This question can only be answered by addressing other related questions, specifically: Who’s asking and for what purpose?
From the perspective of the owner, prospective buyers, the IRS, lenders and divorce & bankruptcy courts, the value of a business for purposes of a sale, estate planning, orderly or forced liquidation, gifting, divorce, etc. can be vastly different.
Intrinsically tied to the various purposes of valuation are numerous definitions of “value.” Here are a few examples:
Investment Value – The value an acquirer places on a business based on a future return on investment determined by assessing past and current performance, future prospects, and other opportunities and risk factors involving the business.
Liquidation Value – The value derived from the sale of the assets of a business that is closed or expected to be closed following the sale.
Book Value – Book value is the difference between the total assets and total liabilities as accounted for on the company’s balance sheet.
Going Concern Value – Used to define the intangible value which may exist as a result of a business having such attributes as an established, trained and knowledgeable workforce, a loyal customer base, in-place operating systems, etc.
Fair Market Value
For the purpose of this article, the focus will be on transaction related valuations. Fair Market Value (“FMV”) is the most relevant definition of “value” and is of the most interest to business owners. The more knowledge business owners and prospective buyers have about the valuation process, the more likely they will come to an agreement on a purchase price.
FMV is the measure of value most used by business appraisers, as well as the Internal Revenue Service (IRS) and the courts. FMV is essentially defined as “the value for which a business would sell assuming the buyer is under no compulsion to buy and the seller is under no compulsion to sell, and both parties are aware of all of the relevant facts of the transaction.” IRS Revenue Rule 59-60 lists the following factors to consider in establishing estimates of FMV:
1. The nature and history of the business.
2. The general economic outlook and its relation to the specific industry of the business under review.
3. The earnings capacity of the business.
4. The financial condition of the business and the book value of the ownership interest.
5. The ability of the business to distribute earnings to owners.
6. Whether or not the business has goodwill and other intangible assets.
7. Previous sales of ownership interests in the business and the size of ownership interests to be valued.
8. The market price of ownership interests in similar businesses that are actively traded in a free and open market, either on an exchange or over-the-counter.
What is Goodwill?
An important element of value, when it exists, is goodwill. The IRS defines goodwill in its Revenue Rule 59-60, stating, “In the final analysis, goodwill is based upon earning capacity. The presence of goodwill and its value, therefore, rests upon the excess of net earnings over and above a fair return on the net tangible assets. While the element of goodwill may be based primarily on earnings, such factors as the prestige and renown of the business, the ownership of a trade or brand name, and a record of successful operation over a prolonged period in a particular locality, also may furnish support for the inclusion of intangible value. In some instances it may not be possible to make a separate appraisal of the tangible and intangible assets of the business. The enterprise has a value as an entity. Whatever intangible value there is, which is supportable by the facts, may be measured by the amount by which the appraised value for the tangible assets exceeds the net book value of such assets.”
Valuation Approaches and Methods
Exploring valuation techniques requires an understanding of the tools available. Which tools are utilized depends in part on the purpose of the valuation and the circumstances of the subject company. Generally there are several approaches to valuing a business. Within these approaches, there are several different methods. Listed below are the three major approaches along with some examples of specific methods that fall under each category.
• Income Approach
Discounted Cash Flow Method
Single Period Capitalization of Earnings Method
• Market Approach
Comparable Publicly Traded Company Analysis
Comparable Merger & Acquisition Analysis
• Asset-Based Approach
Adjusted Net Asset Method
Excess Earnings Method
All of the above methods and approaches are frequently used in business valuations.
Normalizing the Financial Statements
Before the approaches and methods above can be applied, it is necessary to analyze and normalize both the income statement and balance sheet of the business for the current and past periods selected to form the basis of the valuation.
• Normalizing the Income Statement
Normalizing the Income Statement generally entails adding back to earnings certain personal expenses, non-recurring and non-cash items. Examples of these “add-backs” could include depreciation, amortization, auto, boat and airplane expenses, one-time extraordinary expenses and other excess expenses such as owner’s salaries and family member’s salaries that are above fair market value, travel and entertainment, bonuses, etc. Owners usually tend to be extremely liberal when normalizing the income statement in order to bolster earnings, which can artificially inflate valuation. Each item must be carefully analyzed and scrutinized to insure that the normalization process is credible.
• Normalizing the Balance Sheet
Normalizing the Balance Sheet includes adjustments that eliminate non-operating assets and other assets and liabilities that are not included in the proposed transaction, and therefore the valuation. The book value of the assets will be adjusted up or down to reflect their fair market value. Inter-company charges will also be eliminated. Inventory may be adjusted upward or downward based on prior accounting procedures and/or obsolescence. Accounts receivable may also require an adjustment based on an analysis of collectibility.
EBIT – An acronym for earnings before interest and taxes
EBITDA – An acronym for earnings before interest, taxes, depreciation and amortization.
Capitalization Rate – Any divisor that is used to convert income into value. This is generally expressed as a percentage.
Discount Rate – The rate of return that is used to convert any future monetary gain into present value.
(Note: when determining FMV, the earnings stream selected to be capitalized or discounted should be normalized.)
Even with all the terminology and definitions discussed above, the answer to the original question has not yet completely been answered: What is the company worth?
The value driver of a business is the ability of the entity to generate future cash flow or earnings. Business appraisers will assign an appropriate capitalization rate (or multiple) to a selected earnings stream to derive an overall value for a business. The value of the net assets of the business will be compared to the cash flow valuation and may be adjusted upward or downward. For example: if the earnings based valuation is less than the net asset value, an upward adjustment may be in order. Conversely, if the net assets are negligible, a downward adjustment is more likely to occur.
Many appraisers typically use a common range of multiples to arrive at a “ballpark” indication of value (for example, 4 to 6 times EBITDA). While this approach is commonplace, an in-depth valuation of the subject company will produce a more accurate result. There are too many intangible factors to be considered to rely solely on the capitalization of earnings. Of course, the ultimate value of a company will be determined by the marketplace, which can greatly differ from a seller’s expectation, as well as the expectations of potential acquirers.
It is not uncommon for business owners to have an inflated sense of value of their company. This could be due to a variety of factors including emotional attachment to the business, unwillingness to accept the impact of the risk factors of the business, outside influence from previous market conditions, incorrect conclusion of normalized earnings, comparable transactions, etc. Conversely, acquirers often undervalue businesses. In their quest to “buy right” they often end up paying a lower multiple for a company with serious negative factors, while passing up on higher multiple opportunities, which, due to the quality, are actually better buys.
Valuation is a complex process. Owners and buyers will be well served if they rely on professional advisors such as their accountants, business appraisers, intermediaries or investment bankers.
If you are considering entering the world of franchising, an important consideration is assessing the value of the business. All of the following factors either affect or help determine valuations of typical franchise operations:
1. Franchise Agreements:
Typically, franchise agreements can cover a period of twenty years; sometimes with added options. In most situations where a franchise unit has fewer than ten years remaining on the agreement (and options, if any), the value would diminish proportionately.
2. Territory Exclusivity:
Many franchisors do not, as a matter of course, provide an “exclusive” to franchisees within a given territory. More commonly, however, the franchisor will offer a franchisee limited protection for five years, during which time only he or she will be allowed to expand operation to additional units. Even limited protection can be assigned some value; any current territorial rights may have additional — and significant — value.
3. Business Hours
Potential franchisees should consider operating hours when assessing the value of a business. Business in general, and franchise operations in particular, are staying open for increasingly longer periods — some operate 24 hours a day, seven days a week. Locations in certain areas — city centers, bus stations, train depots — may open for shorter hours and fewer days. Since most business owners/managers would prefer the less demanding hours of operation, a premium value will be placed on these units.
This is the most obvious variable. A franchise operation in a suburban or small-town setting has a higher value than one in an inner-city or high-crime-rate area, regardless of other similarities (rent, sales volume, etc.).
5. Cash Flow:
Surprisingly, profitability may not necessarily be the key factor in valuing a franchise operation. A demonstrated, well-documented cash flow can definitely add value to the unit; however, the smart buyer will also look at other variables, such as unusually low food costs or labor costs, sales history, and potential for growth or improvement under new management in determining the overall value. Extreme situations provide the obvious exceptions to importance of cash flow: where the cash flow is extraordinarily high, capitalization of earnings becomes a truer method of valuation; where the franchise is actually losing money due to inefficient management, there would be some reduction in value.
Taking into consideration market variation, the typical rent will be set at approximately ten percent of retail sales. Modifications in value could result if the lease does not cover a period of at least ten years.
Many franchise agreements will require units to be refurbished within a certain number of years (ten is typical), with the franchisee bearing the cost. Since these costs typically fall within a range from $75,000 to $150,000, potential franchisees should pay particular attention to where the operation stands on this timeline. For example, a unit due for remodeling in a year or less could be reduced in value by a fair percentage of the cost of the improvements. The total cost would not be deducted from the value, since these improvements would also be expected to improve business anywhere from five to twenty-five percent.
A professional business broker can be helpful in many ways. They can provide you with a selection of different and, in many cases, unique businesses, including many that you would not be able to find on your own. Approximately 90 percent of those who buy businesses end up with something completely different from the business that they first inquired about.
Business brokers are also an excellent source of information about small business and the business buying process. They are familiar with the market and can advise you about trends, pricing and what is happening locally. Your business broker will handle all of the details of the business sale and will do everything possible to guide you in the right direction, including, if necessary, consulting other professionals who may be able to assist you.
Your local professional business broker is the best person to talk to about your business needs and requirements.Read More
If you have made the decision to sell your business, the wisest first move is to contact a qualified business broker professional, who can . . .
- Advise you on pricing and structuring the sale of your business.
- Prepare the marketing strategy, using professional resources.
- Determine the right buyer for your particular business.
- Educate buyers in the business-buying process.
- Keep you informed about market reaction.
- Present offers and point out strengths and weaknesses.
When it comes time to sell, one of the best decisions a business owner can make is to continue managing his or her business efficiently (and profitably), while depending on the services of a business broker to forge the steps of the sale. The business broker professional is an invaluable advisor during the entire process, offering both objectivity and negotiation skills honed through years of experience in the buying and selling of businesses.Read More
There still aren’t too many ways to finance the purchase of a business. Here are the primary methods:
Some buyers may have the cash available to purchase the business. Some may elect to use the equity in their residence, or other real estate. Others may have other assets that they can sell or borrow against.
Banks may lend against a buyer’s assets as described above. They may also lend against the assets of the business, assuming there is sufficient value to support the loan. The business will also have to make sense to the bank, regardless of the asset value. In fairness to the banking system, many of the figures supplied by business owners have very little relationship to the actual earning power of the business.
Venture Capital Firms
These firms do not, as a practice, lend to small or even many mid-size businesses unless tremendous growth is anticipated. They also usually expect an equity position in the company.
These have become more popular. There is now some competition among lenders for these loans. Many banks offer them, but the large non-bank companies seem to have the upper hand in both acceptance and service.
This category includes family, friends, relatives, credit cards and leasing companies. Some suppliers have been known to assist in the financing of a small business.
This is, by far, the largest source of financing available for the purchase of a business. Many industry experts say that about 90 percent of small businesses sell with, or perhaps because of, the seller financing a good portion of the sale price. Buyers have much more confidence in the decision to purchase a business when the seller is willing to assist in the financing. The buyer has confidence that the seller believes the business will service the debt, in addition to providing a living wage.Read More
Business owners who want to sell their business are often told by business brokers and intermediaries that they will have to consider financing the sale themselves. Many owners would like to receive all cash, but many also understand that there is very little outside financing available from banks or other sources. The only source left is the seller of the business.
Buyers usually feel that businesses should be able to pay for themselves. They are wary of sellers who demand all cash. Is the seller really saying that the business can’t support any debt or is he or she saying, “the business isn’t any good and I want my cash out of it now, just in case?” They are also wary of the seller who wants the carry-back note fully collateralized by the buyer. First, the buyer has probably used most of his or her assets to assemble the down payment and additional funds necessary to go into business. Most buyers are reluctant to use what little assets they may have left to secure the seller’s note. The buyer will ask, “what is the seller not telling me and/or why wouldn’t the business provide sufficient collateral?”
Here are some reasons why a seller might want to consider seller financing the sale of his or her business:
- There is a greater chance that the business will sell with seller financing. In fact, in many cases, the business won’t sell for cash, unless the owner is willing to lower the price substantially.
- The seller will usually receive a much higher price for the business by financing a portion of the sale price.
- Most sellers are unaware of how much the interest on the sale increases their actual selling price. For example, a seller carry-back note at 8 percent carried over nine years will actually double the amount carried. $100,000 at 8 percent over a nine year period results in the seller receiving $200,000.
- With interest rates currently the lowest in years, sellers usually get a higher rate from a buyer than they would get from any financial institution.
- Sellers may also discover that, in many cases, the tax consequences of financing the sale themselves may be more advantageous than those for an all-cash sale.
- Financing the sale tells the buyer that the seller has enough confidence that the business will, or can, pay for itself.
Certainly, the biggest concern the seller has is whether or not the new owner will be successful enough to pay off the loan the seller has agreed to provide as a condition of the sale. Here are some obvious, but important, factors that may indicate the stability of the buyer:
- How long has the buyer lived in the same house or been a home owner?
- What is the buyer’s work history?
- How do the buyer’s personal references check out?
- Does the buyer have a satisfactory banking relationship?
Advantages of Seller Financing for the Buyer
- Lower interest
- Longer term
- No fees
- Seller stays involved
- Less paperwork
- Easier to negotiate