Business owners are always looking to know what their business is worth. Often, it’s just out of interest, perhaps, they know what they’re doing is worthwhile. Sometimes, evaluation is forced upon them through such circumstances as divorce, estate planning, partner buyouts or death of a partner. Whatever the reason is a business valuation is not a simple process.
The process of performing a proper valuation involves three basic steps.
- Analyze and evaluate
- Understand the industry and potential buyers
- Compile and report
While most business owners believe, as they should, that they understand their businesses inside and out. This understanding may not be properly reflected in the business financial statements. Business owners tend to be focused on what is going to generate the business the most immediate profit and cash flow and not necessarily concerned with how the business would operate if somebody else was running it. This is key to the valuation process because in understanding the value of your business you need to understand how much money and cash flow someone else can make from running the business. We spend about a third of our time analyzing the financial statements for the business going back three to five years. We want to look for items that are not market related, non-recurring and out of the ordinary. As part of this process we will compare the business outcomes with independent industry sourced information. This information is available at the cost and is part of the running costs of an accredited evaluation service.
Once we understand the target business and have a good idea of what it’s cash flows will be in the hands of another owner, we need to evaluate the industry and the market to see what buyers are prepared to pay for this type of business. Businesses all differ in terms of their risk. The risk is that cash flows, historically, will not be repeated in the future. Not all cash flows are equal, some businesses have cash flows that are relatively certain into the future. Some businesses have cash flows that are highly susceptible to changes in the economy, changes in staff, and changes in all manner of things. For example, a business like Verizon has relatively secure future cash flows because revenues are for the most part built on annuity revenue models. A contractor on the other hand may not know where his next six months revenue is coming from. Our job is to analyze industry statistics to assess how investors in the past have rated the target business and its industry and we do this through various models including earnings multiples and discount rates.
Finally, when we have a clear understanding of what the cash flows of the business, and what we believe the market will pay for that type of cash flow; we begin the process of preparing a comprehensive report explaining all of this. Our report tends to be 20 to 30 pages and is very comprehensive. It will explain, in detail, the adjustments made to the business financial statements to arrive at what we believe to be the sustainable earnings and cash flows. It will evaluate the potential valuation models that are appropriate and select two valuation approaches that we believe to be suitable. And we will then detail the calculations and assumptions made in arriving at the final valuation of your business.
The typical valuation that we undertake will take between 3 and 6 weeks depending on the availability of information.
Many people believe they can simply take their net profit for the year, multiply it by 3 or 4 as they seem to think as reasonable, and that’s the value of their business. While this may be useful it certainly is not going to win anyone over or convince a buyer that your business is worth you what you arrive at. Our process above, although not necessarily designed for a buy sell transaction, is a tried and tested and legally accepted process for determining a fair evaluation for a business.
Business owners typically make two big mistakes in trying to assess the value of their business. The first mistake is that owners run their businesses on a day-to-day basis. They look at daily cash flow, manage their business from the bank statement, and look to take any opportunity to cut taxes and costs, without taking into account the effect this may have on the value of the business. The second mistake is that owners only see their business as their investment and not from the perspective of the buyer. Many clients I’ve dealt with over the years get offended by the amount that their business is valued at. Owners often feel this way because the effort and personal sacrifice that a business owner puts into a business in an attempt to provide for their family and to make something from their business makes it feel like their business should be worth a lot more. The reality is that a buyer does care about what’s going on personally and the amount of sacrifice that you may have put in, the buyer is looking at a specific set of circumstances and facts that will generate a return for his or her transaction and not what the seller thinks he ought to pay.
Sellers will often result in what is known in the industry as “Rules of Thumb”. “Rules of Thumb” are industry related rules that approximate the value a business could be sold for based on certain metrics. “Rules of Thumb” are just not necessarily hard rules, they are more of suggestions and they probably oversimplify the process of establishing a fair value for a business. For example, an accounting practice may sell for 1 – 1.2 times the annual billings of the practice. At the county practice may sell for one to 1.2 times annual revenues. However, we know that buyers will only buy a business for money that they can take out of it. If you work through the normal methodology that we would follow: establishing a sustainable and realistic cash flow, determining a risk-related rate of return or multiple, and calculating a true valuation you may end up with a different number. For example, if the accounting practice is unprofitable and only makes enough money to pay the owners a reasonable salary, then you would argue that the businesses is not actually worth anything. Why pay a premium to buy a business that would only pay you as much as you could earn working for someone else. These are the types of debates we often have with business owners and this is why a professional valuation is always worth obtaining if the goal is to arrive at a fair market value for the business.
By contrast, a professional value will look at market statistics gathered by professional organizations such as Business Valuation Resources, IBA, First Data, BizComps and others. They will apply these statistics to the results of the target business over a period of time, typically 3 to 5 years of historical values. As a professional valuer, I will spend a lot of time analyzing the historical results of the business to iron out and understand all aspects and anomalies such as owners pay, related party transactions, appropriate rent and payroll costs and more. This analysis is not only necessary to produce a fair valuation, but it provides a wealth of information for the business owner to better understand the value metrics of their business.
Having your business valued can be extremely useful whether you want to sell or even if you just want a full detailed report on your cash inflows and outflows. Like previously mentioned, a lot of business owners want to look for ways to cut costs. Having your business valued, will give you all of the information on where you can cut costs or raise revenues. As a business minded CPA, I have always looked at businesses from entrepreneurial perspective and have over 30 years of experience in doing so. Formerly, with the entrepreneurial advice division of PWC and having run my own businesses for over 15 years, we understand what it takes to make the payroll and costs each period. We will never compromise our integrity or standards, but we will do our best to understand your business and give you a true and honest evaluation.