by Eric M. Magister, M.A. in Law | Business Valuation |
Financial and investment professionals operating in the lower-middle market often use EBITDA as a key metric to analyze a company’s operating profitability and determine its value.
EBITDA is calculated by taking the company’s Earnings (E) and adding back Interest (I), Taxes (T), Depreciation (D) and Amortization (A). This post addresses non-customary addbacks, those which go beyond the company’s interest, tax, depreciation and amortization expenses, to calculate EBITDA.
A common method used to calculate business value involves applying a multiple to the company’s EBITDA. And while business owners who intend to sell their business have many options to increase the transaction multiple, one way to unlock value using this calculation is to identify other, non-customary “add-backs” to increase EBITDA.
What Are Add-Backs?
An EBITDA add-back is an expense that will not be included in the buyer’s future P&Ls for the company. Understanding and applying add-backs and other kinds of adjustments helps normalize a business’s earnings on a go-forward basis. This will give all parties a true understanding of the cash flow, and therefore, the true value of the company.
What Are the Different Kinds of Add-Backs?
EBITDA add-backs generally fall into one of the following categories: abstract accounting expenses, interest expense, plus nonrecurring, nonoperating, and personal expenses. Add-backs and adjustments will vary from company to company, but understanding these major categories is helpful in identifying potential increases to EBITDA, and thus business value.
It is important to understand these add-back categories more fully so as to be able to accurately identify EBITDA increases and ultimately a more complete value of your business. Add-backs are also key for a buyer to understand the full scope of financial benefits the current owner experiences.
Abstract Accounting Expenses
Abstract accounting expenses generally include depreciation and amortization. These are abstract expenses that appear on the business’s profit and loss statement, and while they are considered legitimate deductions for accounting purposes, they haven’t truly occurred during the year when EBITDA is being calculated (i.e., there is no actual movement of cash) and subsequently don’t affect the financial benefits derived during the year in question by the business owner. Adding back depreciation and amortization to compute EBITDA is a customary add-back.
Interest Expenses
How you choose to capitalize a business is completely at the discretion of the business owner and any related interest or late payment fees paid are also an expense that is added back to the net earnings when computing EBITDA. This add back is customary.
Nonrecurring Expenses
Nonrecurring expenses are expenses that are not expected to happen again and are outside of the ordinary course of business. Such expenses often result from one-time, extraordinary events. Some typical examples include:
- Litigation costs
- Professional fees
- Capital expenses
- One-time technology upgrades
- Transaction-related costs
- Facility relocation or renovation expenses
- Bad debt expenses
There is an important consideration here, and that is these expenses are indeed nonrecurring. Clearly, this leaves room for interpretation. For example, if your business is engaged in lawsuits year after year, and such lawsuits are expected to continue, it would be clearly inappropriate to add those costs back, as they are part of the ordinary course of business.
Non-operating Expenses
Non-operating expenses are add-backs expenses that are not required in, or related to the true operating performance of the company. Oftentimes, these are related to non-operating assets or liabilities, such as real estate or vehicles. Some typical examples include:
- Discretionary Travel expenses
- Auto allowances for executives and business owners
- Insurance payments for executives and business owners
- Expenses related to leisure activity
Non-operating expenses appear towards the bottom of the company’s income statement. As they do not directly correlate to the business. As such, they are considered an add-back to help the business appraiser or business valuation analyst focus more on the true value of the company.
Personal Expenses
Personal expenses are often expensed through a business to reduce tax liability. These expenses should be added back because they will end once the business is sold. Some typical examples include:
- Payments to family members who are not actively involved in the day-to-day operations of the business
- Above-market salaries paid to the owners or their relatives
- Bonuses serving as shareholder distributions
- Any expense that is truly personal in nature or discretionary
This category will also include discretionary expenses, such as charitable contributions and food and entertainment expenses. When adjusting for excess compensation, it is important to consider payroll taxes, insurance, and the benefits related to any excess wages.
Negative Add-Backs
Despite the name, EBITDA add-backs will not always increase the earnings of your business. Remember, the purpose of EBITDA add-backs is to reflect the true economic earning potential of a business if a third party owned it. Sometimes, negative add-backs are necessary for items that are expected to decrease earnings of the business going forward.
If the business owner personally owns the real property where the business is located and charges below-market rent, the rent expense should be increased to reflect the cost to new owners who will not have the same favorable rent. Or maybe the business owner does not intend to sell all the business’s assets as part of the transaction. In that case, any revenues associated with those assets should be removed to reflect the actual earning ability without those assets.
Factors to Consider
When accounting for add-backs, you will want to analyze the company’s P&Ls for the types of expenses and adjustments discussed above. Be careful not to miss one-time expenses that are easily overlooked. When putting together your add-backs, make sure each one is legitimate and is defendable.
In addition to the various types of add-backs and adjustments, different companies have different ones they must consider. An ESOP, for example, may have add-backs that would differ from a family-owned business.
In Conclusion
While adding back (or adjusting) EBITDA is valid in most settings, it’s not ideal to go to market for sale with a significant number of other, non-customary add backs. Generally speaking, when it comes to the number of EBITDA add backs, less is more. Buyers, Investors, PE firms and the like prefer fewer add-backs to EBITDA when considering their investment in your business.
That said, the inclusion of valid EBITDA add-backs create a clear picture of your business’s cash flow which makes it easier to understand how much your business is worth. Work with an experienced professional who thoroughly understands this process to ensure you properly compute EBITDA and ultimately receive the greatest value for your business.
![The Three Business Valuation Approaches [Infographic]](https://exitpromise.com/wp-content/uploads/2022/10/three-approaches-to-business-valuations.jpg)
by Eric M. Magister, M.A. in Law | Business Valuation |
At some point during a company’s existence, it’s very likely a business owner will need a business valuation. The reasons for getting a business valuation can range from estate planning, partner buy-out, merger or acquisition, selling the company, or even a divorce. But regardless of the reason, it is very important to understand how business valuations are conducted.
Based on the variables and information available, a valuation professional can follow three types of business valuation models to arrive at the value of a business.
These three approaches used in valuing a business are: the asset-based approach, the income approach, and the market approach.
Business Valuation Professionals typically rely on one or two depending on the type of case it is plus other factors. It’s vital that business owners who rely on business valuations understand the basics of each approach. To help business owners fully understand each of the three business valuation approaches, we’ve created the Business Valuation Approaches.
Asset Approach
The asset based approach is defined by the International Glossary of Business Valuation Terms as “a general way of determining a value indication of a business, business ownership interest, or security using one or more methods based on the value of its assets net of liabilities.”
Any asset-based approach involves an analysis of the economic worth of a company’s tangible and intangible, recorded and unrecorded assets in excess of its outstanding liabilities.
Nevertheless the actual value in the asset-based approach could be much higher than the sum of all the recorded assets of the business.
For example, a Balance Sheet may not always have all the significant assets such as the company’s method of conducting business (its unique business model) and internally-developed procedures, business systems, and products. Placing a value on the method of conducting business that makes a company unique can be difficult.
A business owner can calculate an asset-based valuation for their company using the help of the following two approaches:
Book Value Method: This method is based on the financial accounting concept that owners’ equity is determined by subtracting the book value of a company’s liabilities from the book value of its assets. While this concept is acceptable to most analysts, most agree that the method has serious flaws. This method is recommended for businesses that do not plan to sell their assets or liquidate and want to stay in business for some time.
Adjusted Net Assets Method: This method is used to value a business based on the difference between the fair market value of the business assets and its liabilities. Depending on the particular purpose or circumstances underlying the valuation, this method sometimes uses the replacement or liquidation value of the company assets less the liabilities. Under this method the analyst adjusts the book value of the assets to fair market value and then reduces the total adjusted value of assets by the market value of all recorded and unrecorded liabilities.
All in all, the asset-based business valuation method is a great method to arrive at exact value for which a company can be sold. And even though there are many other methods out there, the asset-based valuation method is often preferred because of its applicability in instances where a business is suffering from challenges relating to liquidity.
Income Approach
The income approach measures the future economic benefits that a company can generate for a business owner. As part of this analysis, valuation professionals assess factors that determine expected income including data such as revenues, expenses and tax liabilities.
When using the income approach, a business is valued at the net present value of its future earnings or cash flows. These cash flows or future earnings are determined by projecting the earnings of the business and then adjusting them for changes in growth rates, taxes, and other relevant factors.
A business owner can calculate an income-based valuation for their company using the help of the following two approaches:
Capitalization of Earnings Method: This method is used to value a business based on the future estimated benefits, normally using some measure of earnings or cash flows to be generated by the company. These estimated future benefits are then capitalized using an appropriate capitalization rate.
This method assumes all of the assets, both tangible and intangible, are indistinguishable parts of the business and does not attempt to separate their values. In other words, the critical component of the value of the business is its ability to generate future earnings or cash flows.
Discounted Cash Flow Method: This method is based on the assumption that the total value of a business is the present value of its projected future earnings, plus the present value of the terminal value. This method requires that a terminal value assumption be made. The amounts of projected earnings and the terminal value are discounted to the present using an appropriate discount rate, rather than a capitalization rate.
The Discounted Cash Flow Method of valuing a closely held business uses the following steps:
- Determine the estimated future earnings of the business.
- Determine a terminal value at the end of the projected income stream.
- Select an appropriate discount rate.
- Discount and sum the estimated future earnings and the terminal value to the present using the discount rate previously determined. The resulting amount is the total value of the business.
Market Approach
The concept behind the market approach is that the value of a business can be determined by reference to reasonably comparable guideline companies for which transaction values are known.
This approach is commonly used especially in contexts where the user of the analyst’s report does not have specialized business valuation knowledge. The market approach is a common method of determining a measure of value by comparing the business or equity interest in question to similar businesses, interests, securities, or intangibles that have been sold.
A business owner can calculate a market-based valuation for their company with the help of the following two approaches:
Guideline Public Company Method: The guideline public company method develops an indication of value based on consideration of publicly traded companies that provide a reasonable basis for comparison to the subject company. The valuation professional will typically conduct a search to identify a group of guideline public companies based on the subject company’s industry, and review financial, industry, and market characteristics to ensure that they are reasonable for inclusion.
Analysts typically express the relationship between the value of a company and a corresponding metric in the form of a valuation multiple.
The multiple is multiplied by a performance metric such as EBITDA and the resulting amount is the total value of the business.
Guideline Transactions Method: The guideline transaction method is similar to the guideline public company method. However, instead of deriving values from public company stock prices, values are derived from transactions in the mergers & acquisition market.
Data for market transactions is typically sourced from various databases.
Conclusion
In conclusion, a business owner can determine the value of their business in several different ways, some of which are better approaches for certain companies than for others.
For example, an asset-based valuation will be particularly suited to businesses that hold investments or real estate or for a business that is generating losses.
Under the income-based valuation, the capitalization of earnings method is well-suited for businesses expected to have stable cash flows, whereas the discounted cash flow method is better suited for businesses whose cash flows may fluctuate.
And finally a market-based valuation will be best suited for businesses in the startup phase or businesses looking for financing.
by Eric M. Magister, M.A. in Law | Business Valuation |
When all other factors are equal, a significant concentration among customers, suppliers, and/or employees results in a lower than expected business value due to the underlying inherent risks associated with any or all of these concentrations.
And for this reason, a business appraiser will use a higher required return (or discount rate), a lower forecast of future earnings, a lower expected earnings growth rate, and/or a lower capitalization factor (earnings or cash flow multiple) in order to form his or her opinion of value.
If the business is on the market, buyers will also view concentrations as an elevated risk and either pay you less for the business or dismiss the opportunity altogether.
There are several concentrations that business owners should be aware of that harm the value of their business. These concentrations include:
- Customer Concentration
- Supplier Concentration
- Employee Concentration
How Customer Concentration Affects Business Value?
Many small businesses have a handful of customers who generate a large percentage of their revenue. Buyers will usually review any client relationship that accounts for more than 10% of revenue and consider it as a customer concentration. Losing one of these key customers could stifle a business’ revenue and derail its ability to generate a profit.
Due to this risk, buyers will generally apply a valuation discount to companies with a high degree of customer concentration. Many buyers are wary of companies that derive a majority of their revenue from a few customers. Although some strategic buyers may be attracted to a company if it has a strong relationship with a particular client, this is an exception rather than the norm.
A concentrated customer base increases the risk for the owner and for potential purchasers. For a potential purchaser to invest in a business with a customer concentration, their rate of return will need to be higher, which translates into a lower purchase price.
Additionally, business owners must be aware that a high client concentration is problematic for potential buyers who plan to borrow money to finance the acquisition because bankers and other lenders will consider a high customer concentration to be an elevated risk . They will consider the buyer’s capacity to maintain the same level of revenue and profit in order to service debt. If the buyer cannot justify the risk, diversify away from the risk, or add new clients, the lender may believe there is too much risk. .
A lender may reject the loan application or may be likely only to offer a partial loan to the buyer if there are customer concentration concerns. The less money borrowed, the less money the seller will get up front when the deal closes.
From an evaluation perspective, many potential business purchasers would view a single client representing 10% to 15% of revenues as a significant negative. Nearly all potential buyers would view client concentration of 30% or more in only two to three clients as a serious issue that would significantly affect the business’ salability.
Any efforts you make to diversify your clientele before selling your company will improve its salability, valuation, and ability to generate the most money at closing.
Most prospective purchasers may attempt to set up a “contingent earn-out” paid to the seller over time which is dependent on the future revenue or profitability received from the company’s largest customers in order to alleviate customer concentration issues. If one of those customers is lost, the seller may never receive the contingent portion of the negotiated purchase price.
How Supplier Concentration Affects Business Value
If a business can’t get what it needs from suppliers, it can’t sell its products to customers. A company’s business may suffer if its connections with its major suppliers deteriorate or if one of its core products or components is no longer available to buy for resale or for production purposes. Therefore, when determining a company’s risk, the character and stability of its suppliers is a crucial factor.
Small business owners often find a reliable supplier to rely on for the majority of their product or material requirements. Why not make your life easy and continue working with a dependable person or organization when you find one?
While the strategy of working with only one or a few trusted suppliers makes running a business less complicated, it can prove to be risky. The Covid pandemic created supply chain issues worldwide. Not even the smallest businesses escaped its negative effects.
For larger businesses, many were brought to their knees and were forced to shut down production lines, invoke layoffs and miss loan payments due to lack of reliable delivery of supplies.
Business owners scrambled to order from alternative suppliers only to be turned away. And that’s because suppliers were only taking and attempting to fulfill orders from existing, good customers. Ouch.
Unfortunately, buyers are acquiring businesses intending to gain market share, not to maintain the status quo. Therefore, as your company grows, the importance of your supplier pool becomes even more important. A lack of available alternative suppliers can and likely will severely hamper growth or even possibly cause your business to shut down.
How Employee Concentration Affects Business Value
Apart from customer and supplier concentrations, critical employee concentration is perhaps the most concern for buyers and one of the most common risk areas for small businesses. The smaller the company, the more likely this problem will occur.
Small businesses often rely heavily on the entrepreneurial spirit of their CEO/owner, who may be primarily responsible for multiple key functional areas. Situations like this are not uncommon, but over-reliance on one person increases the risk and perception of your business. All else being equal, the market places higher value on companies with more complete management teams, including talented individuals leading the key functional areas of sales and marketing, finance, engineering, and operations.
Developing a competent management team who shares the founder’s vision for growth and increasing the value of the business is one of the most difficult as well as the most financially rewarding goals to achieve for your business. Doing so reduces this risk and greatly improves business value.
In Summary
Concentrations have multiple negative effects on the value of the company when present because they are an indicator of elevated risks.
First, concentrations frequently entail the danger of declining revenues as a result of a reduction in customer demand or the company’s inability to continue providing or manufacturing its products.
Second, they can signal a ceiling on revenue growth due to constraint on the company’s capacity for selling product or manufacturing production.
And lastly, without a well-trained management team in place, the absence of the founder may present a situation where the business will no longer be able to sustain and grow its revenue, effectively utilize its personnel, efficiently operate and generate profit for its shareholders.
By focusing on reducing these three concentrations in your business, you will automatically increase the value of your business.
by Holly Magister, CPA | Business Valuation |
Earlier this week, I called out for your most pressing questions about selling a business on several social media channels.
The common theme among the questions raised tells me many business owners are uncertain about how to establish a value for their business, regardless of its stage of development. In various ways, readers asked me about how to value ideas, start-ups and mature businesses.
I’ll tackle the various business stage valuations one at a time:
The first question is “How do I value a business idea for investors?”
An Idea is Not a Business
The late Peter F. Drucker said it so eloquently when he declared “Ideas are cheap and abundant; what is of value is the effective placement of those ideas into situations that develop into action”. And without action, an idea has no value. Period.
In my opinion, there is a wide divide between the vast number of Wantrepreneurs and a successful Entrepreneur. Until an idea is tested and developed, it is virtually impossible to place a monetary or commercial value on it.
If however you are able to successfully file for and obtain a patent for an idea, it may be possible to sell or license the patent to a business enterprise for its commercialization. In fact, if you chose to patent an idea, this is exactly what I would recommend you do. Otherwise you will need several hundred thousand dollars to invest in protecting your patent rights. And that’s before you make a single sale.
If you’ve got an idea for a product and/or service and you are seeking investment from friends, family or an Angel who shares your passion for your idea and is confident in your abilities, your first round of investment should include:
- Founder/Inventor’s Financial Capital – without this, subsequent rounds of financing from other sources of capital will be difficult to obtain; and
- a definition of how the capital raised will be used; and
- a set of milestones and its respective timeline before another round of capital may be raised; and
- an accountability reporting process for investors; and
- a definition of the roles and responsibilities for founder/inventor, investors, and other key employees.
In such a situation, the value of a business idea is decided between the parties and is often tied to the limited risk an investor is willing to take to assist the founder/inventor in determining if the idea has commercial merit.
Another business owner asked me “How do I sell a business when it’s in the start-up stage?”
A Start-up Must Prove its Business Model is Viable
Start-ups are ideas in search of a profitable business model. And until the start-up is profitable, most buyers will heavily discount its value. Unless of course, you’ve developed a product or service that a dominant market player with a lot of cash sorely needs or a set of employees ripe for a talent acquisition.
If that’s the case, and you successfully sell your start-up for an incomprehensible multiple of sales (because you never reached EBITDA), you’re now the equivalent of a Rockstar. Congratulations!
Let’s set that notion aside and talk about how the rest of the world’s start-ups are valued.
Once a start-up has revenue, it is on its way to determine the level of sales and operating expenses it will require to reach profitability known as a breakeven point. Knowing when a start-up should reach its breakeven point is a key to a start-up’s success.
Armed with this information, the value of a start-up for a buyer or investor will be based on these additional factors:
- Revenue over the past 12 months
- Gross Profit Margin
- Net Profit Margin – although, profitability is not absolutely necessary in a start-up
- Industry Size – Is the opportunity in a $1B market or a $1M market? Are there geographical limitations?
- Overhead Costs – Is this a retail business with real estate requirements or a SAAS business with low overhead?
- Booked Future Sales – Contracts, Purchase Orders, etc.
- Does the start-up solve a user’s problem or serve a user’s passion?
- Potential Investor or Buyer’s ability to bring something to the start-up otherwise absent, such as introductions to synergistic relationships, selling opportunities and/or reduction of costs
If there are any shortcomings in one or more of the eight factors noted above, the start-up may not be in a good position to sell its business or take on an investor for an attractive valuation. It may simply be too soon to take on new investors or sell. Or the business model may not be working and a pivot may be needed.
The last question asked was “What is the best way to come up with a fair valuation for my business when I sell it?”
Mature Businesses are Measured by Cash Flow First
Once a start-up has matured and is producing consistent cash flow, proving viability is no longer a concern to a buyer (or investor). Instead, the type of buyer and the business’ cash flow will have the most impact on how a mature business is valued.
A business buyer who is a competitor may desire to acquire your business for strategic purposes. Such a buyer may want to expand into your geographical area quickly or to acquire the knowledge and business contacts your employees possess. For these, and many other reasons, your business would command a higher valuation and price from a strategic buyer.
On the other hand, a financial buyer who simply desires a good return for his investment dollars will likely value your business at a lower amount.
Regardless of the type of buyer your business is sold to, all buyers first look at cash flow from operations as a factor to determine its value. Depending on the industry and size of the business, cash flow may include measurements such as EBIDTA (Earnings Before Interest, Depreciation, Taxes and Amortization), EBIT, Seller’s Discretionary Income, and in some cases Annual Sales). A ‘multiple’ is applied to the appropriate cash flow measurement which differs by industry and changes over time.
The product of the cash flow multiple becomes the basis for valuation. Adjustments are then applied based on the particular circumstances and other factors.
In addition to the buyer type and cash flow there are many other factors which will impact the mature business’ valuation. These factors may include:
- Fixed Assets to be transferred to a buyer
- Liabilities to be assumed by a buyer
- Current Assets such as cash, investments, accounts receivable and inventory transferred to a buyer
- Intangible assets used in the business (Patents, Trademarks, URLs, Trade Secrets, etc.)
- Goodwill
- Lease rights and obligations
- Contract rights and obligations
- Pension Plan Liabilities
- Cost of Capital
- Future Industry Growth
- Revenue Growth Record over past three years
- Projected Company Growth one-to-three years
- The M&A Environment
Unfortunately for the business owner, a single formula to compute the value of a business does not exist, regardless of its stage of maturity.
Nonetheless, it’s important to understand how business valuation factors change as the entrepreneur begins with a business idea which evolves into a start-up and then ultimately matures into a viable business.
by Neal Isaacs, MBA, CBI, CM&AP | Business Valuation |
Business ownership can be a great personal asset not unlike real estate or other financial investments. Not only can a quality business yield cash flow during ownership, its value may appreciate over time until it’s ultimately sold or transferred to others.
Business value can be a complicated topic. By their nature, privately-held businesses are less liquid than publicly-traded stocks. Small businesses typically have more risk but can also have a higher financial return when compared to traditional, liquid investments.
So how can a business owner increase the value of their business, specifically if their goal is ultimately a third-party sale?
If you’d like to understand how to add value to your business, it’s worth considering the three hallmarks of a valuable business:
Improve Financial Clarity
Create Processes & Systems
Build Owner Independence
Business owners who address these important hallmarks of a valuable business are very likely to have more options for exit and attract multiple buyers.
Financial Clarity
Valuable businesses have high earnings as well as high revenue. Put another way, for most small businesses outside of venture capital-backed startups, it’s the bottom line, not the top line on the P&L that matters most to business buyers or investors.
Business buyers seek a consistent, long-term earnings trend that is sustainable and similar to businesses in the same industry. It may sound great that a business keeps half of every dollar that comes through the door. However if the average business in its industry typically keeps only a quarter of its annual revenue, it could be a sign that the owner is overworked instead of properly delegating to a team or skimping on other essential expenses for long-term stability and growth.
When it comes to financial clarity, business owners also need to be able to tell their financial story that is consistent with third-party documentation from the tax returns to the financial statements and all the way back to the business’ bank statements. Being able to do so is the hallmark of solid financial due diligence and will improve the likelihood of a successful sale.
Certain business buyers may appear to be in love with a business concept, brand or industry. However, if the business for sale doesn’t make money, or it doesn’t stand up to the financial due diligence process, the buyer will raise their concerns. Additionally, it’s very likely the business buyer won’t be able to finance the business acquisition through traditional lenders or the Small Business Administration.
Creating financial clarity involves recording income and expenses in a detailed format, appropriately recording expenses and investments appropriately on the P&L and Balance Sheet, respectively, and being able to answer questions about common fees like tax payroll taxes and merchant fees. Recording expenses in modern financial reporting software is a must in today’s sophisticated business acquisition climate. Whether it’s QuickBooks, FreshBooks, Wave Financial or similar, using software is preferred. Handwritten or even Excel-based bookkeeping will likely raise a caution flag by business buyers.
All of this recording and reporting is a great segue to our second hallmark of a valuable business; creating processes and systems for the business operations and administration.
Processes and Systems
Valuable businesses are attractive to business buyers because they have processes and systems for operations and administration. Each process and system ties to all customers, products, vendors, etc. to enable employees, managers, and leaders to report accurately, communicate effectively and ultimately make smart decisions.
For example, when a new customer initiates a purchase, a standard operating procedure should be in place that will allow the order data to flow through the entire business operation and administration. While the purchase order may start in the sales department, it will travel through the warehouse, inventory, shipping, accounts receivable, and ultimately end when the payment of the invoice is received.
Intangible assets such as a good CRM (Customer Relationship Management), an effective lead-generation website, and a great marketing program are very attractive to buyers. Similarly, well-documented HR policies and employee handbooks are vitally important too. Savvy business buyers will recognize a business that is well organized and equipped to serve a growing business.
This type of intangible “goodwill” is what business buyers want to acquire instead of trying to build it themselves. And it’s a value they are willing to pay for!
So let’s bring this all together with our third hallmark of a valuable business, lack of owner dependency.
Owner Independency
If a business has invested in it’s people and processes and systems effectively, there’s a decent chance that the owner is no longer the face of the business. The business owner can probably take a vacation if he or she has a team to manage the business and there’s a plan for how to handle issues that typically arise. If so, this is exactly the type of business that business buyers are most interested in acquiring.
While a small business is inherently owner-dependent in most cases, certain owners are able to succeed in a semi-absentee state for long periods of time. While it’s hard to measure owner dependency, businesses that are effectively structured to earn a profit after supporting all of the systems and people needed to keep owner independence are very attractive to buyers. In fact, if we could all own absentee businesses, there would literally be no limit to how many businesses we could own and how much money we could make.
Add Value to Business for Your Best Outcome
In conclusion, it’s not easy to build a business that has maximized it’s value, but those business
owners who have enjoyed the opportunity to sell their businesses to multiple buyers often enjoy more profit and more time and freedom from their businesses.
Even if a business owner does not plan to sell, paying attention to these three hallmarks of a valuable business will improve the owner’s income as well as quality of life.
by Neal Isaacs, MBA, CBI, CM&AP | Business Valuation |
As a business intermediary helping owners determine the “Most Probable Sales Price,” or MPSP of their businesses here in the Triangle, I hear a common question:
“That value makes sense, but what about all my stuff? Can I get paid for that too?”
The answer is rarely what the business owner wants to hear, but there’s a sound reason for it, and understanding how businesses are priced can help an owner with decisions on how to allocate resources for assets; especially if they are planning to sell in the near future.
In this article, we’ll explore the market approach for small businesses and what value the assets carry…
The Market Approach is Cash Flow Driven
The answer to the question of “what about my stuff” is, unfortunately, the following:
The buyer needs the “stuff” to make money, so the owner doesn’t get paid additional consideration for their “stuff.”
Said “stuff” could be vehicles, heavy equipment, lease up, and more, but essentially it’s the assets of the business. And it’s also important to know and disclose what is the owner’s “stuff” and what is leased/rented to the firm and quite likely someone else’s “stuff.”
There is a way to get paid for the assets of the business, but unfortunately it’s what is often called an “Assets in Place” sale. An assets in place sale essentially means that the business isn’t cash flowing, but there are worthwhile assets that a new owner could build a new business upon and hopefully make their money back.
An assets in place sale is a type of an asset sale, but should not be confused with the deal structure options of an asset or a stock sale.
It Matters Because Business Buyers Compare Multiples
A business can be outpriced if it’s not priced near its peers. There are many ways to price a business, but the “Multiple of Earnings” market approach is the most common for small businesses and it’s a natural approach for buyers because it answers their question of how quickly they can get their money back.
If an owner prices a business at a 4x multiple of EBITDA (or SDE), buyers will likely forgo it because they can buy a business priced at 2 or 3x and get their investment back in two or three years instead of four.
The multiple of earnings approach normalizes businesses because businesses with assets should have their assets depreciated and thereby accounted for in the earnings calculation.
Depreciation of assets is the “D” in EBITDA, and it’s how assets are included in the market approach.
Owners Often “Over-Assetize”
I once evaluated a business and the owner asked me about getting paid for his assets after we agreed on his cash flow and common multiples for that cash flow.
When I asked him if the next owner would need his assets to make the money he was making, he stated that they could use cheaper assets to do the same job.
More specifically, he mentioned that he’d bought an $80K forklift, when a $40K forklift would have been sufficient.
This is not uncommon with business owners; they over assetize, or they have more assets than they need. While this can be great for an owner who needs to make a purchase for tax reasons before a year ends, it doesn’t help a valuation.
In these cases it could make sense to sell off non-essential assets before taking a business to market, or right size the assets that are essential.
A business should only have the assets needed to make the money it’s being sold for, and no more.
There’s a Difference Between Inventory and Assets
The good news is that inventory is totally different than assets. And because inventory is different than assets, owners can get paid up to the wholesale value of their inventory. Nonetheless, they should have a “normal” amount of inventory. The business should be advertised, and transferred with the amount of inventory that it utilizes to make the money it’s advertised to make in normal sales cycle.
Said differently; the can of beans is different than the shelf it sits on. An owner will be paid for the beans but not the shelf.
It Works The Other Way As Well
Some businesses are sold which make a lot of money but have little or no assets. SBA loans can be funded on primarily goodwill, and this is all that’s left when there are no assets. Entertainment facilities like escape rooms or home based service businesses often fall into this category.
Some business can be highly valued even without having a lot of “stuff.”
Categorization of Assets Vs Expense Matters
Owners should work with their accountants to ensure that business expenses land in the appropriate categories. Assets and liabilities should be accounted for on the balance sheet of the business, not the Profit and Loss statement.
A payment for a service vehicle could have elements of both, with a payment reducing debt off the balance sheet, but with interest that is expensed on the Profit and Loss statement.
The details of this accounting treatment will affect the assets and earnings of the business, and it needs to be represented accurately for the next owner to have a true picture of the cash flow.
Making Purchase Decisions Before Selling a Business
Because businesses sold through an asset sale are typically sold “free and clear” of debts, it’s important to consider leasing versus purchasing decisions.
Consider this story. A pool company rents all of their equipment for jobs finally decides it is too inconvenient to do so. They take out a loan and buy some heavy machinery just before deciding to sell their business. This owner is not excited by the fact that the debt of the new equipment would be expected to be paid off at the closing of the sale; that owner has essentially purchased new equipment for the next owner… They had purchased the equipment too close to the intended sale for the value of the asset to be worthwhile to enterprise value of the business.
Much like buying new tires for a car before selling it; an owner rarely gets back the money sunk into new assets for a business too close to a sale.
Conclusion:
Owners should pay attention to the investments they make in their assets. They should understand that buyers buy for the cash flow of the business and not the assets of the businesses.
Knowing the benchmarks for asset investments of an industry can help an owner properly allocate and not waste investment on assets. Furthermore, proper planning for the use of assets over the long term, in relation to the intended sale of a business, can help an owner get the most out of those assets. Finally, owners should make asset investments only in the amount needed for the company to efficiently make money.
Being judicious in investing in assets will enable an owner to have the most options for exit, and discussing with advisors such as accountants and intermediaries what the owner’s long term plans are, can help with decisions on depreciation and asset investment.
by Eric M. Magister, M.A. in Law | Business Valuation |
Quite simply, a business valuation is a process and set of procedures used to determine what a business worth.
Sounds unambiguous, right? But it takes more than just plugging numbers into a formula — a credible business valuation requires knowledge, preparation, and a thorough understanding of the business.
The result is an objective assessment of the real value of the business. In addition to estimating the selling price of a business, a business valuation can be used for many legal purposes such as divorce litigation, shareholder disputes, and estate or gift taxation.
The term business value is a broad term that refers to any form of business valuation which determines the financial health and potential of a company.
While a purchase or selling price is simply an amount that may be asked to be paid for 100% ownership of a given business, the intrinsic value of the business is a larger picture representation of what a purchaser or shareholders may expect to receive financially as a result of ownership.
Assumptions in business valuation may drive results
There are several ways to measure business value. Why? Because business value is seen differently by different people.
For example, a business owner may believe that their business is worth its intrinsic value. On the other hand, a private equity investor may assess a business solely on its ability to generate a profit.
Business value constantly changes. Positive changes in market conditions and a company’s strong financial performance will drive up the perceived value of the business. And when the market changes for the better there is almost always an increase in the number of potential investors. Thus, driving up selling prices.
Business Value can vary greatly depending on who will benefit from the analysis. For example, an entrepreneur seeking a business to fulfill personal goals will have a very different perspective than an investor looking for maximum financial growth potential, or a business owner looking to expand their portfolio of businesses.
Similarly, a competing business will value a business at a higher level for reasons such as synergies in resources and operations, administrative cost reductions, and increased market share opportunities post-acquisition.
In short, the market is the ultimate test of business value. But relying only on the market to determine the value of a business is ignores some basic principles. How the company is marketed to potential investors is essential to achieving the highest selling price.
Three business valuation approaches
By definition, a business valuation is a computational procedure used to determine the value of a business. In fact, there are three:
- Asset approach
- Market approach
- Income approach
Asset approach
Under the asset approach a valuation analyst adopts the view of a business as a set of assets and liabilities. The balance sheet elements serve as building blocks to create a picture of business value. The main asset valuation methods are:
- Capitalized Excess Earnings Method
- Asset Accumulation Method
The Capitalized Excess Earnings method uses complex formulas to calculate the value of a business as the sum of its tangible assets and business goodwill.
The formulas for the asset accumulation method are a set of adjustments applied to the business’s assets and liabilities.
When determining the market values of the business’s assets and liabilities it vitally important to include off-balance sheet items such as intangible assets and any contingent liabilities.
Market approach
Under the market approach a valuation analyst looks for signs from the real marketplace to figure out what a business is worth. The economic principle of competition is inherent.
The market approach to business valuation is a quick and simple way to determine a business’s fair market value. The methods under the market approach use valuation multiples, or ratios, that relate the business market value to some measure of the business’s economic performance. Valuation multiples are derived from the actual selling prices of similar, but not identical, businesses that have recently been sold.
Income approach
Under the income approach a valuation analyst calculates business value based on the business’s expected future earnings and risk. There are two main methods under the income approach:
- Capitalization methods
- Discounting methods
Depending on the method chosen the business valuation formula will differ. For example, the capitalization method divides earnings by a capitalization rate or earnings multiplier. The idea is that the business value is defined by business earnings and the capitalization rate is used to relate the two. The capitalization rate works very well for businesses with a steady stream of cash and predictable earnings.
On the other hand, the discounting method requires a projection of future cash flows which is then converted into present day dollars by applying a discount rate. Then a discount rate is determined which captures the risk of getting the projected income on time and in full.
The underlying assumption for the discount method is that the business will continue in perpetuity, therefore the business has what is known as a terminal value. By applying the discount rate to the forecasted earnings and then multiplying by the terminal value results in the present value of the business.
Business valuation reports
By definition, a business valuation report is a document detailing the scope, key assumptions, business valuation methods, and conclusions of a business appraisal agreement or calculation engagement.
The difference between the two versions of the business valuation report is the content and level of information provided. The appropriate report option and the level of information necessary in the reports are dependent on the intended use and the intended users.
Detailed appraisal
The objective of a detailed appraisal report is to express an accurate value of the business and an unambiguous opinion of value. Typically, all valuation methods that are relevant to the situation are applied. This type of appraisal is recommended if the valuation is intended to be used in court or for tax purposes. The results are expressed as a single amount.
Appraisals and appraisal reports of this nature must conform with the Uniform Standards of Professional Appraisal Practice.
Calculation report
The objective of a calculation report is to provide an approximate range of value based upon the performance of limited procedures agreed upon by the analyst and the client.
This report is an abridged version of a detailed appraisal report and typically excludes detailed analysis of the business and the industry. The distribution of a calculation report is limited only to the client.
A calculation report is often used for internal planning purposes such as the sale or acquisition of a business interest, business planning, succession, and estate planning.
by Eric M. Magister, M.A. in Law | Business Valuation |
Depending on the circumstances and objective of the owner, the value of a business can vary considerably. For instance, upon sale to unrelated party, an owner would expect to receive the maximum purchase price for their business the unrelated party is willing to pay. However, that same sale to a family member or employee may need to be structured so the cash flow of the business can support the purchase price.
For a closely held business, owners generally have little idea about the value of their business, or whether their business is generating an adequate return on investment, and what drives its value.
To bridge this gap, business owners should have a periodic valuation performed to track the performance of their business over time and identify critical factors that have a direct impact on business value.
Factors affecting the value of your business
When thinking about the business valuation and business risks in the hope of selling a business, there are many factors that require a cautious approach. Perhaps the most important factor to understand is the application of valuation discounts. The valuation of a controlling interest versus a minority interest within a privately held business can have different effects, depending on the circumstances. Due to the inherent differences between controlling and minority interests, the value of a minority interest is not equal to its pro rata portion of the whole. This is a direct result of the application of minority interest and lack of marketability discounts. Minority interest discounts reduce value in order to reflect the minority interest’s inability to control the company’s management and policies.
Lack of marketability discounts reflect the difficulty an investor would have in selling and ownership interest. Typically, investors consider how fast their investment can be turned into cash. Therefore, the market will pay a premium for liquidity or, conversely, exact a discount for lack of it.
It is important that the valuation analyst apply the appropriate valuation discounts to adjust the level of value indicated in the valuation method to the level of value being estimated in the valuation engagement. Failure to comply with the proper application of discounts can result in a serious distortion to the estimate of value and result in a meaningless valuation conclusion.
Another factor affecting the business valuation is the specific company risk premium. The specific company risk premium varies with each company and is intended to be an adjustment to reflect a variety of circumstances inherent in the company and its industry.
For a business valuation analyst engaged in determining an appropriate specific company risk premium, the following factors should be considered:
- Economic and Industry Conditions – National, regional, and local economic conditions can have a dramatic impact on a company. In addition, the industry in which the company operates may have more risk than the average of other companies and vice versa.
- Financial ratio analysis – A financial benchmark compares the company’s financial performance against companies of similar size within its respective industry. A comprehensive financial analysis addresses the strengths and weaknesses of the company in terms of size, growth, liquidity, profitability, asset management, and leverage.
- Management team – A company that is highly dependent upon the knowledge and expertise of a single person is considerably riskier than a company that has several key managers. In addition, the relationship between members of the management team can have a dramatic impact on risk.
- Competitors landscape – The level of competition in the company’s market can have a dramatic impact on risk. Does the company operate in a competitive market? What are the company’s strengths and weaknesses when compared to competition?
- Customer concentration – The diversification of the company’s customer base can directly affect risk. How strong is the customer base? Does the company depend upon only a few customers or a main customer for most of its revenue?
- Product concentration – The diversification of the company’s product line or service line can directly affect risk. Are profits highly dependent upon a specific product line or service line?
- Government regulations – Is the business highly regulated? Are there areas of future government regulations that could significantly impact the company’s operations going forward?
- Suppliers – Is the company heavily reliant upon a few suppliers that could have an adverse effect if relationships become difficult?
How to improve the value of your business
Understanding a company’s operating results is an important factor for a business owner to determine the value of a business. Comparing the company’s operations to the results of industry competitors is a great way to find out how they are doing financially relative to their peers. This exercise is known as benchmarking. Through proper comparison, a company can point out its operating strengths and weaknesses, asses management effectiveness, and identify areas where it is outperforming or underperforming the industry. Benchmarking is a fundamental part of the continuous improvement process which will improve the value of a business, but only if done so properly.
by Neal Isaacs, MBA, CBI, CM&AP | Business Valuation |
Most sellers are not sure if they are ready to sell until they know what their business is worth. In fact, the conviction to sell comes when the “pain point” exceeds the value of the business to the owner. A Broker’s Opinion of Value, or BOV, can help an owner determine what the business would sell for on the open market. This, in relation to an owner’s “pain” level, is often enough to make a decision if they are ready to sell.
What is “Pain” in Business Ownership?
Owners who are making money and in no pain typically don’t sell. But most owners have some level of pain in running their businesses and wonder what life would be like without it.
Owners normally have a challenge in quantifying how much pain they are in with their business. The most common forms of pain come in the form of burnout, poor health, or simply age. According to an annual survey by the IBBA and Pepperdine University the top reasons sellers go to market are for retirement, burnout, health, and relocation. These are all synonyms for the pain business owners experience.
To assist owners in determining their pain level, I like to ask them how much pain they are in on a 0 to 10 scale; 0 being pain free and 10 being they would give their business away for free (or pay someone to take it).
The other part of the equation is the value of the business. Contrary to popular belief, a business is not valued on how special it is, how many assets it has, or how late the owner worked the evening before he/she met with the broker! In fact, the Broker’s Opinion of Value takes a market approach, pragmatically determining the “Most Probable Sales Price” by approaching what the business would be worth to a future business owner, and then applying a multiple of earnings based in research of what similar businesses have sold for.
For example, if your apple juice business makes you $100K/year, and other people who have sold apple juice businesses that made $100K/year sold for $250K, a reasonable multiple of earnings is 2.5 times for apple juice businesses in the $100K/year earnings bracket.
A business broker trained in the nuances of putting together a Broker’s Opinion of Value, especially if he or she has been certified as a Certified Business Intermediary, can help an owner determine what their business is worth to a future business owner through a “Recast,” and search through comparable databases such as Deal Stats, formerly known as Pratt’s Stats or BizComps to get the multiple of earnings. Putting all of this together yields the Broker’s Opinion of Value.
What Is A BOV from A Greater Perspective?
It’s my contention that an owner can’t know if they are ready to sell until they know what their business is worth, so they can determine if they’ve “made it” to their financial goal, whatever that may be. While that goal may be subject to their ever-changing pain level, knowing that piece of the puzzle is an incredibly useful tool in determining if they are “ready.”
A BOV empowers an owner to know if they’re getting a good “deal.”
Most people don’t want to take advantage of a buyer on price, they just want to get what it’s worth. An owner receiving an offer on a business can’t know if they’re getting a good deal or not if they don’t know what it’s worth.
Most of my sellers expect way more for their businesses than they are worth, but sometimes I’ve had sellers tell me they turned down offers for their businesses that sounded extremely high to me when I saw their financials. They turned them down because they weren’t ready to sell or because they didn’t realize they were being offered something above what it was worth!
When Is A BOV Not A Good Fit?
Most business brokers, especially those in the “Main Street” and lower middle market segments are great at determining the value for privately held businesses that are being transferred from one owner or set of owners to another owner. For the sale of a business where partial equity is being shifted from one or more owners to another, a more comprehensive evaluation utilizing an evaluation accredited professional such as a Certified Valuation Analyst may be more appropriate.
How Much Does A BOV Cost?
Broker’s Opinion of Value pricing varies among brokers. Some don’t charge for a broker’s opinion of value because they view it as a tool to show owners how they do business, and they don’t want to engage with a business owner if the owner isn’t on board with the Most Probable Sales Price. Others charge a refundable, or non-refundable fee for the BOV contingent upon the sale of the business. In general, this cost ranges from $2-$5,000. From my interviews with Certified Valuation Analysts, their prices tend to start at the $3,000 mark and it’s not uncommon for an evaluation from a CVA to cost more than $10,000.
A Common Result of Working Through the BOV Process
Broker’s Opinion of Values are not necessarily easy for the seller or the broker. For the seller, tax returns, profit and loss statements, and more supporting documentation are requested going back several years. For the broker, a well researched Broker’s Opinion of Value takes several hours to put together.
by Holly Magister, CPA | Business Valuation |
For many entrepreneurs, launching a new business often means walking a fine line between pursuing earnings growth and growing the top-line revenue.
A business can’t be successful in the long-term without earning a profit, but it also must reinvest some of its profit to grow beyond a startup, expanding into new markets or geographical territories.
Understanding the differences between earnings growth versus revenue growth will help business owners prioritize their next growth steps and to recognize the difference between increasing profitability vs. increasing sales volume.
Earnings
Understanding the difference between “earnings” and “revenue” is critical to understanding the differences between earnings growth vs. revenue growth.
The term “earnings” is simply defined as the net profit earned from the operations of a business, or the amount of money left over after the business has paid all costs associated with operating the business.
When computing earnings growth, it is important not to include one-time events such as the sale of assets, interest income or expenses, lawsuit awards, etc. Such income and expenses are non-operating or finance related events. Earnings growth is measured from business operating income, not business net income.
Earnings Growth Rate Formula
- The earnings growth rate formula is as follows:
Earnings Growth Rate = {Total Earnings for a period minus Earnings for previous period/ Total Earnings Growth for Prior Period } x 100
- For example: If the Net Earnings in Year 2 and Year 1 was $480,000 and $400,000, respectively, then Earnings Growth Rate in year 2 would be: $480,000 – $400,000 = $80,000 and $80,000 / $400,000 = .20 X 100 = 20 Percent Earnings Growth Rate.
Revenue
Conversely, “revenue” is defined as gross income, or the total amount of money received for the sale of goods and services before any expenses are deducted. Be aware that revenue can be misleading as it applies to profitability, since it doesn’t take into account any business liabilities and direct or indirect expenses associated with the business.
Revenue Growth Rate Formula
- The revenue growth rate formula is as follows:
Revenue Growth Rate = {Total Revenue for a Period minus Total Revenue for Prior Period} x 100
- For example: If the Gross Revenue in Year 2 and Year 1 was $4,800,000 and $4,000,000, respectively, then Revenue Growth Rate in year 2 would be: $4,800,000 – $4,000,000 = $800,000 and $800,000 / $4,000,000 = .20 X 100 = 20 Percent Revenue Growth Rate.
Earnings Growth vs. Revenue Growth
Once we have a good understanding of earnings and revenue, we can explore how earnings growth and revenue growth are important indicators of how financially healthy a business may or may not be.
Typically, earnings growth refers to the annual rate of earnings growth as a result of investments of financial capital in the form of cash, inventory fixed equipment, real property and human resources (payroll).
Investors often use the average earnings growth to determine whether or not a business is worthy of investment. Generally speaking, the greater the earnings growth, the better!
Earnings is arguably the most important measurement of growth for a business, as earnings growth indicates the health and profitability of a business after all expenses are paid.
Conversely, revenue growth refers to the annual growth rate of revenue from total sales. The revenue growth metric is important because it provides an indication of the health of a business’s sales, and as such, revenue growth remains a popular method of assessing how successfully a business is at selling its own products and/or services.
When the revenue for a business is growing continually, and growing at an increasing rate year-over-year, it is a very good indication of a financially-healthy business. Such a business will be very attractive when it is time to sell the business.
It is important to keep in mind that (bottom line) earnings are somewhat dependent on revenue growth. If earnings are expected to increase over time, then it will be nearly impossible to do so unless revenue increases as well. In other words, reducing expenses by cutting unnecessary costs and creating operational efficiencies will only go so far in improving a company’s earnings. To achieve positive earnings growth over time, revenue growth will also be necessary.
While these two popular business measurements reveal two ways to evaluate the financial health of a business, they also work together to help business owners, lenders, and investors create a more complete picture of a business.
by Holly Magister, CPA | Business Valuation |
EBITDA Margin and Adjusted EBITDA Margin are similar measurements used by business owners and others who value businesses for sale. Let’s break down the two terms to help your understand which measurement of profit and cash flow are most relevant for your business.
EBITDA Margin or Earnings Before Interest, Taxes, Depreciation, and Amortization Margin is a measurement of a company’s “top line” operating profitability expressed as a percentage of its total revenue.
EBITDA Margin therefore provides outside investors, business owners, and potential buyers with a clear view of the business’s operating profitability and cash flow, since the valuation excludes interest, taxes, depreciation, and amortization.
Adjusted EBITDA Margin vs. EBITDA Margin
Adjusted EBITDA Margin differs from EBITDA Margin in that adjusted EBITDA Margin normalizes income and expenses, given the fact that not all companies treat income and expenses the same.
Because Adjusted EBITDA Margin standardizes cash flows and removes anomalies, it is a useful tool to compare multiple companies in an “apples-to-apples” fashion.
Adjusted EBITDA Margin is commonly used as a measurement of cash flow for mid-sized businesses because often owners of these businesses commingle personal expenses with business expenses and sometimes over or under compensate those associated with the business.
Adjusted EBITDA Margin Formula
Adjusted EBITDA Margin is calculated as follows:
Net income
Add or Subtract: anomalies such as below or above market rents paid to related parties, below or above market compensation paid to employees, one-time expenses or revenue;
Add: personal expenses deducted by the business paid on behalf of its owners;
Subtract: Interest Expense, Income Taxes, Depreciation, and Amortization.
Divided by Gross Revenue
Benefits of Adjusted EBITDA Margin
Adjusted EBITDA Margin, by definition, allows a direct comparison of multiple companies – regardless of size, location, or industry. It breaks down operating profit as a percentage of revenue, allowing other business owners or investors to understand how much operating cash is generated for each dollar of revenue earned.
Drawbacks of Adjusted EBITDA Margin
Because EBITDA excludes debt, there are some drawbacks to using adjusted EBITDA Margin to measure the performance of a company. Some companies may use EBITDA Margin deceptively to enhance the perception of their financial performance, especially if the company has a large amount of debt.
Additionally, EBITDA Margin is usually higher than profit margin, and companies that have low profitability may use EBITDA Margin as a way to present a deceivingly high level of financial success.
Lastly, EBITDA Margin as an accounting measure is not regulated by GAAP, making it possible for companies to skew numbers in their favor.
by Holly Magister, CPA | Business Valuation |
How could there be risks in your business relationships? For most business owners who’ve started a business from scratch, the notion of regarding as risky the many positive relationships they’ve built over the years with customers, vendors, and even employees is indeed a difficult concept to wrap their head around.
How could a customer who pays their invoice in a timely manner pose a business risk to you?
How could the company’s biggest vendor possibly be a problem?
And how could your most valuable employee – the one who stays late to get the job done and never complains – ever be your business’ downfall?
The answers to these questions have nothing to do with the great relationships you have built or with the underlying value of your customers, vendors, or employees. Rather it has everything to do with the unknown changes inherent in such relationships which no one can predict.
Change is an Inevitable Business Risk
Seasoned business owners understand that change in their business is inevitable and, when embraced, often results in growth. In fact, it often has been my observation that the most difficult, unforeseen changes result in the greatest opportunities for business and personal growth.
And for those business owners who choose to ignore or resist change, their path to success is perilous and they most often fail.
Why is there such a wide disparity between the two outcomes? It’s a very simple concept: the successful prepare for the inevitable and those who stumble and fall, refuse to do so.
Let’s review the three greatest business risks. Then we’ll cover how to prepare for them.
Customer and Industry Concentration Risks
Customer and industry concentration can be a problem in almost any business. Having more than 8% of the business revenue coming from one customer defines an undesirable customer concentration risk. And having the top three customers producing more than 20% of the business’ revenue is equally undesirable.
The loss of any one or more of these top customers for any business can be problematic.
You may be thinking that won’t happen to me because the owners of these businesses are my friends. They won’t abandon me or my business.
While that may be true, changes in your relationship with your top customers may not be a decision within their control or yours. They may be forced to close their business due to changes in their marketplace. They may die and their families may take over operating the business. And a hundred other things may happen over which you have zero control.
Similarly, your business may be serving a single or only a few industries, which is an industry concentration. For example, you may enjoy a special place working with medical device companies and your reputation has drawn several large accounts in this industry to your business. Such an industry concentration within your customer base is ultimately undesirable. It’s a business risk which you are unable to transfer to an insurance company!
I can hear your objections. You’re thinking “Wait a minute, I’ve worked hard to develop a niche for my business. It’s been a lot of hard work building the relationships I have in this industry. And now finally I’ve become a recognized player in this niche. And now, you’re telling me it’s considered a business risk?”
If you’re business has either a customer or industry concentration risk it’s understandable if you feel frustrated – or even insulted a bit – when you discover others regard your business as risky.
But the truth is lenders, investors, and business buyers are very good at evaluating business risks. And customer and/or industry concentration risks are on top of their radar screen.
Vendor Concentration Risk
Similarly, your business may be relying on one or two vendors that are critical to your ability to deliver products and services to your customers.
If this vendor suffers a disaster or is forced to go out of business, consider the consequences it may have on your business. Would your business be able to meet its obligations to its customers, employees, lenders, etc.?
Do you have an alternative supplier or service provider that would step in? And how long would that type of vendor transition take to get your business back on track?
Ask yourself these simple questions. Your answers will tell you what you need to do. And do it now.
Employee Talent Retention Risk
As a business grows and matures from a startup to a viable (and valuable) enterprise, the risks associated with retaining talented employees rises. Without these employees, your business would not be excelling. And that’s why the relationship between you and your employees is so vital to your long-term business and personal success.
Working with business owners who intend to sell or transfer their business to others, gives me a first-hand opportunity to observe how much can go wrong when selling a business. And without a doubt when selling a business, the human resources risk – specifically, key employees – is a very high risk.
Additionally, it’s not unusual for businesses in the growth stage to encounter major problems with key employees when communication is lacking and it’s not clear to employees what their rights and responsibilities truly are.
Good communications with key employees regarding their responsibilities and holding them accountable is not easy. In fact, I believe it is the single, most difficult goal for a business leader and owner.
Your Call To Action to Reduce Business Risks
The steps needed to address the inherent risks in your business relationships are an example of Napoleon Hill’s philosophy that accomplishments are achievable through persistence and good old-fashioned hard work. He believed “strength and growth come only through continuous effort and struggle.”
If you want to reduce business relationship risks, you’ve got some work to do…
1. Prepare yourself mentally for inevitable changes in your business and the relationships you’ve built. Holding onto the past is not a recipe for business success.
2. Evaluate your customer list to determine if you have a Customer Concentration (or Industry) Risk and work on reducing the concentration.
3. Build a contingency plan to address any vendor concentration risk.
4. Start the employer-employee relationship with a written Employee Agreement that spells out the confidential nature of their work, who owns the intellectual property developed in the business, how trade secrets are proprietary to the business, and whether employees are permitted to solicit your customers and employees if the employee ceases to be employed. And if you haven’t taken the steps to protect your relationship with employees, do so now. It’s not too late.
by Holly Magister, CPA | Business Valuation |
Book Value is defined as the total value of a company if it were to liquidate its assets and pay back its liabilities, or the value of the company according to the financial statement. Book value (BV) is also sometimes referred to as “shareholder’s equity.”
Business Book Value Equation
The book value is calculated by subtracting intangible assets (like patents) and liabilities (including debt, accounts payable, and notes payable) from the value of the company’s total assets (including any land, equipment, and real estate).
Book value = total assets – intangible assets – liabilities
Book Value Uses
Understanding a business’s book value allows you to know that portion of a company’s assets to which shareholders would be entitled in the event the company was liquidated. It’s a measure that allows investors to know whether or not it is a good time to purchase or invest.
Book Value Vs Market Value
While the book value is the value of the company according to its financial statements, the market value is the value of the company according to the stock market if it’s a publicly-held company, or to investors if it’s not. Market value is calculated by multiplying outstanding shares by its current market price per share. BV allows interested parties to determine whether the company’s stock is over-or undervalued, when compared to it’s market value.
When the market value is greater than the book value, the market believes that the company’s assets have a higher earning potential. Most profitable companies will have a market value that is higher than the book value.
When stock trading prices for a company fall at or below BV (a price-to-book ratio below 1.0), the company is undervalued and shares are trading at prices lower than what they are actually worth. This means that the company’s book value is greater than the market value, and the market may have reason to believe that the company’s assets have lost their ability to generate a profit or a return on investment at the same rate in the future.
Book Value Limitations
While book value certainly has purpose, it’s important for business owners and investors to understand its limitations. BV is only a representation of numbers on a balance sheet, and does not factor in any additional market data or the value of the company’s intellectual property (IP) which has not been recorded in the accounting records. Such IP may include items such as trade secrets, customer lists and contracts, employment agreements, and research and development for new products and services to name a few. BV should be only one tool among many used when valuing or analyzing a company or its stock for sale.
by Holly Magister, CPA | Business Valuation |
Net equity value is the fair market value of a business’s assets minus its liabilities. This measured value is used to determine a business’s net worth – or the funds that would be left over and available to shareholders if all liabilities and debts were paid off.
The Net Equity Value Equation
Net Equity Value = (enterprise value + cash and cash equivalents + short and long term investments) – (short term debt + long term debt + minority interests).
Why Net Equity Value is Important to Small Businesses
Banks use net equity value to determine the financial health of a company. When determining whether or not to underwrite a business loan, most banks will first analyze the this equation or equity value. Because this measurement weighs a business’s current assets against its current liabilities, net equity value offers an analysis of how much the business is worth as collateral for a loan.
Many business owners mistakenly believe it’s okay to show net losses on the business’s tax return each year. Intentionally doing so may contribute to a long-term problem when it’s time to obtain business capital, or to increase the company’s working capital line of credit. Bank lenders track the Net Equity for the business applicant over time going back as far as five or even ten years. The bank loan underwriter looks for at this long-term trend and finds it favorable when there is increasing Net Equity over time. When that’s not the case, especially if the trend is declining Net Equity, obtaining bank capital is very difficult.
Net Equity vs. Net Assets
Although similar, net equity and net assets differ in one important way. Net assets are defined as total assets minus total liabilities – where inventory is included in the company’s assets. Conversely, the net equity value calculation does not include inventory as a part of the business’s assets. Fluctuating inventory will affect a company’s net assets day-to-day, but will not affect the net equity value in the same manner.
by Holly Magister, CPA | Business Valuation |
The discount rate can be defined in several ways. For purposes of this post, the discount rate will be defined as it relates to small and medium sized businesses (SMBs) and the Discounted Cash Flow (DCF) valuation method.
As it applies to a business investment appraisal, the discount rate is that interest rate which is applied to the DCF business valuation method in order to determine what the expected future business income will be expressed in terms of present day dollars (or current market value). This measurement is always less than 1.0 and will vary depending on the cost of capital and the expected time horizon between when the investment is made and when the investment will begin to deliver positive cash flow.
The discount rate in the DCF takes into account the time value of money and the risk and uncertainty of future cash flows. In fact, the greater the uncertainty regarding future cash flows from the business, the greater the discount rate will be.
Discount Rate Equation
In order to calculate the discount rate (also called the discount factor or present value factor), the following formula is used:
1 / (1+r)^n
Where r is the required rate of return (or interest rate) and n is the number of years between present day and the future year in question.
How to Apply the Discount Rate to Evaluate a Business Investment
The discount rate is used to calculate the DCF Valuation of a business and the formula is:
| PV = CF1 / (1+k) + CF2 / (1+k)2 + ….. [TCF / (k – g)] / (1+k)n-1 |
Definition
PV = Present Value
CFi = Cash Flow Year i
k = Discount Rate
TCF = Terminal Year Cash Flow
g = Growth rate assumption in perpetuity beyond the terminal year
n = Number of periods in the valuation model (including the terminal year)
Ultimately, the DCF valuation will produce a value of the business (the Present Value of the future cash flow while applying the discount rate) which then can be compared to the asking price of the business.
If the DCF Valuation exceeds the asking price, generally speaking the investment is considered to be a good one. Alternatively, if the DCF Valuation is less than the asking price, the asking price may be too high.
The Discount Rate is only one important part of the Discounted Cash Flow valuation method. Knowing that the projected cash flow from a business investment is accurate is critical to a proper evaluation. If the projected cash flow is exaggerated, intentionally or otherwise, the value of the business investment can be dramatically skewed. A prudent investor should scrutinize projected cash flow carefully.
Similarly, the other assumptions in the DCF Valuation must be considered carefully. Each factor has a unique impact on the ultimate computation.
The discount rate used in the DCF Valuation method is only one way to evaluate whether a business for sale is properly priced. When used in tandem with other business valuation methods, it can help a business buyer make a sound decision about the asking price of a business for sale.
by Holly Magister, CPA | Business Valuation |
The Discount for Lack of Marketability, or DLOM, is a discount applied to a company’s value when an ownership interest cannot be converted to cash quickly, and free of excessive expenses.
Companies that would otherwise struggle to sell shares or ownership may need to apply a discount to make the business more attractive to a potential buyer.
As an example, your shares of Apple stock would sell quickly, and are easily converted to cash. Because Apple is a well-known, profitable, and respected company, its shares are highly marketable. Conversely, interests in private businesses are much more difficult to sell.
Selling ownership in a private sector business is more difficult because there is usually no willing buyer for them, making shares less liquid. Instead, when selling a private company, business owners should expect considerable time, effort and expense, as documentation must be assembled, intermediaries must be found, and sales must be negotiated and closed. It’s because of these issues that small as well as medium-size businesses are not “liquid,” and a discount is often applied to their value.
Determining the Discount for Lack of Marketability
Although there is no one way to measure what a discount for lack of marketability should be, there are two common approaches for calculating the discount for a small, medium, and/or privately-held business. The first is to compare the sale price of restricted stock of similar public companies to the sale price of unrestricted stock of the same company. Doing so helps determine the discount for lack of restricted marketability.
The second method is to compare the price of a company’s private stock sale transactions with the discounted public stock prices offered in its IPO shortly thereafter.
Components of the Discount for Lack of Marketability
Risk and return – An investment’s risk and return profile is determined largely by if and when dividends are paid, how long an interest will be owned, and how retained earnings will be reinvested – among other factors.
One-time transaction costs – When private businesses are sold, owners must factor in legal fees, brokerage fees, accounting fees, and other one-time costs.
Time value of money – It may take several years to sell a private business, creating an opportunity cost for investors forced to hold on to an illiquid investment.
Unique circumstances – Other unique circumstances may make a business unmarketable. An example is a bad reputation, recent controversy, or problems with real estate. These issues will factor into a business’s ability to sell ownership and impact any need to discount the sale price.
Shareholder complexities – It is generally more attractive for a company to have a single shareholder, rather than multiple shareholders – regardless of the percentage of ownership. Shareholder disagreements and disputes can be costly and time consuming, especially in the sale of a private business. Also, simply the presence of multiple shareholders in a closely-held business erodes the likelihood of achieving a quick sale because it may be difficult for the shareholders to reach agreement over the terms proposed by a willing buyer.
by Holly Magister, CPA | Business Valuation |
The term business value is a broad term that refers to any form of business valuation which determines the financial health and potential of a company. While a purchase or selling price is simply an amount that may be asked to be paid for a 100% ownership of a given business, the intrinsic value of the business is a larger picture representation of what a purchaser or shareholders may expect to receive financially as a result of ownership.
Business Value Factors
There are several factors that should be weighed when considering Business Value for a company. These factors include economic value, employee value, supplier value, customer value, partner value, community/societal value, and managerial value. Additionally, intangible assets such as intellectual capital, goodwill, and brand recognition should also be considered. These factors may not hold an actual numeric value in the financial statements, but they certainly contribute to the business’s overall performance and health.
Determine for Whom the Business is Being Valued
Business Value can vary greatly depending on who will benefit from the analysis. For example, an entrepreneur seeking a business to fulfill personal goals will have a very different perspective than an investor looking for maximum financial growth potential, or a business owner looking to expand their portfolio of businesses.
Similarly, a competing business will value a business at a higher level for reasons such as synergies in resources and operations, administrative cost reductions, and increased market share opportunities post-acquisition.
Choose A Valuation Method
The most common standards of value used in small and medium-sized business valuations include fair market value (monetary amount that a buyer may offer and seller accept in exchange for the business), investment value (the value of a business to a particular business investor or owner), and intrinsic value (the value of the business’s true economic potential).
There are a number of methods commonly used to value a small business. A few of these include:
and other various forms of business valuation formulas.
by Holly Magister, CPA | Business Valuation |
Capitalization Rate, more commonly referred to as Cap Rate, is the rate of return on a real estate investment based on the income the property is expected to generate. In other words, the Capitalization Rate is used to estimate an investor’s likely return on investment in a property if the property is purchased with cash. Capitalization Rate is used commonly to compare potential real estate investments and may also be used to compare potential businesses for sale.
Calculating Cap Rate
The Capitalization Rate is calculated by dividing the investment’s net operating income (NOI) by the current market value of the property (or alternatively, the original capital cost). NOI is defined as the annual return on the property minus all operating costs.
Capitalization Rate = Net Operating Income / Current Market Value
The Capitalization Rate is expressed as a percentage.
How to Apply the Cap Rate
Compare investments – By comparing Capitalization Rates, an investor can quickly determine which properties would provide a higher return, and therefore have a higher risk premium. For example, if one property has a Cap Rate of 10% while another similar property in a comparable location has a Cap Rate of 5%, we know that the property with a Cap Rate of 10% comes with more risk, and offers a higher potential return on investment. Alternatively, the property with a cap rate of 5% presents less risk, but also a smaller potential return on investment.
Evaluate Trends – When Capitalization Rates form a trend, they can offer an indication of where the real estate market is headed. Look at trends for comparable markets and properties over a period of a few years, particularly in a sub-market, to identify trends. If Cap Rates seem to be compressing, investors can assume that values are being bid up. Evaluating historical Cap Rate data offers insight into the future direction of property valuations.
The Cap Rate Can Be Deceiving
Keep in mind that while the Capitalization Rate can be an incredibly useful tool for predicting market trends and evaluating property investments, there are limitations to its use. First, when using the Cap Rate to compare the potential return on investment for multiple properties, it is critical to keep in mind that the properties should be similar. A number of factors can affect a property’s potential return on investment – including location, size, age, tenants, and economic fundamentals of the region (population growth, employment growth, etc.). As such, a certain amount of the Cap Rate is subjective.
Additionally, if a property has a complex or irregular net operating income stream, only a full discounted cash flow (DCF) analysis will result in a reliable valuation.
The Capitalization Rate is also not very useful for short term investments. Because short term investments often don’t have enough time to develop reliable cash flows, the investment’s NOI can be hard to determine, making a Cap Rate calculation difficult and unreliable.
Some Capitalization Rates are calculated by dividing the NOI by the original amount the current owner paid for the property. But because market values can fluctuate significantly over time, only using the most current market value will result in a reliable Cap Rate.
Despite these shortcomings, the Capitalization Rate remains a simple and popular valuation tool for real estate investors. Yet by weighing in a number of external factors – including the growth or decline of the property’s value, alternative investments, and market trends – investors can feel confident about using the Cap Rate in their analysis.
by Holly Magister, CPA | Business Valuation |
EBITDA Valuation is an industry multiple or ratio method that is used commonly to determine the Enterprise Value of a company operating in the lower-middle or middle market. It differs from the method typically used by small businesses (also referred to as Main Street Businesses) in that it is not based on the Seller’s Discretionary Earnings (SDE)..
Having gained wide acceptance in the investment and banking communities, EBITDA Valuation is a measure of the company’s cash flow stream. The usefulness of calculating an EBITDA Valuation is in the assessment of a company from the perspective of an outside investor, taking into account factors such as debt and equity.
EBITDA Valuation Formula
Begin by determining your company’s EBITDA, or earnings before interest, taxes, depreciation, and amortization. EBITDA creates a basic picture of a company’s profitability and its ability to make payments on its outstanding debt for a given year. Such payments include interest and principal. EBITDA may be calculated as either a 12 month projection or instead from the previous 12 month’s data. And it’s not unusual for Adjusted EBITDA to be used in the computation.
Enterprise Value = EBITDA * Enterprise Multiple
To compute the Enterprise Valuation of a business, you take the EBITDA amount and multiply it by an enterprise multiple to get the total enterprise value. The enterprise multiple is dictated by the business’ industry, the cost of capital, and the overall health of business. This multiple fluctuates over time which is why it’s very important for business owners, small and large alike, to understand what the current industry multiple is and the factors which have an impact on its direction.
What Is the Enterprise Multiple?
The Enterprise multiple is a statistically derived ratio from recent comparable business sale transactions in a given industry. Additionally, while a single enterprise multiple may be sufficient for calculating Enterprise Value, more often, a range of comparable multiples – from the low end to the high end – is used to calculate a useful spectrum of possible Enterprise Values.
Enterprise multiples often vary by industry, and higher multiples should be expected in higher growth industries (like tech). Lower multiples are often expected in lower-growth industries (like railroad construction). EBITDA Valuation multiples are valuable especially in the appraisal of asset-rich industries, such as distribution, wholesale, manufacturing, real estate, and technology.
For investors and purchasers, an enterprise multiple may be used to determine whether a company is under or overvalued, as a low ratio would indicate an undervalued company while a high ratio may indicate an overvalued company.
Calculating Enterprise Value using EBITDA and an industry multiple creates a snapshot of a company’s value as a functioning business entity which incorporates its underlying debt.
How Is the EBITDA Valuation Used?
Because enterprise value includes debt, it is considered an ideal valuation method for evaluating companies for potential mergers and acquisitions. As an example, a company with a low Enterprise Value would indicate a good candidate for a merger or acquisition.
Factors to Consider When Using EBITDA Valuation Method to Value Equity
Be mindful that when using the EBITDA Valuation method to assess equity, it does not take into account important factors such as working capital and capital expenditures – both of which may possibly have a significant impact on the business’s cash flow.
by Holly Magister, CPA | Business Valuation |
Seller’s Discretionary Cash Flow (SDCF), also sometimes referred to as seller’s discretionary income (SDI) or seller’s discretionary earnings (SDE), is a computation often used when valuing a small or medium-sized business.
While larger, public companies are often valued using the price/earnings ratio (or the price of the stock divided by the company’s earnings) and Enterprise Value, smaller, private businesses may use a number of alternative methods to determine a fair sale price.
SDCF describes the pre-tax and pre-interest profits (EBIDTA) before non-related income or expenses, non-cash expenses, an owner’s compensation, one-time expenses, and adjusted expenses.
The ultimate purpose of SDCF is to calculate what a new owner could expect in terms of annual earnings. Typically, the SDCF is multiplied by a factor which results in the value of the small-to-medium sized business.
Each industry has its own customary factor for the valuation computation and over time the factor will increase and decrease due to changes in the industry.
SDCF Calculation
As described above, SDCF is calculated using six primary figures.
Begin with pre-tax and pre-interest profits (EBITDA) – Earnings before interest, taxes, depreciation, and amortization.
Add non-related expenses (or perks) and subtract one-time income – These include any income or expenses not related to the businesses annual operations. Examples may include, extended business trips for personal vacation, or car expenses when the business does not actually require a vehicle.
Income from a windfall, such as a lawsuit settlement, is an example of one-time income which would distort the normal SDCF if not subtracted.
Add one time expenses – This may include major website redesigns, certain licenses, one time fees, etc.
Add a single owner’s compensation – Add back the compensation from a single owner. Additional owners’ incomes who hold positions within the company should be adjusted for fair market value.
Account for adjusted expenses – Adjusted expenses may include any expense that will change over time, may arise in the future, or may be related to replacement expenses for equipment or other assets needed to operate the business which have exhausted their useful lives.
The SDCF Calculation Isn’t Always Black and White
This calculation tends to not be an exact science, but instead both the buyer and seller must come to an agreement about what exactly will be included in the SDCF calculation.
In fact, it is not uncommon for the buyer and the seller to disagree about the factors and the amounts added and subtracted to determine the SDCF for a business. For this reason, the business owner intending to sell his business should remove personal expenses from the business as much as possible.
Gray areas where the buyer and seller may disagree on the value of an earning, expense, or replacement cost often include:
Replacement Owner’s Benefit – For any company where there are multiple owners who are actively working for the business, only one owner’s benefit can be added back into earnings. An additional owner’s earnings should be adjusted to reasonable market rates (or what it would cost the new owner to fulfill the role based on the current market). Determining these values can sometimes lead to debate between buyer and seller.
Replacement Costs – Replacement costs are projections of what it might cost to replace current assets, and may be a source of disagreement for the buyer and seller. As an example, the seller may argue that some replacement costs may not be necessary, while they buyer may overestimate replacement costs or their frequency.
One Time Expenses – One time expenses typically are added back into earnings, since they are not ongoing costs. However, some of these “one-time” expenses may be disputed as recurring, such as a website design. In this example, a website redesign is typically considered a one-time cost although it can be argued that, at some point, the website will undergo additional updates or redesigns.
If you are considering selling your small or medium-sized business, understanding the SDCF is essential for valuing your business and setting a fair sale price.
Be prepared to negotiate through some of the less-concrete numbers, including those items above that often lead to disagreements between buyer and seller.
