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Prepare To Exit

Exiting a business with financial success takes knowledge and planning.

Change is an inevitable aspect of every life cycle. With business, the final evolution can take a variety of forms. You may be ready to retire and pass the business on to a family member. Perhaps your goal is to sell to outside investors and use the proceeds as a retirement nest egg. Or the business may have declined so much that the best exit is a legal dissolution of your company. These tools and resources will help you manage the big decisions ahead for a successful transition.

How do you value your business?

Alvin Fritschle

By Alvin Fritschle

Alvin Fritschle is the Chairman of the Board of First Bank, a community bank serving Southeastern Illinois and Southwestern Indiana. He has provided financial advice to numerous entrepreneurs for over 40 years as a certified public accountant and the President of First Bank. Over this time, he has demonstrated a strong commitment to assisting his clients with their strategic decisions.

If you have made the decision to sell your business, one of your biggest challenges will be to determine its value. Most entrepreneurs have worked hard for several years to build their business, and it is often the most valuable asset they own. The sales price of your business will have a major impact upon your retirement income. Because of this importance, most entrepreneurs will hire a certified public accountant or a business broker that is familiar with their industry to give them an objective and thorough evaluation of the market value of their business.

Many people consider arriving at a value for a company to be a ’subjective science’. The are several approaches to mathematically determine the value of a company. Each of these approaches has positives and negatives that will work well for some, but will not work for all industries and all buyers. The circumstances of each buyer are different. As an example, an individual purchasing your company to continue it as a stand-alone company has a different future expense structure than a company in a contiguous market wanting to expand into your market. The price they would be willing to pay may be significantly different.

No mathematical formula can determine what your business will be sold for, but it can provide you with a starting point for negotiation with a potential buyer. In the end, your business is worth what someone else is prepared to purchase it at and the value at which you are willing to sell it.

Factors that impact the value of your business

Because of the complexities in determining the value of your company, it is worth the entrepreneur’s time to understand how the value is arrived at. The following summarizes some of the factors, other than sales growth and income, that may influence the value of your company.

  • Tangible assets. A business that owns real estate, equipment, accounts receivable and inventories has tangible assets that can readily be sold. These are the easiest assets to value.
  • Intellectual properties. A business that owns patents and trademark protections will generally sell for a higher price than one that does not.
  • Licensing agreements. If the business sells a product that is protected by geographic distribution restrictions, it may sell for a higher price than one that does not have such protections.
  • Employment agreements. A business that has its key employees under agreements that restrict their ability to go to work for a competitor for a reasonable period of time may have a higher value than one that does not have such agreements.
  • Longevity of the company. If your company has been in existence for several years, it has likely developed a loyal customer base that provides it with a stable source of income and a proven cash flow over time.
  • Reason for selling. The reason an entrepreneur is selling the business can have a negative impact upon the sales price if the potential buyers believe the seller has limited options. If the entrepreneur is selling because of health reason, the buyer may believe they will accept the first offer to get it over with. This is also true of a surviving widow trying to sell a company.

Business valuation methods

The following is a summary of the most common valuation methods used today to value a business.

Asset based valuation method

The simplest method to valuing a business is the net asset value method. This is often the valuation method used when a business does not generate sufficient profits to justify goodwill. It’s also used for businesses of which the owner is integral to its reputation. There are three variations on this valuation method.

  • Net book value. This approach simply takes the net book value of the company’s assets and subtracts liabilities to determine the company’s value. This approach works well if the majority of the assets are liquid assets like receivables or inventory, but does not work for a company that has aggressively depreciated large amounts of fixed assets like buildings and equipment.
  • Fair market value of assets. In this approach, you must make a list of all of the company’s assets and assign a fair market value for each asset. Then subtract the company’s liabilities to determine the value of the company. This approach assumes that the assets of the company sold together has a greater value than the sale of the assets individually. It works well for a company with a substantial amount invested in real estate and equipment that may have a fair market value greater than net book value.
  • Liquidation value. In this approach, you are making the assumption that no one wants to purchase the all of the assets of the company at one time and will have to sell the assets off individually. This approach generally will yield a lower sales price.

This valuation method is more realistic if your company is invested heavily in property and equipment, and it does not have the ability to generate a sustained long-term revenue stream. However, the primary problem with this method to valuing a business is that it does not place a value on a company’s ability to create future cash flows.

Since many entrepreneurs are an integral part of most small company’s sales and operations, and they do not have intangible assets like patents to value, this is the method most often used to value small companies.

Multiple of earnings method

Another simple approach to valuing a company is to multiply the company’s earnings by a capitalization factor. If pre-tax profits are used in the valuation calculation, the profit multiplier will generally be between three and five for a privately held company. As an example, assuming a company generates a profit of $100,000 and sells for an earnings multiple of five, the company will sell for $500,000. Assuming earnings do not decline, the purchaser could expect to get his or her money back in five years and would have a 20% return on the investment. Companies that have a high growth rate will often sell between seven and 10-times pre-tax profits.

In large publicly traded companies this is often referred to as the company’s market capitalization based upon its Price-to-earnings(PE) ratio. While many of these public-traded companys’ stocks will trade at 15 to 20 times their after-tax profits, small privately-owned companies rarely sell for a PE greater than 10. This is the reason large publicly-traded companies can afford to purchase privately held companies at a higher price. This approach works well when valuing a company that does not have a large amount of fixed assets or excess working capital.

Industry specific rules of thumb

Several industries, in particular service industries with repeat customers and franchised retail stores and restaurants, have developed specific rules of thumb to value similar businesses that do not rely upon the net profit of the company. The following are some examples of industry-specific rules of thumb.

  • Certified public accounting practices generally sell as a multiple of gross revenue. If the practice is located in a growth market and has a stable client base, it may sell for as high as 200% of gross annual revenue. If it is a small practice located in a declining rural market with a client base that is primarily income-tax based, it may only sell for 125% of gross revenue. The price of the practice is almost always quoted as a price of gross revenue.
  • Independent insurance agencies are also normally sold as a percentage of annual commissions. Because of the front loading of commissions in life and medical insurance sales, their commissions are normally excluded from the calculation. Agencies that have a client base that is predominantly individual coverage and a low turnover may sell for as much as 200% of annual commissions. While an agency that is primarily commercial insurance that has a higher turnover rate may only sell for 100% of annual commissions. But again, the sales price is nearly always stated as a percentage of commissions.
  • Franchised fast food restaurants often have a valuation formula recommended by the franchisor. One chain I am familiar with values the location based upon gross revenue, while another values its locations by a multiple of gross revenue minus labor costs. If you are selling a franchised business, it is always wise to check with the franchisor in setting your sales price. They generally know what similar businesses have sold at in the past.
  • Natural gas companies value their business based upon the number of customers connected.

Industry specific rules of thumb assume that businesses within the industry have similar cost structures and are in fact a good starting point in arriving at a price. However, when setting the price to sell your business or making a purchase of a business, a more detailed review of the income and expenses for each individual company is required. Long-term contractual commitments may also have a significant impact upon future profitability.

Discounted cash flow method

If you hire a professional to evaluate the fair market value of your business, their analysis will generally calculate the value using three methods – the asset valuation approach, the market value based upon comparable sales and the income approach. The income approach is actually the discounted value of projected future cash flows over a period of time. Potential buyers for your business are primarily interested in its ability to generate future cash flow. This approach to valuing the company is based upon the present value of projected future cash flow. It allows the buyer to compare your business against other potential investments the buyer may have available. In addition, this approach to valuing the company is very useful when projected cash flow is not consistent each year.

The income approach to a company’s valuation is complex, but is based upon projected income and expenses and is thus based more scientifically. There are several factors that can make this approach as simple or as complex as you would like.

  1. EBIDA vs FCFF. One of the first variables that the valuation expert will have to decide is whether to use the annual Earnings Before Interest, Depreciation, and Amortization or the Free Cash flow to Firm. The Free Cash Flow to Firm takes into consideration the impact of future increases in working capital needs and expected capital expenditures that are projected to be needed.
  2. Discount rate. Another factor that will have a big impact upon the value calculated using this method is the discount rate. The discount rate not only reflects the cost of capital to the potential buyer, but also would include a factor to adjust for the risk of not making projections and the impact of inflation. The riskier the business, the more uncertain future cash flows become, thus justifying a higher discount rate.
  3. Number of periods. The final factor that will have an impact upon the income approach is determining the number of periods to include in the calculation. While a seller would like to see the calculation assume the income will continue for perpetuity in the future, no buyer is going to agree to that.
    There are two approaches to determining the number of periods to include the calculation. The first assumes the projected cash flow will continue for 10 to 12 years, and each period is discounted back to today’s value. The second approach assumes a company’s management can reasonably project income for a period of five years and then discounts that income back to today’s value. A residual value is added to this number to reflect the value of earnings over the past five years.

Calculating the value of your business under the discounted future cash flow approach is complex and requires an experienced business valuation expert who. will provide the most accurate economic valuation for your company.

In planning to sell your company, it is important to talk to a business valuation expert that is familiar with your industry. In addition to assisting you in arriving at a fair value for your company, they can provide you advice on steps you can take to improve its value too.

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