Small Business Valuation Primer


by Rudy LeCorps

For simplicity's sake, this article will assume that the buyer will be acquiring a single business with possibly more than one location (for example a small Laundromat business with two locations). In addition, we will not be covering valuation techniques for businesses where more than one product line or service will be acquired. For the purpose of this discussion, we will assume the simplest of all cases. For example if a buyer is acquiring a retail business, that business will be assumed to sell one type of product (for example, children's clothing). This book is also assuming that its reader will be buying, or intends to buy, a small business that is privately held and valued at $1MM or less.

Finally, we will be focusing on valuing a business that is not going to be turned around, but will continue to operate (or grow) as purchased, under the new owner. A business that is failing and in need of an experienced buyer to re-structure and turn it around, or fix it, has to be valued using a different set of valuation metrics. Note that even though there are many ways to value a business, to keep things simple, and in light of its audience, this book will be using a straight forward multiple of earnings (net income) method to help a buyer arrive at a value that is as close as possible to the intrinsic value of the business. But keep in mind that in the end a business' value is equal to what a buyer is willing to pay and a seller willing to accept.

To analyze a business, we begin by collecting and reorganizing its accounting and financial statements. Below is a list of essential documents that need to be gathered and analyzed. To make this analysis worthwhile, financials statements for at least the past three years must be available, preferably on a monthly basis. We recommend buying a business that has been operating (and has been profitable) for at least three full years: Valuation Document Collection

 

Item No.Document DescriptionDate Collected

Note that most brokers and owners will require that you sign a confidentiality agreement and put down a "good-faith" (different from a down payment) deposit before you are given access to such confidential information. That is normal procedure and you should be ready to remit at least 0.50% of your offer price (not the owner's asking price) to the broker to be put in escrow. Some brokers use a fixed amount (e.g. $1,000). That amount is used as proof that you are serious about buying the business and will either be:

Working With The Financial Statements

A few words of caution: Some brokers will provide you with both original financials as well as their version of a set of re-cast financials for the business they are trying to sell. Do not rely on these numbers to make your offer. Brokers generally try to inflate the asking price in order to increase their fee. Unless you can hire your own valuation specialist, follow the instructions in this section to do your own analysis of the business.

Owners of privately held businesses are very motivated to pay the least amount of taxes possible. To achieve that goal, and to the extent permitted by accounting standards, they manipulate their expense accounts in order to show on paper that the business is making the least amount of profit possible. That, in turn, lowers their tax liability on the business' net income. To objectively value a business, its financials have to be reconstructed, or re-calculated. That is, adjustments have to be made to reflect the true profit potential of that business. Such adjustments are sometimes called add backs.

Examples of such abnormal expense items by business owners include extremely large bonuses or salaries to themselves, above-market rent space from a building that is family-owned, and company cars that are used for personal use. Sometimes such expenses may include illegitimate items such as salaries for non-working family members, family vacations marked as business trips, and personal expenses charged to the company. This leads us to conclude that some of these expenses have to be adjusted or re-calculated in context. The prospective buyer can do that by using either (or both) of the following:

The simplest and cheapest way to get such industry data is to review comparable data from publicly held companies that are in the same industry or line of business. Such information is freely available on the Internet and can be downloaded from web sites such as Yahoo! Finance, sec.gov, or any financial web site for which there is no fee for reviewing such information. In addition, all publicly traded companies have their financials posted on their own web site under "Investor Relations". For example, if you're planning to buy a retail clothing business, you may want to look at the income statements of companies such as Gap, Inc., Abercrombie & Fitch Co., Children's Place Retail S, Chico's FAS, Inc., etc., and taking an average of their individual ratios.

Unless the buyer can purchase data for such an analysis, information obtained from the financials statements of publicly held companies are the most accurate way to measure industry ratios (even the IRS agrees with this valuation method through its Revenue Ruling 59-60). The rationale behind it is that public companies have to try extremely hard to keep expenses in line. That is because they have a duty to report to their shareholders, in addition to helping raise their stock price by encouraging investors to buy shares of the company. That effectively results in more realistic numbers when it comes to business expenses.

Multiples are usually calculated by dividing the actual line item expense, either by the company's total revenue, or net income, as long as you keep the divider the same throughout the exercise. For example, to create a ratio for Travel & Entertainment (T&E) the buyer can divide the total amount spent on T&E by the total company revenue. This ratio can then be applied to your own analysis by multiplying it to the T&E expense of your acquisition target. The difference from the number supplied by the Owner and the result from applying the ratio would be used as a T&E add back to be added to the net income. The above step has to be done for each add back item. In the illustration table included in this section, the buyer's analyst used the following add back items for the analysis:

Sample Ratio Calculation Table


Ratio Computation Table For 3 Companies & 1 Expense Line (e.g. Office Expenses) Company 1Company 2Company 3Average Ratio

Exp. LineExp1Exp2Exp3

Revenue (or Net Income)Rev1Rev2Rev3

RatioR1=(Exp1/Rev1)R2=(Exp2/Rev2)R3=(Exp3/Rev3)(R1+R2+R3) / 3


Once ratios have been calculated using the sample table above, it is time to start reconstructing the company's financials by applying the derived ratios to original amounts found in the Financial Statements received from the owner (see sample statements below). The amounts obtained by applying the ratios are subtracted from the original expense line values to deduct the adjusted amounts. Use the table below or a similar one to facilitate this exercise. Note that it is recommended to do the above exercise using at least 5 companies from the industry into which the buyer is looking to purchase. Sample Financials Adjustment Table In this table, ratios can be calculated by dividing total revenue by each one of the line items below. Note that Revenue in this context refers to the revenue of a public company that is being used in the benchmark. Data for this exercise can be obtained by visiting the Internet (e.g., Yahoo!Finance). It is recommended that the buyer calculate at least 5 ratios and use the average to extract a more representative ratio.

 

OriginalRatioAdjustedAddback (Original - Adjusted)

Total (to be added to original net income)

Once reasonable multiples have been applied, the differences should be added back to the income statement of the business. This will result in a noticeable increase in net profit, or a decrease in net loss, from the Income Statement. As can be seen in the case below, there is a sizable gap between the Net Income on the left and the Adjusted Earnings on the right. That adjusted number reflects a more likely income from the business' operations if the owner did not have to minimize income in order to reduce payment of business taxes. To help understand this better, the reader should thoroughly familiarize him/herself with the example provided below. It was taken from the Valuation Analysis of a small chain of technology training schools, which the author was advising.

Once you have constructed an adjusted earning from the business' financials, pricing can be made quite simple. We recommend that the buyer apply a multiple ranging from 1.5x to 3.5x, to the Adjusted Earnings. Using such multiples, a buyer is essentially paying a seller for the right to collect the business operating earnings in the future. Assuming that the business continues to operate forever, the buyer is basically buying an unlimited amount of future cash for 1.5x to 3.5x its current net income. For example if your adjusted earnings are $50,000, your offer price might be between $75,000 and $175,000, depending on how strongly you feel about owning the business and the amount of cash you have to spend. However, if the business operates for the next ten years, for example, and continues to produce the same (or more) amount of cash, the buyer's potential total income from the transaction could be $500,000 ($50,000*10) or more.

Note that it is important to pay close attention to the prices of comparable businesses in the area where your target business is located. Also, note that the multiples suggested above are simply guidelines. You may want to pay more or less, depending on how strongly you feel about the business' prospects and future growth, and how you've structured the transaction with the seller.

The reader might be asking why such emphasis on the Net Income of a business as opposed to just valuing its assets. The truth is that, in addition to the fact that some businesses, such as certain service businesses, do not have any hard assets, assets do not produce cash flow, revenue and income do. Although the assets of a business are important, if they are not generating enough cash flow, they can not help the buyer cover business expenses.

In addition, a business can generally find ways to generate revenues that its assets are not capable of producing. For example, a computer manufacturer may, in addition to selling computers, decide to provide computer maintenance services to its clients. Another example might be a Laundromat owner who decides to provide Dry Cleaning services by contracting out the work to a Dry Cleaning Plant. In both cases, the assets of the businesses (e.g. computers, washers and dryers) do not produce the income received. Because the buyer is acquiring the right to receive the future earnings of the business, its ability to produce cash is really what is important.

As we can see, having your offer price dependent upon the true income (or income potential) of the business is essential. If your value is too low and you are unable to negotiate with the seller, you may be missing on a great opportunity. On the other hand, if your analysis results in overpricing the business, you will be paying too much for a business that may fail after you have invested possibly all of your life savings into it.



Tell others about
this page:

facebook twitter reddit google+

About the Author

Rudy LeCorps and his wife are the owners of various businesses, including a Car Rental Franchise and a Training Publishing company, located in Northern New Jersey and New York City. He is the author of "A Five-Step Approach To Buying A Small Business." You can reach him at rlecor@rgllearning.com or visit his web page at http://rgllearning.com.




Comments? Questions? Email Here

© HowtoAdvice.com

Next
How to Advice .com
Send us Feedback about HowtoAdvice.com
NextPrevious