There are many reasons one might want to establish the value of a business. If you are selling your business, you likely want to know what your business is worth to establish an asking price. If you are a buyer, you will want to ensure that you are not overpaying for a business you are purchasing. You will also want to understand more about the future earnings potential of the business.
Business valuation experts, also called appraisers, try to make the evaluation process a science by attempting to overtly assess risk factors and to appropriately wait those. The net result of engaging evaluation expert will likely be a lengthy report, typically generated with the help of a software package, and costing between $1500 and $5000. Such reports are frequently used for valuing estates, litigation, and business acquisition loans. Recently I needed such a report to move a business ownership from a 401(k) plan at the approach of that magic age where a minimum distribution would be required from such plan.
The question frequently arises as to how useful such reports are to business buyers? The answer is: not very! While they can be used to establish rough parameters of the true value of the business, the truth is the value of a business is dependent on many other factors that often don’t show up in such reports. Most business sellers and buyers are familiar with the heavy use of comparable sales data in the residential real estate world. It is this very same comparable sales data that is most commonly used by business valuation experts. But a key difference that exists between the residential real estate world and the business sales and acquisition world is that in residential real estate most of the key variables are well-known and public data. For example, we know the location of residential property, the school district it is in, and the physical attributes of the unit (such as number of bedrooms, number of bathrooms, and square footage).
In valuing businesses, frequently the relevant data on comparable sales is less well known. For example, it is not unusual for a business to have it sales concentrated among a small number of customers. In such case a known (or unknown) change in the status of one of those customers can have significant impacts on the business’ value.
So what are our options for setting a sales price if you are a seller, or understanding what you might be willing to pay if you are a buyer? This is neither a simple nor perfected process. Almost universally, the process of establishing a value for business starts with comparable sales within the same industry and geographic area. Generally, such a process starts with the gross sales of the business or the seller’s discretionary earnings or EBITDA. We will explore in future posts what those measures are, how they differ from one another, and why which one is most useful may depend on the business. As Ian MacLachlan, president of business team states, “how should a buyer assess the risk of say customer or vendor concentration? There is, as far as I know no easy way. There are many variables affecting even this one variable such as customer stability, lack of alternatives, ability to diversify and others. The subjective aspects can sometimes be tempered by research and due diligence but cannot be reduced to a meaningful certainty.”
[To be continued]