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There are many ways to compute the value of a business, and an equal number of differing opinions regarding a particular methodology’s relevance to an entrepreneur who starts and grows a viable business. But what seems to truly matter most to the entrepreneur who has sold or transferred his business successfully to a new owner, is just how much cash is left after paying taxes on the transaction. And yes, there are more than a few ways to get to that number.
With that said, the entrepreneur growing a business should find it worthwhile to understand business valuation methods, terminologies, and purposes. And even more important to know what is most relevant when valuing a business for sale and what can be done to improve the business’s valuation.
How is a Business Valued?
While there are exceptions to this rule, businesses are valuable if they make a profit. The more profit they earn, the greater their business valuations.
Yet in recent years two exceptions to this widely accepted measurement of business value have been in the news headlines. Included are stories about businesses in the high tech and digital industries with virtually no revenue being acquired for multiple millions. In some cases, it’s even billions. In such cases, the buyer is not acquiring the business for its profit or cash flow. Instead, for the high tech buyer with deep pockets, the name of the game is acquiring intellectual property and/or human talent. Simply stated, in the constantly evolving technology sector it’s easier to buy than to take the time to develop one or both of these precious and very valuable business assets. Accordingly, acquisitions are numerous in these high tech and digital industries.
But for most industries, business value is based generally on one or more measurements tied to earnings (or in other words, profit) or gross revenues and multiplied by a ‘factor’. The measurements may include one of the following:
1. EBITDA – Earnings Before Interest Taxes Depreciation and Amortization
2. EBIT – Earnings Before Interest Taxes
3. SDE — Seller’s Discretionary Earnings
4. Gross Revenue less sales tax (if applicable)
The factor applied to (or multiplied by) one of the measurements above to compute a business valuation varies widely by industry and with other economic factors. For example, a professional services practice may be valued by multiplying 1.2 (or something similar) by the gross revenues earned in the last twelve months. On the other hand, a retail Pharmacy may be valued by multiplying a factor of 4.0 by EBITDA. Then in each case and in all other cases as well, adjustments are made to the computed value for assets that normally would be included in the sale. Such assets may include the fair market value of fixed assets, inventory, accounts receivable, etc. Likewise, the inclusion or exclusion of the business’s liabilities affects its valuation.
Enterprise Value is a concept used by middle market businesses and businesses poised for an Initial Public Offering (IPO). This valuation concept computes a business value on an enterprise level, meaning its valuation includes the capital structure necessary for operations post acquisition. Enterprise Value often exceeds other business valuation computations due to the inclusion of working and permanent capital.
What Increases a Business Valuation?
For the entrepreneur growing a business, knowing what can be done to increase business valuation should be a priority. In many cases, entrepreneurs don’t focus on increasing the business valuation until they begin the exit planning process. This is not prudent.
It’s important to understand there is more than one way to build or grow a valuable business. In order to understand the reasons for this being the case, it’s best to take a look at what motivates business buyers.
Business buyers are motivated to acquire another business to meet either a financial or strategic goal. If the buyer is motivated for financial reasons alone, he will be looking for positive, consistent cash flow from the business operations and adequate capital structure to sustain day-to-day cash needs. In this case, the buyer will be primarily focused on cash flow. The Mergers and Acquisitions (M&A) industry refers to this type of buyer as a ‘financial buyer.’
On the other hand, if the buyer is motivated to acquire a business to meet a strategic goal, the business’s cash flow may not be important at all. In certain industries, producing sufficient cash flow is unlikely to occur for many years due to the intensive need for capital investments. One such industry would be digital mobile application development. It takes a great deal of cash to develop and operate such a business so cash flow is low and in most cases non-existent. This does not mean that the business is not valuable. In fact, such a business acquisition may be extremely valuable to the right ‘strategic buyer.’
But very few businesses have the luxury of selling to a strategic buyer. So if it is the entrepreneur’s intention to increase their business’s valuation, it is advisable to focus on increasing cash flow and developing the proper capital structure to allow the business to grow over time. Additionally, by developing good cash flow and capital structure, the entrepreneur will experience fewer growing pains.
Business Valuation Reports
There are many forms of business valuation reports and each has its own purpose. A business valuation report associated with a cross purchase agreement is not identical to a business valuation report required in litigation. Business Valuation Reports are customized with the end need in mind.
Tools to Improve the Value of a Business
Learn more about How Entrepreneurs Increase the Value of their Business.
My business partner and I have agreed it’s time to sell our business. We do not know what the business is truly worth and we are debating whether we should have an official business valuation done or not.
We haven’t contacted brokers yet and don’t want to be uninformed about our business’ value when we do.
What do you recommend?
As a Broker we find that most business owners do not accurately know what their business is worth so do not feel isolated in that respect.
Our experience is that “official valuations” are often best for Estate Planning, Tax Defense and Divorce. Many times the results of an “Official Business Valuation” and the value that a willing buyer and willing seller end up agreeing on are quite far apart and to further frustrate the situation such valuations are very expensive. For this reason, sometimes; having an “Official Business Valuation” sets an owner up with unrealistic expectations. We find this to be more true with smaller businesses and as the enterprise value of a business goes up in size the two begin to correlate. Thus, without knowing the size and type of business you operate I offer this comment for cautionary purposes.
In our practice we focus on what each of the 5 buyer-types would see as positives and negatives to acquiring your business as the basis for our “market-based-valuation”. We arrive at this opinion of value after having you take a questionnaire that measures your business against a database of over 34,000 other businesses in North America. Next, we couple that data with a fairly in-depth review of your tax returns, P&L’s, AP & AR, inventory, assets, balance sheet, customer concentration, IP/technology and a number of other questions if your facilities or location are key to producing the business results.
Taking into account all of these variables and bouncing them off metrics of how each buyer-type typically ranks them in importance allows us to come up with a range-of-value that represents the range of offers you should expect to receive if you market the business for sale. We find this approach is far less expensive and much more useful in the selling process as it serves as the basis for conversations with you about what is most and least “valuable” about your business as well as serving as the foundation to defend our/your opinion of value in due diligence and final price allocation discussions with the purchasing party. We actually, offer the survey and results at no-charge to help you know where you stand against your peers. Feel free to email me if you’d like a link to take the survey. It takes about 15-20 minutes to complete.
The 5 buyer types are: 1. Family or succession, 2. Financial, 3. Strategic, 4. Individual, and 5. Foreign.
Since I know nothing about the size, type or nature of your business I cannot expound on the various metrics that will sway each type in your situation.
I can however, assure you that the value of your business is actually a range and not a static figure. This comes as a surprise to many sellers; but when you see that there are 5-types of prospective acquirers it begins to make sense that they will value your business differently based on the void that they are trying to fill in their individual growth plans.
For instance, a strategic acquirer (possibly a competitor) might focus on redundant labor, facilities and processes that can be eliminated and thus provide margin enhancement via cost savings. On the other hand, a financial or foreign buyer (possibly a private equity group) will likely need all personnel, facilities and systems to remain intact as their growth plan will focus on increasing sales and taking market share.
The key to getting the most out of a sale is to engage a broker that will perform pre-sale due diligence prior to marketing. This keeps control of negotiations in your court, allows marketing to include multiple buyer prospects fostering competition and most importantly – lets you strategically disclose difficult items and topics throughout the process on your terms which should set you up to negotiate a very short due diligence period and a quick closing. (Due diligence is the phase of greatest risk to you, the seller, losing the deal or having it trade-down).
I could go on and on but will stop here. However, I’m happy to visit with you and talk specifics about your unique situation if it will help you in this process. Feel free to call anytime at (800) 694.6950 and best of luck on this exciting and kinda scary adventure you are embarking on.
Another business broker’s opinion here… I think the decision to get an “official” business valuation depends to some degree on whether the decision between your business partner and yourself is contemptuous or not.
Most business brokers such as myself will provide a “Broker’s Opinion of Value” or “BOV” as a complimentary service or at a price far less than what a Certified Valuation Analyst or similar professional would charge.
With a BOV you would have one more data point to determine whether you and your business partner agree on that value and could amicably move forward with a sale at that price. If there is disagreement as to the value and especially the equity involved, taking the evaluation to the next level with an “official evaluation” at an increased cost may be the answer.
I am selling a small S corp. I owe taxes and the buyer wants to assume the irs debt rather than pay me the whole amount right away. Does the irs allow the buyer to assume the debt?. If they default does the irs come back to me?
The taxes associated with and owed by an S Corporation usually include payroll taxes, sales/use taxes and possibly local business privilege taxes. Such taxes, if not paid, are always the responsibility of the business owners. This is true even if the business owner sells the business to another party.
When you sell a business, regardless of its size, the buyer should request tax clearance certificates from the government before (or as a condition of) the sale of the business.
As for IRS taxes in an S corporation, these are most likely payroll withholding and/or payroll taxes owed by the business. Such taxes will always be considered your responsibility, if not paid in full.
I realize this information may not be what you were hoping to learn. I am sorry about that.
I recommend you seek counsel from either a CPA or Tax Attorney as you negotiate the sale of your business so it’s handled properly and you can put the IRS tax matters behind you. We have advisors who can help you if you don’t have such help. Here’s where you may request assistance.