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Three Approaches to Valuing Your Business

|Valuation

Having a realistic perspective on purchase price is critically important when selling your business. For many business owners, attaching a dollar amount to your company is complicated and comes with some level of personal bias.  After all, you’ve spent years building it from a fledgling start-up to a profitable enterprise, and you want to ensure you can enjoy a financially-secure retirement. But the decision to sell your business can create emotional blinders that obscure the reality of what your business is worth.   Often business owners add some level of value for the blood, sweat and tears they put into the business, where a buyer is going to look at data (financial performance, IP, tangible assets, etc) to determine what it’s worth.

Business owners tell us all the time, “I need $XY million for my business so I can live comfortably in retirement after paying off company debt [in a cash-free, debt-free transaction].” We’ve even seen outside accountants quote a minimum sales price the owner requires based on their future retirement goals (and not the merits of the business). 

While some business owners and CPAs think it makes sense to target a certain sales price for retirement purposes, this target might not align with reality.  It’s the same way you can’t expect someone to pay $50,000 for your 10-year-old, 200,000-mile Toyota Camry because you have large medical bills. 

So, how do you know how much your business is REALLY worth and how much you’ll have for retirement?  There is no one-size-fits-all valuation for a business – even businesses within the same industry are often valued differently. Businesses generate different levels of revenue and profit.  They have other characteristics that increase or decrease value – like quality of management team, level of customer concentration, and types of service/product being sold.   M&A advisory firms, like Business Acquisition and Merger Associates, can give you a third-party view of your business so you understand how the market would value your company.

Once you understand what buyers will pay for your business (and why), you can grow it to whatever level is necessary to achieve your target sales price, and thus your retirement goals.  Dictating a price to the market that is above industry norms and is based on your personal opinion or retirement goals won’t lead to a successful sale.

Industry norms and market multiples often dictate what price you’ll get, but there are several other quantitative methods for business valuations commonly used by both buyers and advisors. Buyers will often consider more than one approach as they put together an offer for your business, and it’s helpful to understand these:

  1. Income-Based Approach. By assuming historical income and cash flow levels predict future profitability, this method determines valuation based on the expected cash flows of the business.  Buyers calculate EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) to compare companies on an apples-to-apples basis, and then apply a multiple to EBITDA to determine purchase price.  Multiples vary based on industry, size, trends and a multitude of other factors.
  • PROS: EBITDA valuation allows buyers to compare the cash flow of two companies while accounting for differences in debt levels, equipment purchases and other discretionary variables.  Valuation based on EBITDA multiples is very common in the lower middle market for B2B service businesses, many manufacturers and distributors.
  • CONS: For start-ups with high growth potential and businesses with large annual amounts of maintenance capital expenditure, valuation based on EBITDA will not capture the true value of your business.
  • BAMA Blog: Learn more about EBITDA and how it is calculated: “Defining EBITDA”
  1. Asset-Based Approach. This method uses your company’s balance sheet to determine the fair market value (FMV) of individual assets minus total liabilities (i.e. net assets), thus calculating what it would cost to “rebuild” your business. The Adjusted Net Asset Value approach looks at the historical cost of each item on the balance sheet and restates costs to current market values (i.e. real estate that has increased in value since original purchase, or equipment that is more or less valuable than its depreciated amount on the balance sheet).  The FMV of these adjusted assets minus liabilities is the value of your business using this methodology.
    • PROS: Data to determine asset value is readily available and fairly straightforward, coming from actual dollar amounts on the balance sheet, third party appraisals and published costs of new equipment, etc.
    • CONS: This valuation approach doesn’t capture the full value of intangible assets like proprietary products/systems, brand, strong customer relationships or goodwill, or take into consideration the future earning potential of your business.  Thus, the asset-based approach typically yields the lowest valuation of the three methods.
    • BAMA Blog: Learn more about intangible assets: “Understanding how intangibles affect the valuation of your business”
       
  2. Market-Based Approach. This method examines other businesses of comparable size in similar industries that have recently been acquired to provide current, relevant valuation guidance. Like real estate market comps, business market comps tell us what buyers are paying today for similar companies.  This is a more common approach for large companies who are required to disclose transaction metrics, and thus provide market intel for companies of their size.
    • PROS: Up-to-date, realistic valuation guidance based on feedback from the actual market.
    • CONS: Individual businesses, even those of similar size in the same industry, vary operationally, financially, and geographically, and are difficult to compare, causing pricing discrepancies.  In addition, financial terms for transactions of private companies in the lower-middle market are not usually disclosed publicly, so it can be challenging to find true market comps for recently closed transactions.
    • BAMA Blog: To learn more about how industry, size and other variables contribute to the value of your business, read this blog “What is my company worth?”

Experienced advisors consider all valuation methods, along with personal industry knowledge, to provide you with an accurate financial picture of your business.  Value is in the eye of the beholder, don’t let personal bias negatively impact your chance of a successful transaction when it is time to sell.