A Business Valuation can Help You justify a Higher Selling Price.

When it comes time to prepare to sell your business a professional small business valuation should be performed to determine a Fair Market Value and increase chances of your business selling for a fair price. If your company has over a $2 million in sales, there is a very good chance that a bank will fund the deal and a formal appraisal will become necessary.

Small business to mid-size companies sell based on a "multiple" of recasted earnings (EBTIDA), other factors such as real estate (sale / lease), location, inventory, age of business, condition of the business assets, industry trends will be factors to include into the overall valuation.

One of the main factors that buyers consider is the prospects for growth. Prospective buyers will look a closely at the company's growth rate and its profitability, from gross margins to cash flow margins to free cash flow margins, and compare those margins to industry averages to see if the company is underperforming or outperforming its industry peers. A close evaluation of the company's proprietary services or products, including its patents, trademarks, brands, and all of the other barriers to entry by potentioal competitors. The higher the barriers you have created, the higher the value of your company.

Fact: Business Owners Have A Valuation Problem

They usually do not know what their businesses are worth.

Their most valuable asset is often the business itself.

But studies show owners misjudge their company’s value by 50% or more1.

Who cares? What difference does it make?

Estate tax issues – heirs may be forced to sell business at fire-sale price.

Buy-sell agreement - may be underfunded, won’t generate enough cash for retirement.

Retirement nest-egg - may be smaller than expected.

Kids may be treated unequally, causing strife and bad blood.

Problems selling the business - may scare away buyers, may leave money on the table, etc.

What types of business owners are at most immediate risk?

Age 50+ whose company’s annual sales are $1 million-plus (and/or have 10-plus employees).

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When the IRS challenges a business valuation and the estate defends itself in court, the result can be a higher valuation and higher estate taxes. In the cases above, court valuations averaged 227% higher than the estate’s. Had the estate not gone to court, IRS valuations averaged 338% higher, but court costs, attorneys, accountants, appraisers, etc, made the total assets of the court valuation and IRS valuation similar.

Recasting Financials to determine Value

Recasting financials is one of the primary services a broker will provide when for determining value and preparing your business for sale.

Most small businesses track of their financial performance by use of balance sheets, Profit & Loss Statements, and Tax Returns. Reporting financials this way is vital to the businesses' operation but it is not really useful when it comes to determining the fair market value of a business and its true financial earning power. Buyer's want to acquire Cash Flow.

Potential buyers need to understand the health of a business, how the money is earned and spent and the operation's capacity for generating more positive cash flow.

Traditional accounting works to minimize a business' tax liability which in turn, inaccurately translates the owner's true net profit.

The process of recasting a businesses' financials is very important in identifying fair market value for a business that is ready to sell. Recasting business financials involves extensive analysis to ensure all relevant and appropriate adjustments are correctly reported.

A business owner's compensation, bonuses, incentives, personal loans and other discretionary expenses are all common areas that are investigated when recasting financials.

These discretionary expenses or owner benefits are to be "added back" into the net income of the business so that a prospective buyer can accurately asses the business and it's future earning capacity. The owner has to see enough cash flow to pay himself a fair market salary and also cover any debt service for loans he may take on to acquire the business.

Additional areas of interest when determing value of the business will be assets & liabilities of the business, in particular equipment and real estate (if owned by the business).

Curious about Business Valuation Methods?
There are several business valuation methods that can be utilized
by a business owner. Which method is used depends greatly on the type and size of the business and most importantly, what is the purpose of the business valuation.

Some appraisals or valuations are strictly used for legals purposes and some are for selling businesses.

Here are some of the approaches available:

Seller's Asking Price

Similar Business Comparison (Comps)

Sales Multiplier

Asset Valution

Return on Investment

Capitalization of Earnings

Excess Earnings

Sellers Discretionary Earnings

Since I am a business broker specializing in valuing and selling business with under $5 Million in Gross Sales, I will focus on what myself and most other business brokers that specialize in small businesses use.

We most commonly utilize the Seller's Discretionary Earnings (SDE) Method, which is based on the restructuring of the businesses' profit and loss (P&L) statement.

The P&L statement is not a true reflection of the business and does not realistically show what a prospective buyer would net when they take over.

Most small businesses make deductions to a business that may be considered a discretionary expense that a new owner may not take advantage of, thus this figure is "added back" into the net profit of the business.

An few examples of a discretionary expense are: "owners compensation", "vehicle leases", "owner's health insurance", and other "Non-Recurring cash expenses". A new owner may not decide to pay for these items through the business, thus these represent real Cash Flow that a new owner will realize and utilize in another way.

Another area factored as an add back is depreciation. In some cases it's justified, in some cases it isn't. A manufacturing company for example may only have an economic life of 10 years before new equipment is needed to stay competitive. In this case adding back depreciation dollars reflects "real" cash flow even though it may not be a cash expense.

Competent business brokers realize they cannot just randomly add back in frivolous items to the new statement. What is important to the seller of a business is Market Value.

Market Value is the "probable price" that the business should be able to attract. Sellers and brokers should not be overly worried about getting the exact asking price, determining a viable range of value is whats important. Marketing the business, attradting buyers and screening them for qualification will be most important.

According to Tom West, brokerage industry expert, puts it very simply: "Asking price is what the seller wants, Selling price is what the seller gets, and Fair Market Value is the highest price the buyer is willing to pay and the lowest price the seller is willing to accept."

Other important factors to consider when using any of the business valuation methods to determine an asking price for a business for sale are:

1. Number of years business has been operating
2. Number of years the seller has owned the business
3. Terms offered
4. Competition
5. Growth and sales trends of the business
6. Location and Facilities
7. Industry - which industry is the business in
8. Number of employees and skill level of employees
9. Is the business a seasonal business
10. Is the business relocateable
11. How closely are the customer and vendor relationships tied to the Seller
12. Lease terms or Real Estate value
13. How accurately can future sales be predicted
14. Value of the Equipment
15. Value of Inventory

If the business is losing money or hasn't been around very long, then a common approach will be value of equipment. In most businesses, equipment value has little to do with pricing - mainly because the value is really in the Income that the equipment produces.

If there is not much income, then we'll look at the replacement cost of the equipment and possible the build-out of the facility as a starting point for asking price.