…“What is my company really worth?”
That’s usually the first question a business owner asks, or is thinking about, when considering to sell a company.
… And soon after a prospective buyer emerges – the seller imagines the opportunity to cry out… “Show Me the Money!”
Constructing a Valuation
In general, the most commonly used criteria and methods for estimating the value of a privately held company are – “Income”, “Asset”, and the “Market Comparison”.
Income Method: This approach utilizes a discounted cash flow methodology that values an income stream, created and maintained through time, to estimate future income.
Asset Method: Uses the fair market value of the assets minus the liabilities. The approach reviews the balance sheet, stated assets and subtracting liabilities. It examines the historical values without reference to the market or current pricing. This method may over or under state the value of a business compared to the market’s perception of price/value.
A mistake business sellers commonly construct is to take the cash flow and then add back the replacement costs of hard and soft assets to get a business’s value. Assets, such as machinery, equipment, inventory, trucks, etc. or brand names, visual identities etc., are essential to the operation of the business. The buyer’s view is that without them the business would not function and hence no cash flow and therefore, no company. That’s why the liquidation of equipment, machinery, inventory etc., is sometimes worth more than the company itself.
Think of your business as a machine that prints money. The cost of the equipment used is not being valued, it is the ability of the entity, the business, the”machine” to generate cash flow. When you buy a business, you are buying cash flow. The equipment only helps in producing that cash flow – i.e., printing money.
If Real Estate is incorporated, it is a separate issue and can be valued as part of the transaction (essential to the business model), or more often the case, separately.
Market Comparable Method: Simply, this method of valuation looks at how similar businesses have sold over the recent past. In addition, comparative ratios or multiples – that have been used in other sales – can be considered in the business being analyzed.
Whatever method is used, just remember the value of your company is what a buyer (the market) is willing to pay and not the seller’s subjective view. The buyer is valuing your business by how much he/she (not you) can make from its operation, not just tomorrow, but in the years ahead.
The Most Commonly Used Approach for Valuing a Business
The above valuation methods are always mentioned when people talk, but in reality what is used most often is a combination which utilizes a Seller’s Discretionary Cash Flow (‘SDCF’) and adds back, or “adjusts” to cash flow all of the financial benefits an owner(s) receives from the business.
This SDCF approach is the Income Method plus the recognition of all the financial benefits – the real-world perks and any and all financial remunerations – that inure to the owner(s). It is often referred to as “adjusted EBITDA”. It is the money, the financial benefit generating capability of the company.
This SDCF approach is the Income Method (above) plus the recognition of all financial benefits – the real-world perks and any and all financial remunerations – that inure to the owner(s). This cash flow is often referred to as “adjusted EBITDA”. It is the financial benefit generating capacity of the company.
Once a complete SDCF has been established a multiple is applied by the buyer to form a business’s market value. Remember, this is subjective and varies from types of buyers.
SDCF x Multiple = Transaction Price
Seller’s Discretionary Cash Flow (adjusted EBITDA) is the single most important metric used in selling a business. It demonstrates to a prospective buyer what money will be available to pay for the new owner’s salary (or new management), the costs of financing a loan (interest and principal) and a return on his down-payment /investment.
Keep in mind, that although you market to a buyer, the final transaction is usually with both a buyer – and his/her banker.
The buyer is not the only party that performs due diligence. Mr./Ms. banker is standing right behind, watching…and evaluating. That is why well prepared financial reports and tax returns are critical. Tax Returns and financial statements will become the foundation, the starting point, of any valuation analysis by the buyer and particularly his/her bank.
Regardless of who the buyer may be – an individual entrepreneur, a Strategic or Synergistic buyer, or even an investment group with substantial financing capability – the ultimate buyer will leverage the acquisition with funding from a financial facility or with the cooperation of the seller, or both. That’s just the way the acquisition world works. Rarely will someone pay all cash.
The Multiple: Once the SDCF or “adjusted cash flow” is identified, a multiple is then applied – which discounts time, risk, sustainability and possible future scalability. The multiple varies and is driven by the type of buyer, the industry, position in the market, company maturity, management team and existing operating systems. As an example, a typical “main street” business may sell between a 1 1/2 and possibly 4 multiple of the SDCF. A lower middle market company may see multiples between three and perhaps as high as five or six. The larger the SDCF is – the more expansive a multiple.
A privately held company with business cash flow of over $2M will attract many types of buyers from many, many areas and support a very firm multiple. While a cash flow of $10M+ will bring buyers from all over the world and may command multiples as high as 8 to 15.
Knowing the type of buyer who would be attracted to the opportunity and bringing multiple buyers to the process creates a bidding tension among participants which is crucial to maximizing value/price.
If there are reasons and importance an Intermediary brings to a deal, this may be one…a very important one.
The “Art and Science” of Valuing a Business
What business owners soon discover is that the application of a multiple, is more of an “art form” (more subjective, more in the eyes of the beholder, the buyer) – and the “science” of a valuation is the recognized SDCF, “adjusted EBITDA”, that the business creates.
So to give someone a general idea of how a small business might be valued, the below example illustrates:
If a business generates $300,000 in SDCF and the buyer applies a 3 multiple (a subjective assessment) – the business value would be (plus/minus any adjustments for inventory or other considerations) $900,000 (3 x 300,000).
Always keep in mind, a business’s valuation is not about determining what a company is worth in the current owner’s hands; it is about the company’s transferable value in the eyes and mind of that one buyer who is motivated and willing to say – – – sold!
In the end – as the divestiture participants reach agreement to the transaction’s price, tension of the process finally relieved, and the closing table becomes in sight – it is then that a seller dreams for the opportunity to cry out: ….“show me the money!”
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