Following a discovery process, an advisor will create a realistic picture of what your business is worth. To begin, the next questions you and your advisors should discuss are:
- Do you know what your business is worth?
- How attractive is your business from a buyer’s point of view?
- If you received an offer today, are you ready to accept it?
- What are you doing to mitigate risk?
- Are you focused on creating value or sustaining a lifestyle?
A qualified advisor will help you work through these concerns and develop an exit readiness assessment. This usually starts with a valuation for what your business is worth in today’s market.
From an owner’s perspective, the most important items that stem from a valuation are: the things in your business that you need to keep an eye on, what valuing a business means to you, and what do you net out in your proceeds – meaning, what cash do you walk away with.
So that you understand what valuators look at, you first need to understand the Standard of Value. Fair Market Value is the price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller (in an open and unrestricted market). But the confusing part to most people is that indications of value are looked at differently by varying groups of experts. You might get different valuations according to who you ask and how they interpret the data.
It’s important then, to understand the key differences in the three Indications of Value that are commonly used:
- ENTERPRISE VALUE. For example, you might hear someone say, “My company is worth one million dollars and there’s a multiple of 5 out there – therefore my business is worth $5 million.” That’s what is referred to as “Enterprise Value” and it is used mostly by the Investment Banking industry. Enterprise Value is the amount of money that’s going to change hands between the buyer and the seller at the end of the day. This is a very important number in that it represents the true value of a company.
- STOCK VALUE. If you hire a valuator to do a business valuation, they look at the “Stock Value.” This would be used if you’re going to sell the stock of the company – which includes interest-bearing debt. (The stock value is the enterprise value less any debt value that is on the books.) Many business owners don’t realize that their company might be worth the $5 million Enterprise Value, but they’re responsible for paying off a $2 million line of credit to the bank at closing. So in reality, it’s really worth $3 million. This can come as a surprise to the business owner.
- NET PROCEEDS VALUE. The important number – the number you will use for retirement and financial planning – is your “Net Proceeds Value” and it is usually determined by an Accountant and/or Financial Advisor. So at this point, you have $3 million. You will also have to pay taxes (estimate $1 million on that) – so now your business value stands at $2 million. Obviously, this number can be significantly different than what you thought you were starting with.
When we’re working with clients, one exercise we perform is a ‘Net Proceeds Analysis’ to show how the money flows through, what the taxes are, and what you have to pay back in debt. We also define how it flows through to different shareholders (assuming there’s more than one business owner).
The bottom line here is that you need to make sure you’re comparing apples-to-apples. It’s very possible an Investment Banker will tell you “I can sell your business for $5 million.”And then your Financial Advisor delivers the news that you’re really going to end up with $2 million. They could very well be talking about the same thing, but they’re looking at it two different ways.
How a Valuator Looks at Your Business
There are several varying approaches a valuator might take when placing a value on your business. Each one has their own merit and is usually best determined by your individual scenario – your products/services, industry, company status, etc.
Asset Based Approach. This is considered a floor value. If you’re an operating business, hopefully you’re worth more than the asset-based approach. This is simply the assets on the books minus the liabilities on the books, equals the equity. That’s adjusted for Fair Market Value – so if you have fixed assets, it’s not solely what’s on your financial statement as there may be some adjustments there.
This approach is useful for valuing holding companies and real estate entities, and it needs to be looked at from a valuation perspective. You do need to perform this exercise (even for working capital and the income and market approaches), but for most cases it is not going to be an indication of true value.
Income Approach. This is the more common approach with which most people are familiar. I would estimate that we value companies by using this approach for 80% of our business valuations for operating entities. And generally speaking, this is how most people evaluate the business.
- Capitalization of historical earnings. Historically, people generally understand that this is where you go back and schedule out five years of income in order to come up with a way to average the cash flow number – or 5 multiple – to ascertain a value. From the buyer’s perspective, they are looking to buy a business for how they think it will perform in the future and based upon their projections of the future cash flows of the business. Most of the time in order to predict this, they fall back on past performance – what they consider indicative years. Of course sometimes this isn’t always reliable, as what happened in the past really might not happen in the next few years. As a seller, you will want to present specific reasons why you think it’s going to change (this could be new products, acquisition of additional business, etc.). From a buyer’s perspective, as well as a valuator’s perspective, it’s tough to get your arms around these projections…because typically, you almost always hear from a seller’s perspective that, “Next year is going to be the best year of my business.” From a buyer’s perspective, it’s hard to pay based upon that.
- Discounted future cash flow. To utilize the discounted future cash flow, you have to be very confident that these projections are going to come to fruition. You want to be able to put your hands on something – it could be new signed contracts, new products developed that have been tested and marketed to work – whatever the development, you will need a good, solid reason (evidence, if you will) showing that the future is going to be different from what has happened in the past.
Market Approach. There are a few ways to handle a Market Approach.
- Comparable transactions. The first method of the market approach is to utilize comparable transactions. Generally an advisor will mine databases which they subscribe to. Such databases contain details of closed transactions and we will try to find transactions of similar companies that we could say would be indicative of what your company could sell for.
This method isn’t used often because you need to obtain recent transactions of comparable-sized companies that do comparable-type things. I’d say maybe 20% of the time we are able to come up with companies that would have indicative values. If we’re able to do it, it’s very suitable – but the process is often problematic in being able to come out with definitively comparable transactions.
- Public companies. The next method uses the comparison of privately-held companies to publicly-traded companies within the same industry. The struggle with using this comparison is assigning an accurate indicative value using the same metrics. For example, it could be price to earnings, price to EBITDA, price to revenue, whatever you feel is indicative in comparison. Then we apply the same metrics to the privately-held company. Normally this will result in a very high value. The valuator uses their professional judgement to clarify that it’s not a publicly-traded company therefore, there needs to be a discount associated with the value. Typically, that discount usually aligns the value with what was determined using the Income Approach.
If you own a very large, private company, this method might make sense. But for the majority of privately-held companies, to make that kind of a comparison is very challenging.