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