Archive for December, 2016

If you ever valued a private company, you probably ran across the venerable Multiple of Discretionary Earnings business valuation method. This technique is perhaps the most common in valuing owner-operator managed businesses. Its appeal is simplicity and excellent coverage of value factors that demonstrate what creates business value and how you can improve operations in order to increase business worth.

As this example shows, the Multiple of Discretionary Earnings method lets you assess the company across a set of key financial and operational performance factors. You score the business on each factor, input a set of financial figures, and the method calculates both the earnings multiple and the overall business value.

Better run, more profitable businesses generally command higher selling prices in the market. The Multiple of Discretionary Earnings method captures this trend very well. For example, you may ask the questions:

  • How much is business value affected by the stability of business earnings over time?
  • Is the quality of management team important to business value?
  • What is the effect of customer concentration on the company’s valuation?
  • Is a business with efficient, well documented business practices more valuable?

The method lets you answer all these questions and more. Importantly, you can spot weaknesses and opportunities to see how much your business value would increase if you made improvements. A great way to make strategic decisions that translate into a greater business value!

But one question remains. Just how high do the earnings multiples get in the ‘real world’? Is there a reasonable range of Seller’s Discretionary Earnings multiples a private business can actually sell for?

This brings us to the area of statistical data analysis. One way you can answer this important question is by studying comparable business sales. You can relate the actual business selling prices to earnings and calculate the earnings multiples observed in the market place.

Conventional wisdom tells us that private businesses tend to sell for somewhere between 0.1 and 4 times the SDE (Seller’s Discretionary Earnings). However, if you analyze the business sales data, you will discover that the range is quite a bit wider.

True enough, close to 90% of private businesses do sell for earnings multiples in the range of 0.1 to 4. But the upper 10% defy this trend.

Indeed, the top 10% of private businesses can price above 50 times the SDE. If you visualize the earnings multiple trend versus the percentile of sold businesses, the graph starts out smoothly, reaching the multiple of 4 for a 90% business sale percentile. Thereafter, the graph trends sharply up, reaching beyond 50 times the SDE for the top 1% of all businesses sold.

This is perhaps an interesting demonstration of the 10% – 90% statistical adage. The highest 90% of the earnings multiples are commanded by the top 10% of all businesses.

What are the reasons for such dramatic differences in selling multiples? Here are some we have noted:

  • Successful businesses at the top of their game command much higher valuation multiples than their peers.
  • The best businesses attract the bulk of business buyers and investors who bid up the selling prices competitively.
  • The top performing companies have the best earnings growth prospects, which directly affect their value.

One statistical reason often overlooked is that in some industries business sales are priced on other measures of financial performance or condition. For example, high technology companies are often acquired based on their assets, especially intellectual property; or their gross revenues.

The earnings multiples could be very high if these companies have not yet been optimized for peak profitability. The acquiring entity, typically a large corporation, may have a very different vision for profitability using its own economies of scale, market access, and capital to grow the young company further.

A business appraisal is a serious project. Making sure clients understand what to expect is something you would want to handle with care. Spelling out what happens each step of the way can save you some grief down the road.

Consider just some possible situations that could lead to client disappointment. Let’s say you prepare a business valuation report for the client’s eyes only. Unbeknownst to you, the client shares the appraisal report with a lender who demands additional disclosure before making a loan. The client is frustrated facing more costs and delay. The moral? Agreeing on who your business appraisal is intended for is very important.

In fact, business appraisal standards such as Uniform Standards of Professional Appraisal Practice (USPAP) require that you state in your report what format your valuation follows. If your client is the only party intended to read the report, you can opt for the Restricted Appraisal format. On the other hand, if others are expected to see the valuation results, USPAP standard requires you to choose the broader Appraisal format.

The level of information disclosure you provide could make a lot of difference. An outside investor or business buyer may not have the information that the business owners take for granted. Hence, if the business is put up for sale, you should consider additional disclosure to make your report useful in a business sale or equity investment situation.

Want to avoid phone calls from an irate client over the bill? It would be wise to state what your fees are going to look like up front.

You may also spell out the rules of engagement, especially how possible misunderstandings are to be resolved. Limiting your exposure in case of a dispute could save you a lot of trouble as well.

These are just some of the reasons you should consider preparing a letter of engagement before starting on a business valuation project. Let the client see what the project is going to take in terms of cost, time, and effort both on your client’s part and your own.

Here are some key elements to include in your letter of engagement:

  • Purpose of the proposed business appraisal
  • Scope of the valuation project
  • How the results will be reported
  • Who will do the work
  • Project fees and how the client is to be billed
  • What the client’s responsibilities are
  • Limitation of your liability and how disputes are to be resolved
  • How the valuation project can be terminated by the parties
  • Any assumptions made at the outset

Prepare an engagement letter and share it with the client. Getting a client buy-in early on can help you grow a steady following of happy customers and well managed valuation projects.