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How to Value Your Business

 

How to Value Your Business

As you consider the transition plan for your business, it’s important to understand the value you might receive upon selling it. If you own shares of stock traded on a stock exchange, the value of your investment will simply be the number of shares multiplied by a stock price. Valuing and selling a closely held business not traded on the stock exchange is more difficult.

When estimating the value of a company, there are certain drivers of value you should consider. Value:

  • Must be transferrable. If there is reliance on key people, the value may not be transferable.
  • Is future-oriented. The past is only a guide; what happens after the purchase is what matters, but it can be hard to predict.
  • Must be able to get a return on investment; buyers don’t care about equity.
  • Is affected by supply and demand. If the supply of businesses is high and demand for buying businesses is low, purchase prices are impacted.

When you receive an appraisal of real estate, art, antiques or a business, you receive an estimate of the value a seller would receive or a buyer would potentially pay for. For someone to estimate the value of a particular asset, it’s important to know what characteristics drive value. For example, you could have two paintings that look exactly the same but have dramatically different values; one may be an original and the other a copy. The same holds true for businesses. Even though their financial results may look the same, they likely won’t have the same value.

Value Is Not Calculated Just by “Applying a Multiple”

Many business people talk about “multiples” paid and will prepare “back of the envelope” calculations. Many of these calculations are not worth the napkin they are written on. A more thorough appraisal will consider multiples, but the multiples chosen will be based on the industry and characteristics of a company that create the risk and return of an investment. 

The basic formula for value is:

  • Income / Rate = Value ($100K / 20% = $500K)
  • Income x Multiple = Value ($100K x 5 = $500K)

“Income” is based on the future, not the past, and “rate” and “multiple” are based on risk characteristics. Income needs to be consistent with the rate used (e.g., you can’t use a pretax rate with after-tax income). You also need to consider what assets are included in the income used to arrive at the value. You may need to add excess assets or subtract liabilities.

Value is driven primarily by risk (rate) vs. return (income). Risk affects the expected future return, which affects the multiple a buyer is willing to pay for that risk. Higher risk can result from concern about the potential loss of a customer, industry risk, condition of equipment or loss of a key contract. Other attributes that could increase risk include:

  • High debt level.
  • High concentration of sales to one customer.
  • Reliance on a key employee (e.g., one sales person drives all sales).
  • Reliance on a key manager (e.g., one employee manages the business).
  • Reliance on one supplier (e.g., a distributor with one supplier).
  • More intangible assets compared to tangible assets.
  • Lots of competitors.
  • Low barriers to entry (e.g., restaurants, consulting firms, retail stores).

Assets/Liabilities Included Make a Difference

The assets and liabilities that you anticipate will be in a transaction can have a significant impact on value. For example, a company could have excess assets (e.g., cash or land) or liabilities (e.g., debt, pension liability or a lawsuit). Understanding which assets and liabilities are included in a value is important in understanding a valuation.

Transaction Structure Matters

In the real world, there are many variations in structuring a sale, including as an asset sale or a stock sale. Some sellers will receive the money upfront, and some will receive it over time or in an earn-out. The structure of a deal will affect the price because of risk and tax considerations. As the assumptions relating to structure change, so will the offered price. In addition, tax on the sale will likely be paid and should be considered when you are estimating your net proceeds from the sale. To understand your net cash flow from a transaction, you should consult your tax advisor to discuss the tax implications of a sale.

Most sale transactions will be done based on an asset value and include only those assets in the transaction. If the transition will be going to family or current shareholders, an equity or stock value may be used.

Value Is in the Eye of the Beholder

Value of a business can mean different things to different buyers/sellers. The valuation assumptions will define what type of “value” is considered (fair market, strategic or liquidation). If you have a strategic buyer, they may be willing to pay more for the synergies they would gain. If your business is rapidly deteriorating and you are contemplating a reorganization, liquidation value may be the most relevant.

Understanding the nuances to a valuation and how transactions are structured is an important aspect of understanding the net cash you will receive when selling. This article summarizes some of the key aspects, but many other nuances can impact a company’s value. Working with an experienced appraiser will help you through the process.

If you have questions or want help performing a thorough valuation, contact Wipfli’s experienced appraisers.

Author(s)

Lisa Cribben
Lisa M. Cribben, CPA/ABV, ASA, CMA
Partner, Business Valuation and Transaction Support Services
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