Perhaps the best known reasons for getting a business valuation are a business sale or purchase and handling a legal challenge such as divorce or partner dispute.
You can also use business valuation as a strategic planning tool. And one of the most important questions to address is whether you should keep your doors open or wind the business down.
Using business valuation for strategic decision making
So how can business valuation help you make this critical decision? In addition to giving you a number, business appraisal shows how well the business creates value for its owners.
One of the central questions: is running the business worth the effort? Or, using the business appraisal terminology: does the business create enough value for its owners?
Enter the Capitalized Excess Earnings business valuation method. Known as the Treasury Method, this classical valuation technique lets you determine the value of business goodwill and total business value.
Here is how the method works:
- First, it identifies the value of business tangible assets. Essentially, this is the capital committed to support the business operations.
- It calculates the return required given the business investment made.
- Next, it determines whether the business is profitable enough to generate additional earnings, known as excess earnings.
- Based on these excess earnings and business growth prospects, it calculates the value of business goodwill.
- Finally, it determines what the business is worth.
Notice that business goodwill depends on the company’s earning capacity. The total business value then is the sum of its tangible assets and goodwill.
Put another way, the business must first pay for the capital invested by the owners and then generate additional earnings to make it worth while – over the long term.
This gives you a way to address the question of whether running the business makes economic sense:
If the business goodwill is positive, your business produces enough earnings to justify your efforts.
On the other hand, zero or negative goodwill value shows that the business is having trouble paying for the investments already made – including cash, inventory, equipment and facilities.
Is the business worth the trouble in the long run?
Given the long-term view of business value you get from the Capitalized Excess Earnings method, you can make the decision:
- If the business generates sufficient earnings to cover your long-term investment and produce significant goodwill, it is worth the trouble to continue running it. The business will likely increase in value to make it an attractive acquisition target in the future.
- If business earnings fall below the expected returns on your investment, it may be time to wind down the current operations or plan for stratetic changes in the company.
Using Treasury Method for Business Appraisal
If you are thinking of selling your business or plan to buy one, the central issue is how to determine the business sale price.
Setting the selling price of a business right is very important to a successful business acquisition. More deals go wrong because business buyers and sellers fail to agree on how to price the business.
In the current economic climate pricing a business for sale is more challenging than ever. You need to complete two important tasks to get it right:
- Conduct a business valuation.
- Structure the price and terms of the business sale.
Business valuation is the first essential step toward figuring out how much your business can sell for. Since the intent is a business sale, market-based business valuation methods should be your first choice.
Business valuation using private business sales comps
The most compelling way to determine the value of a business for sale is to compare the selling prices of similar private businesses that have sold recently. You can estimate your business market value using the valuation multiples derived from such transactions.
The typical valuation multiples help you estimate your potential business selling price based on the company’s gross revenues, net sales, net profit, EBITDA, cash flow or asset base. Using the business sale statistics, you can calculate your likely business sale price as a single number or a range of values.
Income business valuation – customized to your specific situation
Such market based business value analysis is an excellent way to determine the business fair market value. However, each business sale transaction is unique. The objectives and risk perceptions of the business buyer or owner may differ considerably.
That’s where the income-based business appraisal comes in. This approach to valuing a business for sale lets you account for your specific goals. To use the formal business appraisal terms, income-based business valuation may adopt the investment value standard. The result may be a business value that is either below or above the fair market value.
Strategic buyers can pay a premium price for the right business
The typical situation involves a synergistic business buyer. Such a buyer may be looking to realize some unique benefits through business acquisition. Often, the analysis of business value will show the number that is considerably higher than the fair market value estimate obtained from business sales comps.
The result of an income based business valuation depends on the forecast of business earnings and its risk. A strategic buyer may have plans for your business that indicate considerable earnings growth upside over the long term. In addition, the buyer may have a well-planned ownership transition strategy that minimizes the business risk. The result is higher business value.
Financial business buyers look for low cost income streams
At the other extreme are financial buyers who are interested in acquiring the business income stream at the lowest price possible. Expect conservative business valuations and low business purchase price offers from this group.
Find the right buyer to maximize your business selling price
Savvy business owners can make the search for synergistic business buyers an important part of their strategy to maximize the business sale price.
Valuing a business based on its assets
You should also consider using asset based business valuation methods. The key advantages offered by this approach is calculation of business goodwill and purchase price allocation among the business assets in a tax advantaged way.
Putting the deal together – business sale price and terms
Once you know what the business is worth, it is time to structure the terms of the business acquisition that make sense to both the buyer and the seller.
In addition to the business selling price, your deal structure needs to account for these important elements:
- The amount of buyer down payment.
- Terms of seller and lender financing, including the principal amounts, maturity and interest charged.
- Any amount of the business sale price to be held back in an earnout.
- Payback period required by the buyer to recover the down payment.
- Acceptable living wage for the new business owners.
- Amount of capital expenses required to run the business after the sale closes.
- Working capital injection if the business sale is structured as an asset transaction.
- Business acquisition expenses such as professional fees, closing costs, licenses and permits, and due diligence expenses.
Your business value and sale price may differ!
There could be a considerable difference between the appraised value of the business and its actual selling price. The reason is that the deal terms are unique to each transaction. As the terms vary, so does the amount of cash flow required to make your business acquisition work financially.
It is not unusual for a business to sell at a considerable discount if the seller insists on an all-cash transaction. Offering seller financing to a qualified buyer tends to increase the selling price while reducing the capital gains taxes for the seller.
The Multiple of Discretionary Earnings is a classical example of direct capitalization methods under the Income Approach to business valuation.
Using this technique you can determine your business value as a capitalized multiple of business discretionary cash flow. The valuation multiplier used by the Multiple of Discretionary Earnings method is built up based on your evaluation of business financial and operational performance factors.
Importantly, your business valuation result is calculated as though the business were offered for sale.
Business asset sale assumptions
Small business sales are usually structured as asset transactions. In such situations the following assumptions are typical:
- Business assets are delivered free and clear to the buyer. The seller pays off all liabilities prior to the business sale close.
- The buyer gets all hard assets, including inventory, plus business goodwill.
- The seller usually retains cash, accounts receivable and any non-operating assets.
- Business owned real estate is appraised separately.
Your Multiple of Discretionary Earnings business valuation calculation requires that you make several adjustments that match this asset business sale scenario:
Net working capital adjustment
Net working capital adjustment accounts for the liquid capital needed to run the business. This includes cash on hand, accounts receivable, but excludes the short-term portion of long term debt. The inventory is also excluded to avoid double counting – since the method’s valuation multiplier has the inventory value built in.
Adjustment for value of non-operating business assets
You need to specify the value of non-operating assets. These assets do not currently contribute to business income, hence their value is extra.
Value your business on a rented premises basis
Most small businesses lease their premises. If your business owns its property, it is common practice to adjust the income statements for a fair market rental expense. This affects your business cash flow and capitalized business value. You can then value the real estate separately as part of the deal.
Two business values: owners equity or total invested capital
If you need to determine the value of business owners’ equity, specify the long-term liabilities as well. Otherwise, your business appraisal is done based on the market value of invested capital – which includes both the equity and debt holders interests.
This is the business value the buyer gets in an asset sale.
Valuation of Business – Multiple of Earnings