Valuation of Business

1. Capitalized Earning Approach

Capitalization refers to the return on investment that is expected by an investor. The logic is readily understandable to any business person-- it's as simple as evaluating return on investment based on the risk involved. As simple as it is, it provides a good understanding of how a buyer may initially approach valuaing your business.

To demonstrate the capitalization method of valuation, let's look at a mythical and highly oversimplified business. Imagine the business is simply a post office box to which people send money. The magic post office box has been collecting money at the rate of about $10,100 per year steadily for ten years with very little variation. It is likely to continue to collect money at this rate indefinitely. The only expense for this business is $100 per year rent charged by the post office. So the business earns $10,000 per year ($10,100-$100). Because the PO box will continue to collect money indefinitely at the same rate, it retains its full value. The buyer should be able to sell it at any time and get his initial investment back.

A buyer would look at this "minimum risk" business earning $10,000 and compare it to other ways of investing his or her money to earn $10,000 per year. Let's assume a near no risk investment like a savings account or government treasury bills currently pays about 4% a year. At the 4% rate, for someone to earn the same $10,000 per year that the magic PO box earns, an investment of $250,000 (250,000 times 4%= $10,000) would be required. Therefore, the PO box value is in the area of $250,000. It is an equivalent investment in terms of risk and return to the savings account or T-bill.

Now the real world of business has no magic PO boxes and no "no risk" situations. Business owners take risks and have expenses, and business equipment can and usually does depreciate in value. The higher the perceived risk, the higher the capitalization rate (percentage) that the buyer will use to estimate value. Rates of 20% to 25% are common for small business capitalization calculations. That is, buyers will look for a return on their investment of 20% to 25% in buying a small business. However, as we'll see below, some businesses have value to some buyers for reasons that have little to do with the amount of money they are earning.


2. Excess Earning Method



This method is similar to the capitalization method described above. The difference is that it splits off return on assets from other earning (the excess earnings). For example, let's suppose Mr. Owner runs a business that manufactures novelty products. His company has Tangible Assets of $900,000. Further let's suppose that Mr. Owner pays himself a very reasonable market value salary-- the same amount that he would have to pay a competent manager to do his job. After paying the salary Mr. Owner's business has earnings of $360,000.

The financially rational reason for owning business assets is to produce a financial return. Let's say that a reasonable return on Mr. Owner's Tangible Assets is 15% per year. A reasonable number here should be based on industry averages for return on assets adjusted to current economic conditions.

So $135,000 of Mr. Owner's profits are derived from the tangible assets of the business ($900,000 x 15%= $135,000) The remaining $225,000 ($360,000 - $135,000 = $225,000) in earnings are the excess earnings.

This $225,000 excess earning number is typically multiplied by a factor of 2 to 5 based on such considerations as the level of risk involved in the business, the attractiveness of the business and the industry, competitiveness, and growth potential. The higher the factor used, the higher the estimate of the business will be. A typical multiplier number is 3 for a solid, but not spectacular small business that is judged to be average in terms of the level of risk involved, the attractiveness of the business, the industry, competitiveness, and growth potential. The actual factor used is a mix of opinion, comparison to others in the industry, and industry outlook.

Let's suppose that Mr. Owner's business is a bit better than average in these factors and assign a multiplier of 3.6. Therefore, the value of this business can be determined as follows:

A. Fair market value of tangible equipment $900,000
B. Total Earnings $360,000
C. Earnings attributed to Tangible Assets
($900,000 x 15%=$135,000) $135,000

D. Excess Earnings
($360,000 - $135,000=$225,000) $225,000
E. Value of excess earnings
($225,000 x 3.6=$810,000) $810,000


F. Estimated Total Value (A+E) $1,710,000


The capitalization methods work best for medium size businesses that have substantial assets such as recievables, inventory, and/or fixed assets.


3. Cash Flow Method




Buyers often look at a business and evaluate it by determining how much of a loan the cash flow will support. That is, they will look at the profits and add back to profits any expense for depreciation and amortization but also subtract from cash flow an estimated annual amount for equipment replacement. They will also adjust owner's salary to a fair salary or at least an acceptable salary for the new owner.

The adjusted cash flow number is used as a benchmark to measure the firm's ability to service debt. If the adjusted cash flow is, for example, $300,000, and prevailing interest rates for business loans are 8%, and the buyer wants to amortize the loan over 5 years, the maximum this buyer would be willing to pay for the firm would be about $1.2mm. This is the amount that $300,000 per year would support over 5 years.

Therefore, when using this method, the value of a company changes with interest rate conditions. It also changes with the terms a buyer can obtain on a business loan. From a buyer's perspective this may make sense, but from a seller's perspective it introduces a sort of arbitrariness into the process.



4. Tangible Assets
(Balance Sheet) Method


In some instances, a business is worth no more than the value of its tangible assets. This would be the case for some (not all) businesses that are losing money or paying the owner(s) less in total than a fair market compensation. Selling such a business is often a matter of getting the best possible price for the equipment, inventory, and other assets of the business. It is generally best to approach other firms in the same business that would have direct use for such assets. Also, a company in the same business might be interested in taking over your facility. This would mean your leasehold improvements (modifications to space, etc.) would have value and the equipment would have value as "in place" plant and equipment. In place value is higher than the value on a piece by piece basis such as at a sale by auction.


5. Cost To Create Approach
(Leap Frog Start-Up)


Sometimes companies or individuals will purchase a company just to avoid the difficulties of starting from scratch. The buyer will calculate his or her start up needs in terms of dollars and time. Next he or she will look at your business and analyze what it has and what it may be missing relative to the buyer's start up plan. The buyer will calculate value based on his or her projected costs to organize personnel, obtain leases, obtain fixed assets, and cost to develop intangibles such as licenses, copyrights, contracts, etc.).
A reasonable premium of above the sum of projected start up costs may be offered because of the effort and time being saved by the buyer. The more difficult, expensive, and/or time consuming startup is likely to be, the higher the value would be based upon this method.



6. Rule of Thumb Methods


One of the most common approaches to small business valuation is the use of industry rules of thumb. While most financial analysts cringe at the use of these approaches, they do have their place, which we believe to be as adjuncts to other methods.
One industry rule of thumb says a payroll service customer is worth 1.5 to 2 times its annual service fees. Another says that small weekly newspapers are worth 100% of one year's gross income.

The problem with these and all rule of thumb formulas is that they are statistically derived from the sale of many businesses of each type. That is, an organization might compile statistics on perhaps 100 small weekly newspapers that were sold over a two year period. They will then average all the selling prices and calculate that the average paper sold for 100% of one year's gross income. The rule of thumb is thus created. However, some newspapers may have sold for twice one year's gross while other may have sold for half of one year's gross.

The rule of thumb averages may be accurate for those businesses whose performances are right about at the average. The business with expenses and profits that are right on target with industry averages may well sell for a price in line with the rule of thumb formula. Others will vary. To apply the rule of thumb to a business that varies significantly from the average is not appropriate.



7. EBITDA Method


Some buyers value a company by simply multiplying the Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA ) by a factor, typically in the 3 to 6 range. This straightforward approach tends to be used for companies with sales over $5,000,000 that have a management infrastructure in place

The advantages are:

It avoids the issue of depreciation and amortization, since most companies use a depreciation and amortization schedule that is intended to take best advantage of the prevailing tax laws.

It avoids the issue of taxes, which usually vary according to the ownership structure

It is uncomplicated, and most useful for companies that are well established and earnings are consistent and predictable going forward

It lends itself to comparisons with similar sales

It is most suitable for companies larger than $5MM in revenue, especially companies where variations in tangible assets do not significantly effect the value of the company

The disadvantages are:

It makes no distinction between companies that have a large working capital requirements (current assets, less current liabilities), versus small working capital requirements

It makes no distinction between companies that have large fixed asset needs, vs small fixed assets

It makes no provision for companies that have very substantial real depreciation (e.g. trucking companies, where the trucks rapidly decrease in value) as opposed to companies where actual decrease in asset value is less than the IRS depreciation allowance. In some cases EBIT is used instead of EBITDA when there are large, recurring depreciation expenses.

Even when the EBITDA method is appropriate for valuation, certain adjustments and allowances need to be made before the simple formula can be applied. And of course, the actual multiplier used (whether 3 or 4 or 5 or some other number) is likely to be vigorously negotiated between buyer and seller.

If you would like to know if the EBITDA method may be appropriate for your company, please contact us.



8. Valuation based on Synergies


In some instances, a buyer will pay a somewhat higher price than any of the above methods would justify.

This could be the case when a buyer sees clear and immediate synergies: if the buyer can make 2 + 2= 5. A strategic buyer may pay a premium if for example, he can gain immediate and sizable economies of scale, gain a new distribution channel for his existing products, or a new product that can take immediate advantage of his existing distribution channels. A buyer may consider this method of valuation when a very high proportion of the seller's gross revenue will, after the acquisition, fall to the buyer's bottom line.

A few examples where we have been able to sell companies based on synergies include:

Example 1:

We have sold several payroll service companies. Payroll service companies (such as Paychex or ADP) often acquire smaller companies in their industry. When they do so, they are more concerned with top line income than bottom line profit. More accurately, they are concerned with what the bottom line income would be if they were to transfer the selling company's customer base to their own system where they have excess capacity. They can add incremental payrolls without a corresponding increase in expenses. A payroll service company that has gross receipt of say, $500,000 and is breaking even, could represent a profit of several hundred thousand dollars to an acquirer already in the business that can process more efficiently and can eliminate much of the smaller firms overhead.

To the buying payroll service company, a more important calculation than the selling company's earnings is a comparison between the cost of gaining customers through acquisition vs. the cost of gaining equivalent customers by traditional methods like hiring salesmen, advertising, etc. Because payroll service firms can accurately estimate their processing expenses based on gross revenues, these companies tend to sell for a multiple of their annual gross sales with only minor regard for their profit or loss.

Example 2:

Some time ago, an outdoor furniture company approached us looking to acquire a complimentary company. They had great distribution of their porch and patio furniture and specifically wanted to acquire a company that made or imported a product that could be sold through the channels they had built. We were able to find an importer of wicker planters that matched its distribution channel perfectly. They agreed to pay a premium based on the synergies they knew they could achieve.

Example 3:

A few years ago we represented a mail order seller of knitting supplies for sale. We found a buyer, a large mail order company of quilting supplies, and showed them how they would gain economies of scale, synergies, and customers that could be cross-sold (knitting customers would buy quilting supplies and vice-versa). They buyer paid a premium justified by the excellent synergies.

Warning

There are companies that overplay this synergy concept by claiming to be in touch with buyers who will pay far more for your business than any valuation method would justify. They may be foreign buyers who are anxious to get a foothold in the US or other synergistic buyers who will pay for hidden assets. Their arguments are quite seductive; who doesn't want to sell their business for twice its value?

However, the rest of the sales pitch is that you need to pay them a large amount of money upfront,typically $50,000, or the names of these overly generous buyers won't be revealed. They make their money primarily based on the upfront fees. After you pay the upfront fee, you'll get a very nice write-up of your company with fancy charts and printed on the finest cloth weave paper, but you won't get a buyer to overpay for your company.

When buyers buy based on synergies, they typically pay a reasonable premium over the financial methods described previously, or based on some logical method that reflects the buying companies likely earnings (such as with payroll service companies, above). For example, instead of using a multiple of 3.5 times EBITDA, they may use 5.5 times EBITDA. Now the difference between a multiple of 3.5 vs. 5.5 is significant to be sure, but it is not the double or triple valuation that you were promised, before you paid the hefty upfront fee.


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