There are several factors that can positively and negatively affect a business valuation from the point of view of the buyer. Some common factors that add value to a business valuation include:
- The organization, including its employees and internal processes
- Its reputation in the industry
- How well the business fits with the acquiring business, including the culture
- Terms of the final deal
- How “hot” the industry is and if it’s getting hotter
- Overall market conditions
- Other intangibles
- Timing of the offer
- Number of competing offers
Click here to see a video of Ron Chernak, a business broker talking about intangible assets that add value to a business valuation.
When I sold my first business, the payment was to be made in the acquiring company’s public stock. Since it was during the dot com era, stock prices reflected the good market conditions and were on the rise. Also, the acquiring company had a hard deadline for the transaction since it needed to complete the transaction prior to its year end close. This deadline added value to my business so I began to increase my demands as the closing date got closer. Therefore, I was able to leverage several factors that enhanced the value of my business from the prospective of the buyer.
On the flip side, there are factors that can discount a business valuation from the prospective of the buyer, including:
- Employment-related liabilities
- Environmental liabilities
- Litigation liabilities
- Tax liabilities
- Product warranty liabilities
- Contract liabilities
- Duress by seller such as health or monetary issues
- Lack of time to complete the deal on the part of the seller
- Not using an intermediary to remove emotions
- Coming to an agreement too quickly/easily
- Only one offer
- Overall seller naïvety since a buyer may buy many businesses while a seller often only sells a business once
Click here to see a video of Ron Chernak and John Zayac two owners of large M&A brokerage houses, explaining ways to enhance or detract from a company’s business valuation.
How to Value an Existing Lifestyle or Micro Business
When it comes to buying a business, size does matters. Most lifestyle or micro businesses have under 1 million in annual sales. When it comes to lifestyle and micro businesses, the owner is also the top manager.
For business valuation purposes, a good rule of thumb for a marketable lifestyle or micro business is that the owner should generally earn about 10 to 20% of the gross sales.
Therefore, a lifestyle or micro business that does $400k in revenue should have an owner that earns between $40k to $80k per year from owning and working in the business.
Often when the million dollar gross sales per year threshold is eclipsed, the owner’s income drops to 10% or less. This drop is mostly due to the need to increase management,which leads to thinner margins, and higher inventory or carrying costs.
In summary, the important issue for you as a buyer is how much can you expect to earn?
When it comes to lifestyle and micro businesses where the owner is responsible for managing employees, taking care of customers, and other day-to-day activities, the owner likely views bookkeeping as a low priority. If anything, he relies on compiled financial reports and is far less inclined to use these reports to run their business. Therefore any financial records provided by the seller may be less accurate and require more due diligence on the part of the buyer.
From the prospective of an accountant or a banker, the value of a business is purely based on historical financial statements, which can be an incomplete view of a company’s real value.
Other factors that drive the value of a business valuation is its location, equipment, inventory, employees, patents, existing customer base, industry, vendor supplier relations, completion, and what you plan to do with the business after a sale. Therefore, you cannot rely on your accountant or banker to define a quantitative value of a business you are looking to buy.
Other value drivers aside, another rule of thumb is that businesses often sell for a little more than two times discretionary earnings.
To understand discretionary earnings, you must first understand that a small business is an economic entity that provides a product or service that customers buy in sufficient quantities to allow the owner to pay all costs and operating expenses, including the owner’s salary.
Let’s say that water represents revenue and a bucket represents the volume of all non-discretionary costs and operating expenses such as rent, employ salary (including a fair wage for the owner), marketing, insurance utilities, etc.
The lip of the bucket represents the breaking even point of discretionary income. The water or revenue that overflows the bucket is considered discretionary income.
Let me be clear– discretionary income is not yet profit since the surplus revenue can be used in a variety of ways. The owner can use the surplus to buy more inventory, increase his promotional expenses, pay off debt, or pay himself more money.
It is the discretionary income that is most often used in a business valuation. According to a business broker’s friend, with over 15-year experience selling businesses, the average selling price for lifestyle and micro business was 2.3 times the business’s discretionary earnings.
5 Reasons for a Business Valuation
There are many reasons to conduct a business valuation. Some business valuations are pretty straight forward while others can be quite complicated. If there is a good possibility that the valuation will be challenged on legal grounds or by the IRS, it is often best to have the business valuation performed by a qualified appraiser.
That said, I have counseled scores of clients on business valuation issues and I have come to the conclusion that there are five primary reasons for conducting a business valuation.
- The first and clearly the most popular reason for conducting a business valuation is related to some form of merger & acquisition (M&A) activity. Most of the time, it is the buyer that is attempting to value the business they are considering buying.
- Another reason to conduct a business valuation is related to estate planning. When a family owned business is passed on, there may be estate and gift taxes involved. The American Tax Relief Act of 2012 set the exclusion of estate and gift taxes at $5 million with a maximum of 40% estate tax above this threshold.
- As new members enter and exit a closely held business, there is often a need to establish shareholder or membership values for some form of buy/sell arrangement.
- Intergenerational transfers of ownership often involve transferring a mix of assets to several parties. Allocating them among the parties requires an understanding of the value of the asset.
- Finally, some owners choose to covey their ownership to their employees through an Employee Stock Ownership Program (ESOP), which requires credible evidence of the value of the business.
This post originally appeared in SteveBizBlog.com and was derived from content from just one chapter in the book “Buying or Selling a Small Business”. Buy the compete book at Amazon.com.
When you buy the book you get links to exclusive streaming videos from experts in the Merger and Acquisition (M&A) space as they comment on key aspects and provide valuable insight based on their professional experiences with buyers and sellers.