Over the past few months, we have been discussing the relative merits of taking your company public. While this can be one way to dispose of your business, it’s not the most common way for small business owners to move into the retirement phase of their lives. It is far more common for a business owner to transfer ownership of the company to an interested family member, valued employee or other third party through the sale of the business. But how do you place a value on the business into which you have poured your heart and soul? That is what we plan to explore in this month.
The concept of valuing your business is simple. All you have to do is figure out what a willing buyer will pay in order to obtain ownership of your company. While the concept is simple, the application can be complicated because there are so many factors involved in determining your company’s value. Each person who might be interested in purchasing your company will likely have a different perception of its value. This stems from the fact that there are many ways to determine your company’s value. Let’s take a look at some of the more common valuation methods.
Some of the more common methods of valuing a business are:
Multiple of earnings -
- Multiple of earnings
- Net asset value
- Net book value
- Discounted cash flow
- For service businesses, some factor of the net billings
One of the major ratios thrown around in the public company arena is the price-earnings ratio. This is the price of a share of stock divided by the company’s annual earnings per share. Even if you aren’t valuing a public company, this can still be a reasonable method in valuing your own company. As a general rule of thumb, a buyer can reasonably expect to recover the cost of a business in three to five years.
Net asset value -
What is the value of the assets of your company less any liabilities the buyer will assume? For that matter, what are the assets of your company? The assets of your company include not only the recorded assets like cash, receivables, inventories, fixed and other assets, but they also include intangible assets. Does your company own a lucrative patent? What’s the value of that asset? Is the property in your company old and, therefore, likely to be undervalued based on current market conditions? Did you pay too much for the property from which your company presently operates? In determining the net asset value, you will likely need to involve valuation experts such as appraisers to help you establish the real value of assets. The value of the liabilities assumed is generally close to the recorded value.
Book value -
In some cases, the book value of your company is what you can reasonably expect to receive for the business. Book value is the recorded value of your assets minus your liabilities, but be careful in determining that value. Some companies keep their books on the accrual method of accounting while others use the cash basis. Some companies use an income tax basis while others use generally accepted accounting principles. The value of assets and liabilities under alternative methods of accounting can have a significant affect on the book value of the company. For example, under the cash method of accounting, accounts receivable and accounts payable are not recorded. Suppose that your year-end accounts receivable are $100,000 and accounts payable are $50,000. If you don’t include these in the valuation of the company because you use the cash method, you just left $50,000 on the table.
Discounted cash flow -
The ability of an investor to recoup the purchase price of a business will come down to the cash generated by the business. An investor will want to not only recover the cost of the investment, but also receive a reasonable rate of return. To achieve these goals, investors often look to what’s known as the discounted cash flow of the company. In essence, the investor will look at the cash provided by company operations and then discount that cash flow so that the cash received will pay for the business plus give the investor some earnings on the investment based on risk. The rates of return used can be subjective, but there are some published sources that provide some guidance in calculating reasonable rates of return.
Net billings -
One of the more popular methods of selling some service businesses like accounting firms or law firms is to pay some factor of annual billings. While the amount can be easy to calculate, the trick is to make sure you receive the billings for which you pay. If you buy a company with $1 million in annual billings, you will want to make sure the billings are there from year-to-year. For that reason, purchasers generally pay for the businesses in installments. For example, a buyer might pay for that $1 million in billings based on 20% of the annual billings for each of the next five years. That way, if a client leaves after the first year, the buyer won’t be stuck paying for revenue that no longer exists.
Valuing a business for sale to a third party can be tricky at best. Each of the preceding methods can be appropriate only in limited circumstances and it generally takes a fairly sophisticated business person to determine which is most appropriate. Are you looking to buy or sell a business? Give us a call before you sign on the dotted line and let’s talk about how best to value the transaction to give you the best possible chance for a successful investment.
Have a great April.