Business Valuation for Private Companies
Understanding the Basics
Years of hard work have gone into building your business. Now it’s time to sell and receive your reward for the risks you¹ve taken and the extraordinary effort you¹ve put forth. The purpose of this brochure is to provide some basic information to owners of privately held companies to assist them in understanding how to value their business.
Enter the world of business valuations. As a lawyer specializing in providing legal counsel to sellers and buyers of privately held companies, I am very much a part of that world. I have been involved, over the past 20 years, in hundreds of transactions where the value of the business is of primary importance. Although my role is not that of a professional business appraiser, I deal with business valuations questions and issues on almost a daily basis.
- Overview Of Appraisals
The business appraisal process is applicable in many situations. Appraisals are performed in matters involving; (i) estate and gift tax valuation; (ii) divorce; (iii) business dissolutions; (iv) employee stock ownership plans; (v) buy/sell transactions between business owners; (vi) purchase of minority ownership interests; (vii) purchase of family member’s interest; (viii) purchase of dissenting shareholder interests; and (ix) financing/investment opportunities. The first four areas usually involve situations in which the company is not being sold and there is no true arms-length transaction to determine the value. The last five areas listed may involve an arms length transaction, but value is still being determined without the benefit of an actual purchase or sale of the entire company. It is the absence of an arms-length sale that makes the appraisal process necessary. Appraisals are not generally used, at least formally, however, in the context of valuing a business for sale. The proposed sale price of a company is generally obtained from four primary sources. The business intermediary (business broker or investment banker) will undertake an in-depth analysis of the business and will generally be the most influential in establishing value. The intermediary, although usually skilled in providing appraisals, will, in most acquisitions, not perform a formal appraisal nor produce a written appraisal report. Most formal appraisals are performed in those situations noted in the prior paragraph. Input on the proposed sale price is also obtained from the interested party’s certified public accountant, attorney and other business/industry acquaintances. In some cases, the CPA may also engage in providing business appraisal services.
- Return On Investment
The ultimate criteria that a buyer looks at in valuing a business is “return on investment.” Buyers determine value/price by determining what reasonable rate of return will be required based on the risk of the investment. Investors looking for a high degree of safety and certainty invest in treasury bonds and are happy with a “reasonable” return around 5%. High risk investors may elect to go with pork bellies or an unknown high risk (but possibly highly profitable) start-up company and would expect a “reasonable” annual return of 30% to 50% because of the high degree of risk involved. In assessing what the return on investment will be, the company’s profit is recalculated or recast. This recast profit usually reflects profit before deducting interest, taxes, depreciation and amortization (and is referred to as “EBITDA”). In addition, recast profits include add backs for any extraordinary expenses and excess compensation. Recast profit is then used to calculate value.
- Calculating Value Based On Return On Investment
Purchasing a privately held company would generally be considered to be in the middle to high risk range. Expected annual returns for business acquisitions will fall within a range of 15% to 30%. For example, if you purchase a business for $10,000,000, and sell the business in five years, you should receive an annual return ranging from $1,500,000 to $3,000,000. Whether that return is paid out each year or at the end of the fifth year when the business is sold does not matter as long as you receive your targeted return and the company can meet its cash flow requirements. Value is arrived at by translating the expected rate of return into a “multiple.” The multiple is determined by dividing the expected rate of return by 100%. For example, if you require a 20% return then the multiple would be five (100% ÷ 20% = 5). The multiple is then multiplied times the recast profit to determine value (see Section II regarding “recast profits”). For example, if recast profit equals $2,000,000 and the multiple is 5, the company value would be $10,000,000. Why do some companies have a value based on a multiple of 2 or 3 while others have a multiple of 15 or 20 or higher? Low multiples may apply when you are just buying or selling a job (service companies). Much higher multiples will be used if the company has a proprietary product or intangible assets that may not be reflected on the balance sheet and earnings are poised to increase geometrically. Ultimately, there are many factors which come into play when establishing price.
- Factors Affecting Value
- All of the following factors will impact the multiple used to determine price:
- Financial performance (past and projected)
- Management (depth and experience)
- Capacity of facility and equipment
- Condition of assets
- Market/Product strength (national and international)
- Cyclical or seasonal nature
- Industry conditions
- General economic conditions
- Systems in place
- Number of customers
- Availability of components/parts
- Proprietary rights
- Liability profile
- Intangible assets
- Other Appraisal Methods
Beginning with a targeted rate of return on investment to arrive at a multiple is a good beginning, but some valuation reality checks should be inserted as part of the valuation process. These reality checks involve applying some basic appraisal methods. Two of the primary appraisal methods used are: (i) discounted cash flow; and (ii) market comparisons.
Discounted Cash Flow.
The discounted cash flow method values the future cash flow stream in today’s dollars. In other words, how many dollars should an investor spend today based on the dollars that the business will generate each year thereafter. Factors used to determine the discounted cash flow include: (i) annual percentage growth rate; (ii) percentage profit margin increase; (iii) discount rate; (iv) capital expenditures; (v) working capital requirements and (vi) perpetual growth rate. Slight variations in one or more of these five factors (1% up or down) can lead to significant fluctuations in value, so each assumption used to establish each part of the equation is critical.
The market comparison method can only be used if there is current market information for companies that reasonably match the profile of your company (industry, size, profit, geographic location, product mix, etc.). In most cases it is hard to find true market comparables for private companies. The terms and conditions of private company sales are not generally publicized and are not readily available. There are certain groups that compile information on private company sales that investment bankers may have access to. Note that an exact match is not always necessary. For instance, public companies can be used as private company comparables by making prescribed adjustments.
Generally more than one appraisal method is used in order to provide a cross check against the other method or methods. The results of each may be averaged or a weighted average may be used, with the most extreme values (high or low) given the least weight. The discounted cash flow and market comparison methods can be checked against the return on investment analysis as discussed earlier. Note that any formula value has to take into account all of the factors noted in Section 4 to account for the unique characteristics of each business. Top^
- Performance Payments & Stock Deals
Terms affect the price. A buyer will pay more if the purchase terms provide for a small down payment with a long term, low interest, unsecured note. Price may also increase dramatically if the seller is willing to get paid on a performance basis (e.g. if buyer achieves targeted sales and or profits in the future, seller gets paid more). The price can go even higher in a stock deal. Buyers who can use their stock (almost always a public company or a company preparing to go public) to acquire another company are generally willing to put a much higher value on the seller. Sellers should, however, proceed with caution on some of the more creative deal structures. The old adage that “cash is king” should not be totally abandoned. Receiving cash may reduce “value,” but at the end of the day, could be worth a lot more than the “paper” the seller may end up with, such as a note or stock certificate in someone else’s company. The sale of assets instead of stock may also increase the price because the buyer may obtain additional tax benefits. Top^
- How Net Worth Affects Value
A high-tech company with only a formula written on a piece of paper or software contained on a disk may be worth $50,000,000 but a manufacturing company with a balance sheet reflecting $20,000,000 of assets, a $10,000,000 net worth and a liquidation value of $2,000,000 may only have a value of $5,000,000. This is because the high-tech company may be expected to generate $5,000,000 or more per year in profits while the manufacturing company is projected to only earn $1,000,000 per year. Price is not based on asset values or net worth but on the return the Buyer can expect to get on his investment. Asset values and liquidation value are distant secondary factors in the valuation process and may only be relevant to the extent they provide some protection against a total loss of the buyer’s investment. Top^
- Marketing & Negotiations
Two of the biggest factors that will determine the value of your business are; (i) proper marketing; and (ii) effective negotiating. I have witnessed numerous cases where prices have increased as much as 20% to 50% because the business intermediary/broker brought a number of qualified buyers to the table to bid on the seller and the negotiations were handled in a way that increased both the interest of the buyers and the price. Top^
- To Sell Or Not To Sell
Age and Lifestyle.
Is it time to do other things and take advantage of other opportunities.
Value Verses Operating Income.
Continuing operations and taking profits for an additional two or three year period and then selling may be the only way to get the value that you desire. This analysis should, however, include the loss of earnings from sales proceeds and the emotional and physical toll of working an additional two or three years.
Taxes; Return on Investment and Estate Planning.
Determine if you can live on a reasonable investment return on after tax dollars generated from the sale. Analyze the benefits of a tax free transaction or a charitable remainder trust. Determine whether or not the business should be passed on to family members to avoid being taxed both on the sale of the business and then again when the proceeds pass through your estate.
The business acquisition market is cyclical. If you elect not to sell while merger and acquisition activity and prices are high then you run the risk of selling in a soft market or having to continue operating the business until there is a market rebound. Top^
- Cyber Information
The Internet is a good source of business valuation information. Some suggested sites are:
Yahoo On The Money
- The Final Analysis
Facts, figures and formulas comprise a large part of the business valuation process and can provide critical information in arriving at a base-line value for your business. In the final analysis, however, the price paid for the business will be largely determined by making the most of the attributes of the business through your negotiating skills combined with the marketing abilities and negotiating skills of your professional advisors.