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Cashing
Out ... What is Your Business REALLY Worth?
© 2001 Elena
Fawkner
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;
and (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.
Elena Fawkner is editor of A Home-Based Business Online
... practical ideas,
resources and strategies for your home-based or online
business.
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