital markets
Usually, the entire business sells, not just a handful of shares as with public company stock sales. An important consequence is that there are a lot fewer small business sales than public company stock trades. So the pricing trends take longer to develop.
Small business selling prices are less volatile than public company stocks because there is little incentive to speculate and take advantage of temporary price movements. The fact is that valuation multiples for private firms tend to change slowly over time.
For example, the valuation multiples for small manufacturing companies over the last 13 years have changed as follows:
Business sale price to gross revenue valuation multiples increased by an average of 1.4% per year. The average multiple was 0.51, being just under 0.6 by the end of 2007.
Business sale price to seller’s discretionary cash flow valuation multiples grew 2.2% annually, averaging 2.22 and approaching 2.45 by 2007 year end.
4. Valuation multiples for private firms depend on the company’s size
Small, privately owned businesses, are generally seen as more risky than their Fortune 500 counterparts. Business people price this additional small company risk right into the valuation multiples.
If you compare the sales of private businesses that are similar in size to yours, you are likely to get a far more accurate estimate of business value than measuring it against a multinational.
5. Small business valuation multiples include company-specific risk
The vast majority of small businesses are operated by their owners. These business people expect additional returns on their investment of time, effort and money in a specific business. The valuation multiples derived from small business sales reflect this type of company-specific risk.
In contrast, public company investors don’t usually work for their portfolio companies and reduce their risk through diversification. Unlike the working small business owners, public company investors do not expect, or receive this additional return.
Is there a better way to value a small business than try to second guess the market? Yes indeed! Remember that the value of any business depends on its earnings prospects and risk.
By analyzing your business from this income producing perspective, you can determine what the business is worth to you – given your expectation of earnings and risk tolerance.
Buying or selling a small business is a big commitment – of your time, resources and talent. It is worth your while to get an accurate business valuation.
One way you can put business valuation to good use is as a strategic planning tool. Knowing what your business is worth helps you make informed business decisions in a number of critical situations.
Many business people consider selling their business at certain point. Given the years of hard work that go into building a great business, the owners naturally are interested in the business sale price that fairly represents what their business is truly worth.
Business valuation is about risks and returns
If you have a good idea about the business earnings levels and stability going forward, you can determine what your business is worth. The methods under the income approach to business valuation are your best tools here.
These methods let you calculate the business value directly from your business earnings forecasts and risk assessment, which you capture as the so-called discount and capitalization rates.
Since business people have different tolerance for risk, your discount and cap rates may be different from mine. This in turn will translate into different estimates of business value.
The important point is that you can use the income-based business valuation to determine what the business is worth to you – based on your own expectation of earnings and risk.
A different perspective – market approach to valuing a business
Comparing the recent selling prices of similar businesses gives you an idea of what your business can sell for. If you have access to reliable business sales data, you can estimate your asking price, consider the financing terms required to close the deal, and see how long it can take to sell a business like yours.
Reliable business sale comps = defensible business market value
Your business valuation should include such market-based analysis. Using valuation multiples based on private business sale comparables you can assess your business market value based on its revenues, profits, cash flows, and assets.
If your data comes from reliable sources, your market value estimates are easy to defend in buyer negotiations.
Business intrinsic worth versus market value: to sell or not to sell?
Now, what if your business market value estimates fall below your income-based business appraisal result? This may well mean that, given the current market conditions, you are unlikely to sell your business for the price that truly reflects what the business is worth to you.
Example
Let’s say your market analysis shows that you can probably sell the business now for around $700,000. In addition, you will likely need to offer seller financing for 50% of the deal, so the cash you see at close is $350,000. But your Discounted Cash Flow valuation analysis indicates that the business is really worth $1,000,000.
In short, to sell the business today would mean that you will give up about $300,000 and put an additional $350,000 at short-term risk!
Your business valuation model should include different methods
You can base your decision not to sell the business on such income and market-based business valuation analysis. Simply put, you may decide to postpone the business sale until the market conditions improve, business buyers are again able to raise adequate acquisition capital and the offers begin to look promising.
If you think small domestic call centers are a thing of the past and have been outsourced offshore, think again – there are over 15,000 small and mid-size call center businesses operating in the US alone, classified under SIC 7389 and NAICS 561421.
While the average call center employs nearly 300 agents, many businesses in this industry have fewer than 20 employees. The average annual revenues for private call center companies top $11,000,000. However, many small home-based call centers are much smaller – generating around $400,000 in annual billings.
Key value drivers for call center businesses
When it comes to valuing a privately owned call center, size makes a big difference. Indeed, larger firms with annual billings of $10,000,000 or more command valuation multiples that are more than twice those for small call centers whose revenues are in the sub-$1,000,000 range.
Call centers tend to be quite labor intensive and rely upon customer service rep recruitment and training. Businesses that have their direct labor costs under control tend to get higher valuations. Above average call centers keep their direct labor costs to within 50 – 51% or revenues.
Business valuation methods for valuing call center companies
Private call center sales that took place recently offer you an excellent indication of what such businesses are worth. The best valuation multiples are those that give you the most accurate estimate of what a similar business is likely to sell for. Here is our list:
The spread between the low and high selling prices for the EBITDA based business value estimates is about 60% that of the revenue-based figures. We take this as an indication that business buyers and sellers tend to use EBITDA more often when pricing the “real-world” call center business sale deals.
Put another way, the buyers value business profitability above the revenue or business assets in this industry.
Valuing a day care center business based on its income
No call center valuation is complete without the use of at least one of the income-based business valuation methods. For larger call center companies the Discounted Cash Flow method is the usual choice.
Business goodwill valuation for existing call center companies
Call centers that have been around and established a track record of success can command a substantial premium on the market due to their goodwill. To calculate what the business goodwill is worth you can use the well-known Capitalized Excess Earnings method.
As the name implies, this valuation technique lets you calculate the value of business goodwill by capitalizing a part of the business earnings. The idea behind this business valuation method is that superior earnings translate into higher business value.
You can value any business or professional practice three ways, known to professionals as valuation approaches:
Market – by comparing your business to similar businesses that sold recently.
Income – by assessing your company’s earning power and risk.
Asset – using the business assets as your valuation basis.
Business Valuation Three Ways
There are a number of well-known business valuation methods under each of these approaches. It is a very good idea to use several such methods to determine what your business is worth.
So what methods should you pick for your business valuation? The answer depends on your specific situation and the assumptions you make. Truly, business value is in the eyes of the beholder.
Valuation of a business for sale – buyer and seller’s numbers may differ
Consider a typical situation when a business is put up for sale. Business owners, naturally, would be very interested in the highest possible business valuation numbers. On the other hand, a business buyer is likely to be far more conservative when valuing a business to buy.
Conservative business valuations in gift and estate tax situations
Business owners looking to minimize gift or estate taxes will look for the lowest possible business appraisal. The same owners are likely interested in a higher number when presenting their business to strategic investors. Needless to say, the tax man will probably be skeptical if your business appraisal is too low.
Partner buyouts – two views of what a business is worth
In a partner buy-out situation the remaining partners want the lowest possible value for the departing partner’s share of the business. On the other hand, that departing partner is interested in a higher valuation. This is one reason why buy-sell agreements are important.
Are all these different business people fudging numbers? Not necessarily! What they are doing is factoring in their specific assumptions into their business valuation. And these assumptions affect the results they get.
Different assumptions affect your business valuation conclusion
The main point is that your business valuation numbers can differ from someone else’s. This does not disprove your business appraisal – as long as you can demonstrate that your assumptions and business valuation method choices make sound sense.
Business valuation model = key assumptions + choice of methods
Enter the business valuation model – the set of assumptions you make and business valuation method choices for your business appraisal. Based on your specific situation, your business valuation model may differ from mine – yet both can produce defensible business valuation results.
A business seller and buyer may come up with a different opinion of what the business is worth. To close a successful business sale though, they will likely arrive at a compromise – a number acceptable to both parties.
If you convince your investors that your business is worth a certain amount, then your business valuation works. You have made the right assumptions at the outset and picked the business valuation methods that made sense to your investors.
The moral of all this? Your business valuation is right if it serves its intended purpose.
To make sure that it does, you need to spell out your assumptions and be able to show clearly why your choices of business valuation methods are the best.
