“What is my company really worth?” That’s usually the first question a business owner asks, or is thinking, when considering to sell their company.
And soon after the prospective buyer emerges – the seller imagines to cry out…“Show Me the Money!”
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 is a common approach for many privately held companies. It utilizes a discounted cash flow methodology that values an income stream, created and maintained through time, to estimate future income.
Asset Method: This approach 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. Often it is used in a liquidation review.
A mistake sellers commonly make 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. Without them the business would not function and hence no cash flow and 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 (“machine”) to generate cash flow. When you buy a business, you are buying cash flow. The equipment only helps in producing that cash flow.
Real Estate 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 business 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 (not you) can make from its operation, not just tomorrow, but in the years ahead.
What Is 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 to derive a business’s value, is a combination which utilizes the Seller’s Discretionary Cash Flow (‘SDCF’) and adds back or “adjusts” to cash flow all the financial benefits an owner(s) receives from the business. Once a SDCF has been established, a multiple is then applied.
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.
The SDCF is the company’s profit, as shown on the Tax Returns, plus the owner’s salary, benefits, any bonuses, distributions or any financial benefit the company pays back to the owner. This identifies all the cash generated by the business that the owner enjoys. It also includes taxes, interest expense, and non-cash expenses such as depreciation or amortization.
The SDCF (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 a buyer and a banker. The buyer is not the only party that performs due diligence. A banker is standing right behind him, watching…and evaluating. That is why well prepared financial reports and tax returns are critical. The Tax Return will become the foundation, the starting point, of any valuation analysis by the buyer and 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 institution or with the cooperation of the seller. That’s just the way the acquisition world works. Rarely will someone pay all cash. Why would they with such low capital costs and if the SDCF supports an acquisition loan?
The Multiple: The SDCF or “adjusted cash flow” is now applied to a multiple which discounts time, risk, sustainability and possible future scalability. The multiple varies and is driven by the type of buyer, industry, company maturity, management team and the existing operating systems. A typical “main street” business may sell between a two and a four multiple of the SDCF. While a lower middle market may see multiples between three and perhaps as high as five or six. The larger the SDCF is – the more expansive the multiple. A privately held company with business cash flow of over $2M will attract 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 critical 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 participants in the sale process agree to the business’s value, the tension of the process is relieved, and the closing table finally becomes in sight – it is then that a seller dreams to cry out: ….“show me the money!”