When considering the value of your company, there are basic value drivers. While it is difficult to place a specific value on them, one can take a look and make a “ballpark” judgment on each. How does your company look?
|Business Type||Little Demand||Some Demand||High Demand|
|Business Growth||Low||Steady||High & Steady|
|Market Share||Small||Steady Growth||Large & Growing|
|Profits||Unsteady||Consistent||Good & Steady|
|Management||Under Staffed||Okay||Above Average|
|Customer Base||Not Steady||Fairly Steady||Wide & Growing|
|Litigation||Some||Occasionally||None in Years|
|Sales||No Growth||Some Growth||Good Growth|
|Industry Trend||Okay||Some Growth||Good Growth|
The possible value drivers are almost endless, but a close look at the ones above should give you some idea of where your business stands. Don’t just compare against businesses in general, but specifically consider the competition.
As part of your overall exit strategy, what can you do to improve your company?
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Business valuations are almost always difficult and often complex. A valuation is also frequently subject to the judgment of the person conducting it. In addition, the person conducting the valuation must assume that the information furnished to him or her is accurate.
Here are some issues that must be considered when arriving at a value for the business:
Product Diversity – Firms with just a single product or service are subject to a much greater risk than multiproduct firms.
Customer Concentration – Many small companies have just one or two major customers or clients; losing one would be a major issue.
Intangible Assets – Patents, trademarks and copyrights can be important assets, but are very difficult to value.
Critical Supply Sources – If a firm uses just a single supplier to obtain a low-cost competitive edge, that competitive edge is more subject to change; or if the supplier is in a foreign country, the supply is more at risk for delivery interruption.
ESOP Ownership – A company owned by employees, either completely or partially, requires a vote by the employees. This can restrict marketability and, therefore, the value.
Company/Industry Life Cycle – A retail/repair typewriter business is an obvious example, but many consumer product firms fall into this category.
Other issues that can impact the value of a company would include inventory that is dated or not saleable, reliance on short contracts, work-in-progress, and any third-party or franchise approvals necessary to sell the company.
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Consider two different companies in virtually the same industry. Both companies have an EBITDA of $6 million – but, they have very different valuations. One is valued at five times EBITDA, pricing it at $30 million. The other is valued at seven times EBITDA, making it $42 million. What’s the difference?
One can look at the usual checklist for the answer, such as:
- The Market
- Revenue Size
- Regional/Global Distribution
- Capital Equipment Requirements
- Intangibles (brand/patents/etc.)
- Growth Rate
There is the key, at the very end of the checklist – the growth rate. This value driver is a major consideration when buyers are considering value. For example, the seven times EBITDA company has a growth rate of 50 percent, while the five times EBITDA company has a growth rate of only 12 percent. In order to arrive at the real growth story, some important questions need to be answered. For example:
- Are the company’s projections believable?
- Where is the growth coming from?
- What services/products are creating the growth?
- Where are the customers coming from to support the projected growth – and why?
- Are there long-term contracts in place?
- How reliable are the contracts/orders?
The difference in value usually lies somewhere in the company’s growth rate!
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Two businesses for sale could report the same numeric value for “earnings” and yet be far from equal. Three factors of earnings are listed below that tell more about the earnings than just the number.
1. Quality of earnings
Quality of earnings measures whether the earnings are padded with a lot of “add backs” or one-time events, such as a sale of real estate, resulting in an earnings figure which does not accurately reflect the true earning power of the company’s operations. It is not unusual for companies to have “some” non-recurring expenses every year, whether for a new roof on the plant, a hefty lawsuit, a write-down of inventory, etc. Beware of the business appraiser that restructures the earnings without “any” allowances for extraordinary items.
2. Sustainability of earnings after the acquisition
The key question a buyer often considers is whether he or she is acquiring a company at the apex of its business cycle or if the earnings will continue to grow at the previous rate.
3. Verification of information
The concern for the buyer is whether the information is accurate, timely, and relatively unbiased. Has the company allowed for possible product returns or allowed for uncollectable receivables? Is the seller above-board, or are there skeletons in the closet?
The initial response to the question in the title really should be: “Why do you want to know the value of your business?” This response is not intended to be flippant, but is a question that really needs to be answered.
- Does an owner need to know for estate purposes?
- Does the bank want to know for lending purposes?
- Is the owner entertaining bringing in a partner or partners?
- Is the owner thinking of selling?
- Is a divorce or partnership dispute occurring?
- Is a valuation needed for a buy-sell agreement?
There are many other reasons why knowing the value of the business may be important.
Valuing a business can be dependent on why there is a need for it, since there are almost as many different definitions of valuation as there are reasons to obtain one. For example, in a divorce or partnership breakup, each side has a vested interest in the value of the business. If the husband is the owner, he wants as low a value as possible, while his spouse wants the highest value. Likewise, if a business partner is selling half of his business to the other partner, the departing partner would want as high a value as possible.
In the case of a business loan, a lender values the business based on what he could sell the business for in order to recapture the amount of the loan. This may be just the amount of the hard assets, namely fixtures and equipment, receivables, real estate or other similar assets.
In most cases, with the possible exception of the loan value, the applicable value definition would be Fair Market Value, normally defined as: “The price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.” This definition is used by most courts.
It is interesting that in the most common definition of value, it starts off with, “The price…” Most business owners, when using the term value, really mean price. They basically want to know, “How much can I get for it if I decide to sell?” Of course, if there are legal issues, a valuation is also likely needed. In most cases, however, what the owner is looking for is a price. Unfortunately, until the business sells, there really isn’t a price.
The International Business Brokers Association (IBBA) defines price as; “The total of all consideration passed at any time between the buyer and the seller for an ownership interest in a business enterprise and may include, but is not limited to, all remuneration for tangible and intangible assets such as furniture, equipment, supplies, inventory, working capital, non-competition agreements, employment, and/or consultation agreements, licenses, customer lists, franchise fees, assumed liabilities, stock options or stock redemptions, real estate, leases, royalties, earn-outs, and future considerations.”
In short, value is something that may have to be defended, and something on which not everyone may agree. Price is very simple – it is what something sold for. It may have been negotiated; it may be the seller’s or buyer’s perception of value and the point at which their perceptions coincided (at least enough for a closing to take place) or a court may have decided.
The moral here is for a business owner to be careful what he or she asks for. Do you need a valuation, or do you just want to know what someone thinks your business will sell for?
Business brokers can be a big help in establishing value or price.Read More
“As shocking as it may sound, I believe that most owners of middle market private companies do not really know the value of their company and what it takes to create greater value in their company … Oh sure, the owner tracks sales and earnings on a regular basis, but there is much more to creating company value than just sales and earnings”
Russ Robb, Editor, M&A Today
Creating value in the privately held company makes sense whether the owner is considering selling the business, plans on continuing to operate the business, or hopes to have the company remain in the family. (It is interesting to note that, of the businesses held within the family, only about 30 percent survive the second generation, 11 percent survive the third generation and only 3 percent survive the fourth generation and beyond).
Building value in a company should focus on the following six components:
- the industry
- the management
- products or services
- comparative benchmarks
The Industry – It is difficult, if not impossible, to build value if the business is in a stagnating industry. One advantage of privately held firms is their ability to shift gears and go into a different direction. One firm, for example, that made high-volume, low-end canoes shifted to low-volume, high-end lightweight canoes and kayaks to meet new market demands. This saved the company.
The Management – Building depth in management and creating a succession plan also builds value. Key employees should have employment contracts and sign non-compete agreements. In situations where there are partners, “buy-sell” agreements should be executed. These arrangements contribute to value.
Products or Services– A single product or service does not build value. However, if additional or companion products or services can be created, especially if they are non-competitive in price with the primary product or service – then value can be created.
Customers – A broad customer base that is national or international is the key to increasing value. Localized distribution focused on one or two customers will subtract from value.
Competitors – Being a market leader adds significantly to value, as does a lack of competition.
Comparative Benchmarks – Benchmarks can be used to measure a company against its peers. The better the results, the greater the value of the company.
Three keys to adding value to a company are: building a top management team coupled with a loyal work force; strategies that are flexible and therefore can be changed in mid-stream; and surrounding the owner/CEO with top advisors and professionals.