Terry Lammers — March 25, 2019 — March 25, 2019
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What is your company worth? It’s important to know your business valuation.
If you’ve put any thought into life after running your current business, you’ve likely given this question some consideration. But the real question is this: Is your own estimate accurate?
More than likely, it isn’t. Sure, no one knows your business better than you do. That doesn’t mean you understand the ins and outs of determining what someone else would pay for it. The factors that can influence a company’s value in the marketplace — whether making an initial public offering (IPO) or not — are far too numerous for an owner to see from deep within the weeds of running day-to-day operations.
Reaching the True Value
In my experience as a Certified Valuation Analyst (CVA), overly high expectations are incredibly common. Some owners see a few changes that could send profits soaring. Theses are things a new, well-capitalized owner could easily fix. Yet, they inflate the value of their companies. Unfortunately, this isn’t how the market works.
True value is much harder to pinpoint. It is sometimes far less entwined with immediate profit potential than you might think. In 2017, for example, 76 percent of companies that listed for an IPO were unprofitable the year prior to going public. In the end, it comes down to the financial or strategic value in the eyes of the investors. This is something that’s not easily discerned by the owner alone.
Verify Your Value
Clients who seek out my company for valuations are often shocked — both positively and negatively — by what they learn during the process. Just recently, I surprised a client because my assessment was nearly double what he was expecting to take home in a sale.
His assumption, like many others, was based on a simple review of earnings before interest, taxes, depreciation, and amortization (EBITDA). This equation is certainly valuable in a sale. It represents a basic assessment of a company’s free cash flow before certain expenses and financing activities that might not hold true under new ownership. However, it’s not the only factor.
Before we valued his business, he assumed that his low EBITDA wouldn’t result in much profit from a sale. He said he might as well close up shop and scrape up what money he could from his inventory and receivables. Little did he know that he’d be looking at a value based on EBITDA on top of keeping his cash, collecting accounts receivable, and getting paid for his inventory. Those additional pieces added $ 25 million to the $ 26 million value I had already assigned to his business alone.
The Need For Accuracy
All of that goes to show how critical an accurate valuation is for a potential seller. That owner is in a much better position than he would have been based on his own valuation.
Others have an even more pressing need for a clear picture. Many of our clients are nearing retirement and counting on the sale of their businesses to make those retirement plans possible. Whether they over- or underestimate the value of their businesses, the end result for their latter-day adventures could be vastly different from what they expect.
These two examples by no means represent the only instances when it’s important to seek a professional valuation. Many owners don’t have a clear picture of their businesses’ operating capital needs and how they might impact what buyers will pay. And others are selling in a market with little or no comparable sales.
A Professional Appraisal
In these and countless other scenarios, you need a professional appraisal from a CVA who’s backed by credentials from a nationally recognized association, such as the American Institute of Certified Public Accountants or the National Association of Certified Valuation Analysts. These credentials signify extensive training and standards and provide legal backing for the value your appraiser ascribes to your business.
Beyond seeking out credentials, you should find someone you can trust to assess all the nitty-gritty details of your business. Don’t neglect to ask around in your network and do your research because this is going to be someone you work with closely for up to a month.
The Art and Science of Valuations
Ultimately, the task of a CVA is not simply to arrive at some hard number for the cost of your business; instead, it’s to determine your business’s fair market value.
The IRS Revenue Ruling 59-60 defines fair market value as “the price at which the property would change hands between a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.”
The determination of that price can come from one or all of three approaches: the income approach, the asset approach, and the market approach. The approach your analyst uses will depend largely on the health of your cash flow.
Income Approach
In the income approach, a healthy cash flow — either historical or forecasted — is used to determine value. This involves analyzing an organization’s various income streams, determining which of them hold real value in a sale, and arriving at a potential return on investment for a buyer.
With clarity about cash flow, a buyer can see just how long it will take to reap that return and judge worth accordingly. Your analyst’s job is to determine this on behalf of many potential buyers. This is a frequently used approach because it provides a straightforward value assessment in the case of a robust cash flow.
Asset Approach
The asset approach is most often used when a company is losing money or already closed down. In this case, the analyst will figure out a total value of all tangible (and possibly some intangible) assets and determine his or her valuation accordingly.
Market Approach
The market approach involves a similar process to that of a home appraisal. In this framework, your analyst uses the trading multiples of comparable companies to determine the multiples of your business. Two homes with three bedrooms and a single bath on the same street are probably worth a similar price. So it often goes in a business sale.
However, just as there are a number of unique factors in every home sale — including differing neighborhoods, school districts, and home conditions — there are qualifying factors that limit the effectiveness of this approach when it comes to businesses. It’s best used as a sanity check after first arriving at a number by employing other approaches.
Altogether, determining fair market value is a delicate balance of art and science. To achieve that balance, you need a credible, trained expert who can provide professional judgment and help you navigate any complications that might arise.
Complicating Factors
We can dig even deeper into the art and science to find a whole host of other factors that impact the value and the prospect of a sale. These additional considerations are often blind spots for the would-be seller.
For example, can you place a dollar value on your company’s dependence on you as the owner? What would it cost for a new owner to pay someone else to do your job? If you pay yourself $ 150,000 for a job that would probably fetch $ 300,000 on the market, that’s going to hurt your sale prospects. Flip those numbers, though, and you’re adding cash to the final valuation.
Your contributions aren’t the only ones to consider, though. Do you depend heavily on any specific employees? Your potential buyer will be wondering what happens if that employee leaves in the event of a sale. Similarly, if you rely heavily on one specific vendor, your buyer might be concerned about the impact on your business if that vendor raises prices or folds.
More Considerations
Other expenses and cash flow influences will play a role as well. Your current rent, your overall operating capital needs, and even your terms on receivables might be working for you as it stands. A new owner, however, might feel differently.
Also, keep in mind that the value of assets doesn’t define the value of a company — the cash flow does. For example, I worked with a client who bought expensive assets (over-the-road trucks) and took on more debt. He thought the price of the company would go up because of the value of the new equipment. But that equipment didn’t add cash flow to the company — it replaced existing equipment — so the value of the company stayed the same.
Intangible elements can have an unexpected impact, too. How diverse is your customer list? I once worked with a trucking company that had one customer. That’s right, one. If that customer leaves, that company’s income vanishes overnight. Would you buy a business with that much risk? Most companies have more than one customer, but many still depend heavily on just a few for the bulk of their revenue. If you’re looking to sell, diversifying that list will make you much more attractive to buyers.
Review and Research
Considering such a wide range of influences can make your head spin. But it’s the valuation analyst’s job to sift through all of this information and normalize your business’s income statement.
You can expect your CVA to spend a good deal of time reviewing your financial reports, as well as examining your management team, trends in the market, and more. It’s a time-consuming process, but it’s well worth the investment.
Making the Most of Your Valuation
When you finally come away with your valuation, you have the power to make more informed decisions. But that data isn’t only beneficial for owners who are on the verge of a sale. Whether you’re looking to sell in one year or 10 — or are just vaguely curious — a thorough valuation is an important tool for assessing the long-term prospects of your business.
There are a few steps you can take to make the most of your valuation:
1. Lead with your life plan.
Your plan for your business shouldn’t be separate from your broader financial plan for your life.
While 78 percent of Americans feel “extremely” or “somewhat” concerned about the amount of money they’ll have at retirement, many people have successfully turned to entrepreneurship late in their careers as a way to strengthen their financial future. The proportion of flourishing entrepreneurs between 55 and 64 increased from 15 percent to 24 percent from 1997 to 2016. For many in that group, the value of their companies is a critical component of their overarching financial security.
Some of these business owners are planning to sell their business to a key employee or family member. Knowing the worth of the business now will enable these owners to work with those buyers to ensure they have the necessary funds when the time comes to pass on the business.
2. Don’t forget the tax man.
If you make a profit on the sale of your business, a big tax bill is probably coming. Always factor this into your final numbers when you’re considering a sale.
When you sell a business, the IRS treats it like a sale of assets and will levy capital gains taxes according to how long you held those assets. In 2018, taxes on short-term assets ran as high as 37 percent, while long-term assets capped at 20 percent.
If you’re aware of the potential tax implications, you can clearly weigh your options. Do you hold on to the business longer to get those long-term rates? Or would it be better for you to maintain ownership and a salary but let someone else run the company? The tax bill is a reality that you can’t avoid if you choose to sell, so be sure the sale will make sense after the tax man comes knocking.
3. Analyze your analyst.
At the end of the valuation process, you should expect a thorough, clear report from your analyst. You’ll receive a written report detailing all the data your CVA considered, his or her evaluating procedures and methodologies, any assumptions or limiting factors, and a final valuation.
If anything is unclear, ask for further explanation. Your appraiser probably spent a lot of time making normalizing adjustments to your financial statements, so reviewing the report can be disorienting for the owner. Take a close look at these adjustments, and be sure you feel confident that they’re accurate.
Your company’s worth adds to the bigger picture of your organization’s financial health and plays a significant part in your personal financial plans. Just as you seek a doctor’s opinion on your physical health, you should seek out expertise when assessing the big picture of your company’s health. A valuation performed by a CVA removes the mystery from your company’s value and gives you a clearer view of what your next steps might be.
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