When it comes to buying, selling or investing in a business the important question becomes ‘How much is the business worth?’
As an investment banker and investor I have looked at over a thousand businesses over the last 20 years. Those businesses were sometimes represented by a realtor, sometimes represented by a lawyer, sometimes represented by an accountant, sometimes represented by a business broker and sometimes represented by the business owner. Each one of them has their own way of valuating the business.
The business owners know the business best but are often emotionally attached which skews their valuation. Realtors often lack the business training to understand the profitability and focus on the marketing of loosely defined ‘potential’ of the business. Lawyers are masters at identifying and mitigating risk. Accountants are excellent at being able to measure profitability. Business brokers perhaps have the best reference point at any given time to put the business into perspective with what’s happening with the industry and economy.
It is no wonder that the business owner valuates the business based on what he thinks it is worth, therealtor based on what he thinks he can persuade the buyer it is worth, the lawyer based often based on the value of the assets and the accountant more likely based on the cash flow it can generate.
The above approaches are based on different valuation models:
1. Goodwill. This has nothing to do with the value of the hard assets or liabilities, rather it is based on owner’s perception of what the name of the company is worth in the marketplace in terms of attracting sales. It is viewed as being the hard work that the owner has put into the business over the years in order to establish it as a profitable ongoing concern.
2. Book Value. This approach looks at the value of the assets if they were to be sold right now, less the total amount of debts. Often the owner will ask for a goodwill amount on top of this but if the business is being liquidated then the goodwill doesn’t exist or won’t be realized.
3. Cash Flow. This technique takes the average annual cash flow or EBITDA defined as earnings before interest, taxes, depreciation, and amortization over the last 3-5 years and applies a multiple. The multiple can be anywhere from 1X EBITDA (for professional practices and consulting firms) to 20XEBITDA for cable and telecommunication companies. The multiple also changes as the economy, competition and other factors change.
There are other methods that valuators will use. Basically, they’re different ways to put a dollar value on the business and really have nothing to do with what the business is worth. Unless you are planning to liquidate the business and sell off its assets, the value of the business is what someone is willing to pay for it.
Brokers, realtors, accountants, and lawyers are advisors hired by the owner to help him sell his business. Their job is to find an ideal buyer and persuade that buyer to pay the most possible for the business. The fact that they use formulas and other techniques to put a price on that business is really irrelevant, except for their attempt to build credibility that the business is worth what they say it is.
Here is my valuation for the business – a business is worth what someone is willing to pay for it!
If you don’t believe me, ask yourself what AIG was selling for at the end of the liquidity and credit crunch of 2007-2008. In January of 2007 AIG shares were trading at over $1200 each and at the beginning of Feb 2009 AIG shares were trading at $6 per share. Even after the company had been identified as being in a liquidity crunch analysts were still claiming the value of the stock was over $100 a share. The shares may have been worth that amount, but because the buyers weren’t willing to pay anything more than $6 per share for the company, it wasn’t worth more than that at that time.
Valuating a business is only one aspect of selling the business. The other aspect is the structuring of the deal. Sometimes a lower valuation can end up providing more money to the owner that is selling the business if it is structured in a way that the owner can leverage the upside. There is always more than one way to get what you want.
If you’re selling your business or buying a business and would like some help you can find me onLinkedIn (Baldo1) or on Facebook.
Net income is a figure that tells you how much money a business is making, or does it? Though in theory net income is supposed to tell you exactly how much money a business made, for small businesses it is not always the case. Making it more confusing is the use of various variant formulas used by commercial realtors to describe the profitability of specific businesses in their marketing efforts. There are some basic considerations that are useful in determining a business’ profitability.
Profitability is the difference between revenues and expenses; what the business receives from its customers and what it pays in order to deliver the product or service. “Cash flow”, “operating cash flow”, “cash from operations” and related terms refer to the difference in the actual cash held by the business for the year (or whatever period being looked at). Profitability is the true measure of profitability because it accounts for the portion of the business’ assets used in producing the sales for a given period.
Commercial realtors often use cash flow, or related terms for marketing a particular small business because it is a larger figure than that of profitability and makes it seem like the business is much more viable than it may actually be. In many cases, a business showing a positive cash flow may be losing money and be a poor investment.
When calculating profitability of a small business, include the following considerations:
Revenue – Examine revenue, its source and nature. Revenue only counts if it is from the regular or ordinary operations of the business. If there are items of a non-operating or extra-ordinary nature (revenues from a special one-time opportunity, such as rental of premises by film production company, and gifts or incentives from suppliers), then remove them out of revenues because they are one-time items and you can’t count on them repeating in the future.
Expenses – Income statement should include all items used in the manufacturing, marketing, distribution and sales of the product or service. Draw a business process map and list all the steps and items required to supply the product or service and then make sure there is a cost line for each item. One of the biggest mistakes made is not including all the labour costs under expenses, especially when it is an owner operated business. If the owner manages the business regardless f whether he is drawing a salary the cost of paying someone a competitive wage to do his job should be included in expenses. This also applies to any family members that are working the business – their wages (at market rates) should be deducted as an expense.
Non-Business Expenses – Sometimes an owner may include items under expenses that may not be necessary or appropriate to include. For example, automobile expenses for a business that doesn’t require an automobile. For the purposes of calculating profitability for the sale of the business, these items should not be removed as an expense.
Depreciation and Amortization – In many cases, a business uses equipment (such as in manufacturing), leasehold improvements (such as restaurant and retail), and other assets (such as trees in a tree lot). Once these resources are used they have to be replaced. For that reason it is important to know how much of the resources value you consume for the production of what you’ve sold for the period and to include it as expense lines.
If you incorporate these considerations when calculating cash flow you’ll soon realize that most small businesses for sale are actually losing money. This is often the reason, or at least contributing factor in their decision to sell.
These considerations will help you determine the true profitability of the business according to the financial statements of the company. However, be aware that you are basing your calculations on figures provided by management or the owners. It is quite likely that these figures aren’t totally accurate. If you decide to purchase the business, then it would be wise to conduct or have conducted detailed due diligence by someone who knows what to look for.
Be detailed in your understanding of the business and examination of all aspects of operations and you should end up with an accurate profitability figure. Only then can you decide what the business is worth to you.
By Baldo Minaudo, M.B.A. (www.baldominaudo.com), author of “The Banker Who Saved His Soul” (www.baldominaudo.com).