Understanding that the correct price for your business is the highest price a buyer is willing to pay should make valuating it an easy proposition. But knowing you’ve gotten the most possible from your years of investment and hard work is as difficult as being certain you got highest possible dollar value for your home. It’s complicated — half art, half science.
Further complicating the issue, a decision to sell your business isn’t the only time you’ll need to determine its worth. Valuations are also needed if you want to obtain a loan, arrive at a figure for a buy-sell agreement, gift an interest in the business to your children or calculate estate taxes upon the owner’s death.
Fortunately, there are several steps and several experts who can help determine a value that is fair to all parties involved.
Valuation methods
Many methods are accepted as appropriate for determining the value of a business. People hear commonly about earnings multiples and balance sheet approaches, but none are necessarily more common than another, nor are they one size fits all.
- Multiplication (or capitalization) of earnings — establishes a price by multiplying past or current earnings,
- Excess earnings — works much like earnings multiplication but splits off return on assets from other earnings,
- Cash flow — determines the worth of a business according to its ability to service debt and pay expenses,
- Balance sheet — establishes a price based upon the net value of a business’ equipment, inventory and other assets,
- Cost to create — calculates value based on a new owner’s costs to staff, lease, obtain fixed assets and to develop intangibles, such as licenses, copyrights, contracts, etc.,
- Rule of thumb — relies on industry-specific rules of thumb (usually best used in concert with another method),
- Value of specific intangible assets — considers the buyer’s desire to purchase an intangible asset versus creating it.
The method right for you should depend on the type of business you run. If you have a manufacturing business, you may want to go with the balance sheet method where you have an appraiser come in and determine the value of the equipment. Service businesses, however, are usually lean on assets. And if the business is especially dependent on an individual, it’s far more difficult to determine a value for sale purposes because its value is so dependent on the individual and relationships he or she has built with clients. If it’s not so individual-dependent, as in the case of a retail business, appraisers are more likely to use the earnings multiplier model, which usually looks at three times annual earnings.
Establishing value
Unfortunately there’s not a standard way to come up with a value for each business. Some larger companies will turn to business valuation consultants, an effective but expensive option. Most businesses, however, find they can get the help they need from trade associations and others in their business.
Bankers, accountants and attorneys are also key consultants to help in the process, especially when you’re considering selling your business. In addition to helping you arrive at a fair price, they can help you weigh the tax consequences and determine how best to structure the sale. For example, would it be more advantageous for you to take cash up-front or spread payments out over five years? Would you benefit more from a stock sale or asset sale? How should you allocate the price to various assets to minimize taxes?
Preparing to sell your business
After learning how best to valuate your business, you’ll want to determine what business assets you want to sell (e.g., equipment, inventory, tools, customer lists, accounts receivables, real estate, etc.).
Keep in mind that in the valuation process, a little foresight can help increase the value of your business. Try to anticipate both the assets and the information a prospective buyer will want. Be prepared to offer a long list of documents to justify your asking price:
- Financial statements and tax returns for the last three to five years,
- Corporate books, records and cash flow analysis,
- Asset list, including equipment, inventory, accounts receivables, long-term contracts and customer lists,
- List of liabilities to be assumed/retained,
- Employment information, including contracts, a list of benefits offered to employees and a list of accrued vacation, sick or personal days,
- Vendor/supplier list,
- Insurance contracts,
- Lists of any government orders or environmental issues,
- Survey and building plans,
- A list of licenses needed to run the business.
It’s also helpful to have an idea of what you as seller would be willing to or want to do after the sale, especially in terms of signing a noncompete agreement or continuing to work in the business after the sale.
Before information is released to a prospective buyer, however, assure yourself they are serious and financially able to complete the purchase, and require they sign a confidentiality agreement.
One rule of thumb
Whether you’re valuating your business for a future sale or an operating loan, the process can be complex. Rules of thumb are difficult to apply — with one exception: Don’t rely on only one opinion.
Talk to more than one person. Talk to trade association contacts and others in your business. Talk to your accountant about valuation methods. Talk to your attorney for advice on structuring the sale. Talk to your banker about his or her experience in valuating businesses like yours for loan purposes.
Consulting a variety of resources may require more time, but the payoff in getting a fair price for your hard-won business will be well worth the added investment.