What is my business worth?
That is a frequent question asked and I always answer that question with a question: “Why do you want to know?”
Understanding the value of a business may be necessary for legal purposes (estate, tax, divorce), transaction reasons (exiting or attracting capital), or an owner is looking for a benchmark number to gauge future growth in value.
The most common reason today, because of demographics, is the owner is preparing to retire, and in most cases the largest asset in the financial plan is the business. According to The Exit Planning Institute, 75-80% of the owner’s wealth is tied up in their business.
Retirement means exiting the business. So, it would be nice to know what the largest asset is worth. Am I right?
Valuing a public company is straightforward: simply multiply the number of shares outstanding by the share price and you have the market capitalization. Bam – value.
Valuing a private company is a whole different ballgame. There is no formula!
I had a business owner recently lament that he had an evaluation done on his business and three different values were presented that were so diverse he felt the numbers to be completely useless.
Exasperation and confusion ensued. Here is a bit of clarity on what is a complicated topic.
There are four basic approaches to calculate privately held business value:
1) The Income Approach: This method utilizes discounted cash-flow analysis and is considered the most in-depth approach. The computation includes the following steps:
- Normalize the business financials through the process of recasting. Privately held businesses often have expenses in their financials — travel expenses, auto expenses, and other personal expenses thrown into the P/L to minimize taxes, or they may incur one-time extraordinary expenses that will never happen again—that should be added back to earnings before interest, taxes, depreciation, amortization (EBITDA) in order to give a true picture of profitability to a buyer.
- Forecast future free cash flow the business will generate then discount the projection back to the present value to account for the time value of money. The discount rate applied, called the hurdle rate, is based upon the buyer’s perception of risk in the deal and ultimately represents their expected return on investment (ROI).
- Terminal or residual value is then calculated using the Gordon Growth Model.
Warren Buffet likes this approach. It is very complex and requires significant financial modeling experience. If a company has recurring revenue and cash flow is predictable this approach makes sense.
2) The Market Approach or Comparable Company Analyses (CCA): This method compares your business to the prices that an investor has paid for other similar companies. DealStats, (formerly Pratt’s Stats), serves as a great resource for statistics.
For example: A financial buyer, such as a private equity group (PEG), will look at a business’ Trailing Twelve Months (TTM) adjusted EBITDA and apply a multiple based on the price the market is bearing. For example, the energy sector is currently valuing in a range of 5-9X adjusted EBITDA.
3) Asset Approach: This is a process of understanding what the value of the assets on the balance sheet are if liquidated or replaced.
Side note: Book value, or assets minus liabilities, is what an accountant may use to value a business. Unless the business is being liquidated this is not an appropriate method to determine value.
4) Rule of Thumb: This methodology is based on experience in a specific industry.
For example: I had a question regarding a physician’s office value this week. Typically, rule of thumb, physician practices are valued at 1.0-1.25 times earnings. Another rule of thumb is to determine what a public company is trading at and reduce it by 50% to reflect private company illiquidity.
The value of a business could encompass a mix of all of the above approaches and is dependent upon the industry in which the business operates.
Valuing a private company is complicated. It is based on assumptions and estimations that can change by a hair. As you can see, a simple formula can’t work.
In the end, when an owner is going to retire and reap the ultimate reward for all the years of dedication and hard work in building that company, the value of the business will be what the open market will deliver and will be driven by the caliber of the buyer and what they are willing to pay!
We at Legacy Partners begin the exit planning process by understanding the value of our client’s business so we can guide them to harvest the equity created at the highest level, and go onto whatever that next chapter post-ownership looks like.
Run your business as if you will own it forever…but be prepared to sell it tomorrow!