Whether you’re planning to buy or sell a business, the starting point is to determine the fair market value (FMV). FMV is always a range, never a specific number.
Obstacles to a buyer and seller agreeing on value are numerous; owners generally have invested so much of their lives into their business they believe FMV is too high, buyers may have never owned a business and never run a business so they don’t know where to begin to determine FMV, and sometimes both buyers and sellers can have a very different perspective as to business FMV.
Additionally, FMV is different for different purposes: Different norms can result in different values for divorce court vs. for a business sale vs. for a buy/sell agreement between existing business partners.
The Science of Business Valuation
Business valuation is a complex field. Business valuation is a discipline of its own and no one article can cover all of the considerations that go into the FMV calculation. What follows is a summary of some of the major considerations experienced CPAs and attorneys will review when assisting a client in buying or selling a business.
Value is generally determined after examining a number of considerations. For example:
1. Is the business a high- or low-risk business? Risk is not only a function of what industry the business is in (e.g., sporting goods, computers, etc.), but also a function of the competition (e.g., local competition, on-line competition, etc.). For example, savvy buyers would not want to compete with Starbucks, nor would they compete with on-line computer retailers.
Bottom line: The higher the business risk, the less the business is worth – and vice versa for lower risk businesses.
2. Are there “excess earnings” (EE) in your business? This is generally the biggest driver of business valuation. Buyers pay for excess earnings! To keep it as simple as possible EE can be explained in the following example:
A specialty manufacturer is selling. Their records show the family is earning $480,000 per year made up of the following: $80,000 net income, Mom and Dad receive annual pay of $75,000 for full time management plus $25,000 for part time admin tasks and the six adult children each receive $50,000 annually including perks.
A buyer’s (or seller’s) first step is to determine whether this business creates EE. To do this, the fair market value of the owners’ efforts must be determined. Due diligence reveals the two older owners work a combined 80 hours per week and their six children each work 55+ hours per week.
A buyer then looks at the local area to determine the cost of wages they must pay to third parties to replace the family’s efforts. Research indicates hiring employees to cover the family’s efforts would have an annual cost of $465,000 (that is: $80,000 for a manager, $25,000 for an admin worker and $360,000 to hire nine other 40-hour per week positions to cover the 330 hours per week of the six other family members).
In this scenario the business generates excess earnings $15,000 per year (that is: $480,000 minus the replacement cost of $465,000). Buyers then must decide what they will pay to purchase that $15,000 of excess earnings income stream. Answer: not much.
3. Buyers will also pay the fair market value of business assets acquired. This includes tangible assets such as equipment and delivery vehicles; and intangible assets such as long term leases at below market rates and patents. All of these components must be valued in the purchase or sale process. For tangible assets, it’s generally easy to determine FMV for each component. On the other hand, intangible and other assets are more difficult to value. Regardless of the agreed upon value of the total purchase price allocated to assets, the buyer is still limited to paying a total price based upon EE.
4. Buyers want to purchase organizations that aren’t dependent upon the personality or skills of a specific person or family. An example of this might be to compare buying a restaurant franchise with buying a local restaurant that finds its popularity tied primarily to the personality of the husband and wife sellers of the restaurant. If a buyer acquires a franchise, nothing will be different for their customers. After sale the product will be the same, the workers may stay or be easily replaced and none of the customers know who owns the franchise.
On the other hand, consider a popular local restaurant – let’s call it “Maria’s Italian Restaurant” – that drives its customer base through the entertaining “high touch” personality of Maria. Maria is out on the floor every hour entertaining customers with her personality, treating customers like family and humorously directing her husband Mario who does the cooking. The customer base loves the environment and the food is great too.
In the case of Maria’s Italian Restaurant most potential buyers should know that many of those customers will move on quickly after the sale, as the restaurant would no longer be “Maria-centric.” The buyer might replicate the recipes – but they can’t replicate Maria. Unique local restaurants, small boutique consulting firms, and small service firms are usually “Maria- or somebody-centric,” and as a result they don’t command a high value, regardless of their excess earnings.
5. Obstacles to entry. Regulations and licensing or ease of entry will impact FMV.
How should one initiate the process of buying or selling a business?
A business owner should begin the process of increasing the FMV of their business at least five years ahead of their target sale date, if not the moment the business is created.
Business sellers and buyers should hire experienced business sale/valuation attorneys and CPAs. These advisors can hold owners accountable to themselves and can assist them in not only successfully running their business, but assist them each year in increasing the value of their business. These same advisors will assist buyers in determining FMV, including conducting due diligence when reviewing a seller’s financial records.
Conclusion
In summary, many complex components may impact the FMV of a business. The most important component is likely going to be excess earnings. Business owners utilize the help of experienced professionals and should continually think long term when running their businesses, focusing not only on paying the bills and earning a profit but also continually making decisions with an eye toward enhancing business FMV for the day they may eventually sell.
***
About the Author: Vincenzo Camporeale has a degree in economics, and is the retired owner of a CPA firm in the eastern US, with over 25 years experience assisting closely-held businesses with $1 million to over $40 million in annual sales.
Photo Credit: stock photo
This is a very good primer for the uninitiated. Investment bankers run 4 general analyses and sort of triangulate a value. Discounted cash flow (or what we call “DCF”), transaction comparables, market comparables/market value, and leveraged buyout analysis.
Most businesses with EBITDA below $1 million annually sell for about 2-3x cash flow. For businesses over $1 million annual profit, they tend to sell for a much higher multiple, often 5-6x EBITDA. If it’s a business that has substantial physical property, those are generally excluded from the multiple and sold separately.
EBITDA is a decades old concept that is very valid, but with small closely controlled business is not an indicator of value. EBITDA is an early step in getting to Excess Earnings. The due diligence I referred to will identify many necessary adjustments to move from EBITDA to EE. Once EE is calculated one can arrive at FMV.
Although I don’t plan to buy or sell a business I thought this was very interesting!