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Cashing Out...
What Is Your Business REALLY
Worth?
by Elena
Fawkner
The way you arrive
at a value for your business can give you much-needed ammunition when it comes
to justifying your asking price and therefore allow you to influence what the
prospective purchaser is willing to pay.
* * *
Question: What is your business REALLY worth?
Answer: Whatever someone else is willing to pay for it at the time.
That's a true statement as far as it goes, but it doesn't take into account
that the way you arrive at a value for your business can give you much-needed
ammunition when it comes to justifying your asking price and therefore allow you
to influence what the prospective purchaser is willing to pay.
Here's a quick primer of the various methodologies commonly used for valuing
businesses (for purposes of imminent sale or otherwise):
1. Asset Valuation
This is used by businesses with predominantly physical assets, especially
inventory. Typical businesses that would use this approach are manufacturing and
retail. The valuation takes into account the following figures: (a) the fair
market value of fixed assets and equipment; (b) the value of leasehold
improvements; (c) owner benefit (the seller's discretionary cash for one year -
comes from the adjusted income statement); and (d) inventory.
2. Capitalization of Income Valuation
This is used by businesses with predominantly intangible assets. It places no
value on physical assets, only intangibles. Typically used by service
businesses. Under this method, various factors are given a weighting of 0-5 with
5 being the most positive score. The average of these factors yields the
"capitalization rate" which is then multiplied by the buyer's
discretionary cash (75% of the owner benefit defined in 1. above) to arrive at
the market value of the business. The factors to be rated are:
(a) owner's reason for selling
(b) length of time the company has been in
business
(c) length of time the current owner has owned the business
(d) the degree of risk
(e) profitability
(f) location
(g) growth history
(h) competition
(i) barriers to entry
(j) future industry potential
(k) customer base
(l) technology
3. Capitalized Earnings
This method is based on the rate of return anticipated by the investor. Small
businesses are expected to have a rate of return of 20-25%. So, if your small
business has expected earnings of $10,000 for the year, its value may be $40,000
- $50,000.
4. Cash Flow
This method is simply based on how much of a loan the purchaser could get based
on the adjusted cash flow of the business. The adjustments to cash flow are for
amortization, depreciation and equipment replacement. Obviously, when using this
method, the value of the business fluctuates with changing interest rates.
5. Discounted Cash Flow
This method discounts the business's projected earnings to adjust for real
growth, inflation and risk. It calculates the value today (i.e., discounted for
time) of the business's future earnings.
6. Leapfrog Start-up
This is used when the buyer wants to save him or herself the cost, time and
effort of ramping up a new business. The buyer estimates what it would have cost
to do the startup less what is missing plus a premium for saved time. The more
difficult, expensive or time consuming the start-up would otherwise be, the
higher the value that will be arrived at using this method.
7. Excess Earning Method
Similar to the capitalized earnings approach, but the return on assets is
separated from other earnings which are deemed "excess" earnings
generated. The return on assets is usually determined by industry averages.
8. Owner Benefit Valuation
This method is based on the seller's discretionary cash flow. It is usually used
for businesses whose value comes from its ability to generate cash flow and
profit. The formula is to simply multiply the the owner benefit by 2.2727.
9. Rule of Thumb Methods
These are rough guides based on industry averages. Many industry organizations
have developed methods for their particular industries. They are highly
unscientific and hardly rigorous but act as a good "gut-check". You
certainly wouldn't use them on their own but they can be useful to check that
the value you've arrived at using a more scientific approach is in the ballpark.
10. Tangible Assets (Balance Sheet)
This method is basically a value of the business's current assets and nothing
else. Typically used where the business is losing money. This approach will
usually be utilized when selling the business is just a matter of getting the
best possible price for the equipment, inventory and other assets of the
business. A good strategy is to approach other firms in the same business that
would have a direct use for such assets.
11. Multiple of Earnings
A multiple of the cash flow of the business is used to calculate its value.
12. Value of Specific Intangible Assets
The value of the business is based on how much it would have cost the buyer to
generate the intangible asset. Typically used where specific intangible assets
that come with the business are highly valuable such as a customer base.
Customers with a high likelihood of being retained are valuable in most
industries.
The most appropriate valuation method for you depends very much on the nature
of your business. If you manufacture widgets, for example, you'll want to use
the asset valuation method. If you offer website design services, on the other
hand, you'll want to use the capitalization of income method instead. If you're
selling a web-based business where the major asset is your high traffic volume
and/or list of ezine subscribers, you will probably want to use the value of
specific intangible assets method, such as 10 cents per subscriber (or whatever
the going rate is).
Is more than one valuation method applicable to your business? If so,
calculate the value of your business in accordance with all of them and see
which gives the best result (i.e., highest value). Another good approach is to
average your calculations to get a reasonable ballpark figure.
Whichever method you choose, understand it inside out so that when the time
comes, you can authoritatively justify your asking price to potential buyers.
Pulling a figure out of thin air without any substantiation whatsoever is much
less impressive than being able to say, with confidence, "I worked with my
advisers using a number of different methodologies to value the business. We
adopted the value of specific intangibles method because the backbone of the
business is our large, loyal ezine subscriber database. We also calculated it on
the basis of capitalization of income, which yielded a similar value. I can show
you the calculations if it will help you see where the number comes from."
By following this approach you may not necessarily get the value you are
after (for this reason, many sellers artificially inflate their asking price so
they have room to be negotiated down), but at least you have a solid starting
point for negotiations and are much more likely to be able to negotiate a price
both buyer and seller are able to live with.
* * *
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Copyright 2001 by Elena Fawkner
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