What is my business worth?
Placing
a market value on a business will be the most important and perhaps most
difficult part of the selling process. Prospective buyers will make the decision
to purchase a business based on the potential future upside, but will establish
a price on the business based on past and current performance. Fortunately,
performance is well documented in company financial reports from which a
business valuator can use definitive ratios to determine net worth. There
are probably as many formulas to develop market value as there are different
types of businesses. In the final analysis there is one definitive determinant
of business worth, “The amount a willing and educated buyer is willing to
pay for a business.”
When you are ready to begin the valuation process, it is important to remember that a Business Intermediary or a business valuation service is the best bet in determining a value that is more in line with what the market is willing to pay for the business. A professional Business Intermediary is in the marketplace working with buyers and has his pulse on market conditions that affect values. It is necessary to meet with a business broker, who will in turn confer with the seller's CPA. The Business Intermediary will then use comparable business sales, financial information and present market conditions to determine market value.
Objective factors that affect sale price:
- Owner's Discretionary Cash flow (ODCF)
- Asset value
- Inventory
- Accounts Receivable (A/R) and Accounts Payable (A/P)
- Leverage
- Asset vs. Stock
- Years in business
- Employees
- Reason for Selling
- Length of training
- Business type
Once analysis of the financials statements has created a base of value, there are many subjective aspects that will adjust the sale price up or down. The objective and subjective factors are intertwined in establishing the ultimate sale price. Find out more about the factors that impact value.
1. Owner's Discretionary Cash flow (ODCF)
The largest component of determining value is deciphering how much money the business makes. Different valuation methods view cash flow with many different meanings. When dealing with small businesses the description of Owner's Discretionary Cash Flow (ODCF) will be used in most valuation models. Most small business sale prices are determined by using a multiple of cash flow. If a prospective buyer cannot receive a good return on his investment for a business purchase, the business price is too high. If the business is purchased using leverage and the ODCF cannot cover the debt payment, the business is most likely overpriced and will probably not sell. In real estate, a buyer's main focus is a location, while in business transfer it is ODCF.
2. Asset value
Many buyers want to know how much of the business price is allocated to what they can feel and touch or hard assets. Normally the higher the value of the asset, the higher the sale price. Conversely, outdated, non-working duplicate assets do not add value to a company, rather they detract from it. Just as important as getting a business valuation, getting an equipment appraisal could assist in the valuation of the overall business. A business owner needs to ensure that his business does not become “upside-down”, when his asset value is much higher than his ODCF, since that would only yield him a sale price driven primarily by his asset value. Assets are key to the operation of any business, yet if an owner is continually building an asset base and not consequently building the sales and cash flow, he is hindering the ultimate sale price.
3. Inventory
Inventory value falls under the same heading as assets, which are items a prospective buyer can feel and touch. Inventory, similar to assets, is essential to the operation of a business, yet too much inventory can have a negative effect on sale price as well. A sale price can be determined with or without inventory value, but either method will require an inventory count before the closing date. Dead and obsolete inventory will not add proportionate value since it will not be counted at closing and therefore deducted from the ultimate sale price.
4. Accounts Receivable (A/R) and Accounts Payable (A/P)
When a small business is valued it is normally based from a multiple of ODCF with hard assets and inventory included in the sale price. When A/R and/or AP are included in a business sale, the price derived from the earning multiple will be adjusted up or down based on the net values of the A/R and A/P. When a buyer purchases the accounts receivable, the sale price increases dollar for dollar above the predetermined sale price from a multiple of ODCF. Normally, there are provisions in the contract for any uncollectible A/R that either affects the seller carry-back note (if there is one) or a refund of a portion of the sale price. If a seller does not want to hassle with adjusting A/R after closing, a buyer can take a chance on A/R by paying a predetermined discounted percentage. Conversely, accounts payable assumption decreases the business sale price dollar for dollar. Example: $1,000,000 all cash sale price $ 800,000 cash at closing, $ 200,000 assumption of A/P.
5. Leverage
The terms of payment on a business sale will have a major impact on both the sale price and how long it takes to sell. A business that can be purchased using a high leverage factor generally will be worth more than one that requires all cash. Funding options can include conventional financing, SBA financing, seller financing, and all cash.
6. Asset vs. Stock
The two types of business transfer are the purchase of a company's assets or the sale of its stock. In the small business arena, a stock sale is usually most beneficial for a seller, while an asset sale is most beneficial for a seller, while an asset sale is most beneficial for a buyer. Determining the type of sale will have a direct impact on the sale price with an asset sale usually commanding a higher sale price than a stock sale.
In an asset sale, the buyer primarily buys the assets of a corporation only (fixed asset, goodwill, non-compete, etc). The advantage to a buyer is the ability to allocate the sale price with a high asset base that will allow for a higher future deprecation schedule. In addition, by purchasing only the assets, the buyer does not assume any of the corporation's legal liabilities.
In a stock sale, the buyer primarily purchases the stock of the corporation. The advantage to the buyer is the ability to buy the total package including contracts leases, permits, and licenses that are in the corporate name. The disadvantages as previously mentioned are the legal liabilities and lack of depreciable asset base. The tax advantages to the seller in a stock sale are usually significant, which is why most business sellers prefer this method of sale.
Since buying a business goes beyond the financial statements, there are several factors that increase and/or decrease the value based on financial analysis. The most difficult part of convincing a prospective buyer to pay for the goodwill (subjective) portion of the business can be validated by placing economic values on intangibles such as: employees, company longevity, patents, customer base, and of course the biggie, cash flow.
7. Years in business
Longevity equals less risk. We have observed that after ODCF and fixed assets, the number of years in business is the second most important factor for buyers. Since the purchase of a business is one of the hardest decisions one will have to make, there is the need to eliminate as much uncertainty as possible. All things being equal, a fifteen-year-old firm will sell for more money and more quickly than a five-year-old firm with similar financials.
8. Employees
The old adage, “Employees are a company's most important asset” could not apply more than during the business transfer process. Quality, quantity, and tenure of employees will have a direct affect on not only the value of a company but also on the probability of the business being sold. The strength of the employee pool stars at the top with a solid management team and/or right-hand person. Buyers will be keenly interested in determining which employees will be able to help him learn the business and survive the transition period. Businesses that have the owner as, “chief, cook, and bottle washer” will not command the price and attention of a company with a solid management team in place.
9. Reason for Selling
A difficult psychological obstacle for a buyer to understand and believe is the seller's reason for selling. A justifiable, acceptable reason for sale will increase the probability of sale for the highest justifiable price. The top reasons for buyers are retirement, fatigue and sickness. The most common reason is probably fatigue, which usually occurs between 7-12 years of ownership. The least acceptable and most problematic reasons for buyers include: inability to handle the business, preference for another business, or problems with employees.
10. Length of training
It is standard procedure that a seller will be required to remain with a company for a period of time to train the new owner in the operation of the business. The length of this period will vary in part on how well the owner has distanced himself from the business in the years before the sale. As previously stated, if the seller is the “chief, cook and bottle washer” then it is a safe bet that the transition period will be longer since the seller is the only one with the important knowledge. Similarly, if the business is technical and dependent upon the owner in the operation, the training will likely last for an extended period.
Unless the aforementioned circumstance characterizes your situation, the training period will likely be only a month or two. Usually, this short period is included in the sales price with the ability to negotiate additional training. It is important to remember that some buyers will want the seller out of the operation as soon as possible to be able to fully assert themselves in their new roll. Conversely, other buyers will want to keep the seller around for as long as possible as a safety net. It is good procedure to structure additional time after the original period for phone consultation or monthly meetings. This additional consultation period adds a comfort level to the new owner and as such, will often shorten the time the seller might otherwise be required to stay.
12. Business type
Different types of businesses are more attractive than others to prospective buyers. Some people prefer a Ford to Dodge or a two-story home to a ranch style home. There are different buyer preferences for business types as well. A manufacturing buyer would not be comfortable behind the counter in a retail store and vice versa. There is a well-defined hierarchy of desirability in the different types of businesses. The four primary types of businesses listed in order of desirability are: Manufacturing, Wholesale, Service and Retail.
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