What Is a Business Worth?
Many courts and the Internal Revenue Service have defined fair market value as: “The amount at which property would exchange between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having a reasonable knowledge of relevant facts.” You may have to read this several times to get the gist and depth of this definition.
The problem with this definition is that the conditions cited rarely exist in the real world of selling or buying a business. For example, the definition states that the sale of the business cannot be conducted under any duress, and neither the buyer nor the seller can be pushed into the transaction. Such factors as emotion and sentimental value cannot be a part of the sale. Surprisingly, under this definition, no actual sale or purchase has to take place to establish fair market value. That’s probably because one could never take place using the definition.
So what does make up the value of a privately-held business? A business consists of tangible and intangible assets. The tangible assets are the most visible and the ones on which buyers too often base a judgment on the value of a business. Factors of value, fixtures, equipment and leasehold improvements are often valued first by the buyer. Well maintained equipment and attractive interior surroundings are the first things a buyer sees when visiting a business for sale. Make no mistake, regardless of what prospective buyers may say, the emotional impact of a physically well-maintained business can be a very positive factor. In addition, it is much easier to finance tangible assets than intangible ones.
However, buyers have to consider what is really behind those well-maintained tangible assets. There are many businesses, especially today, in which physical assets play a very small part in the success of the business. These intangible factors include: the business’ reputation with its customer or client base, and within its industry; mailing lists and customer/client lists; quality of product or service; reputation with its vendors and suppliers; strength of the business’ technology and other systems; plus many other factors that can add a lot more value to the price of the business than can shiny equipment.
Although the intangible assets listed above cannot be seen, they are certainly an important part of the business – and purchase price. Businesses that don’t need expensive fixtures and equipment can, in many cases, be expanded more quickly and inexpensively because they do not require cash-intensive equipment purchases. Buyers, to their own detriment, do not want to pay the same price for equivalent cash flow for businesses that do not have lots of equipment. They want to buy tangible assets.
Business brokers and intermediaries know how to point out to prospective buyers the advantages of businesses that may not require lots of equipment but have those all-important intangible assets that create steady cash flow. Business owners who have a service or other type of business that does not rely on the heavy use of tangible assets and are considering selling, should talk to their professional business broker/intermediary who can point out the pluses and the hidden assets of the business.
“There are many reasons for valuing an entity, and those circumstances can lead to different outcomes…For instance, a business’s value for sale on a going-concern basis will differ from its value for liquidation purposes. It similarly makes a difference if the valuation is for an orderly liquidation as opposed to a forced one. For example, the value of a company for estate-tax purposes (fair market value) likely will differ from its value for a sale to a specific purchaser (investment or strategic value). In some instances involving litigation, the courts or the law may dictate which standard of value to use.”
Source: Journal of Accountancy , August 2003
The two variables – EBIT and DCF numbers – are affected by not only the financial aspects of the business but also the non-financial aspects, which can be both objective and subjective. For purposes of buying or selling a company, it is important for the seller to determine the floor price (the lowest acceptable price) and for the buyer to determine the walk-away price (the highest possible offer). Valuing companies may be more of an art than a science, but there are three basic factors that buyers focus on when trying to establish a price for a target company.
- Quality of Earnings
i.e., not a lot of “add-backs” or one-time events like the sale of real estate which does not reflect on the true earning power of the company’s operations. It is not unusual for companies to have some non-recurring expenses every year, whether it is a new roof on the plant, a hefty lawsuit, write-down of inventory, etc.
- Sustainability of Earnings After the Acquisition.
The key question a buyer often asks is whether he is acquiring a company at the apex of its business cycle or whether the earnings will continue to grow at the previous rate.
- Verification of Information
i.e., the concern for the buyer is whether the information is accurate, timely and relatively unbiased. Has the company allowed for possible product returns or allowed for uncollectible receivables? Is the seller above-board, or are there skeletons in the closet?
When a seller talks about earnings, earnings really needs to be defined; e.g., EBIT or EBITDA; last year’s earnings or this year’s projected earnings; EBITDA – CAP X; restated without prerequisites but with add-backs, etc.
When a buyer is analyzing earnings, is it for one year, three years, interim earnings annualized, combination of reporting periods, projections, etc.? What is the timeframe for measuring earnings and what is the trend of earnings?
Another concern in measuring earnings in the future is related to what changes might affect earnings, such as increase in rent, family members off the payroll, loss of key customers and/or vendors, etc. Beware of companies that are locked into long-,term contracts in which they are unable to raise prices or companies in a commodity-type business in which there is unrealistic market pricing.
The following questions are useful to understand the business and thereby value the company more prudently:
- What’s for sale? What’s not for sale? Does it include real estate? Are some of the machines leased instead of owned?
- What assets are not earning money? Should these assets be sold off?
- What is proprietary? Formulations, patents, software, etc.
- What is their competitive advantage? A certain niche, superior marketing or better manufacturing?
- What is the barrier of entry? Capital, low labor, tight relationships?
- What about employment agreements / non-competes? Has the seller failed to secure these agreements from key employees?
- How does one grow the business? (Maybe it can’t be grown.)
- How much working capital does one need to run the business?
- What is the depth of management and how dependent is the business on the owner/manager?
- How is the financial reporting undertaken and recorded and how does management adjust the business accordingly?
Much of the information above will influence the person’s perception of value. Valuation is often in the eyes of the beholder, whether the price is rational or not.
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