The Ultimate Guide to Business Valuations
Your business may be your most valuable asset, and building a successful company can take years of time and effort. If you’re considering selling your business down the road, this comprehensive guide to company valuations can help you make an informed decision – and maximize the price you receive for the sale.
Accounting Rules of the Road
Many larger businesses use an accounting system that complies with Generally Accepted Accounting Principles (GAAP), and these rules apply to accounting transactions and how financial statements are generated.
While you may not use GAAP accounting now, you may need to implement these accounting standards as your firm grows. At a minimum, implementing the accrual method of accounting is a definitive best practice.
If you follow these rules of the road, a potential buyer can compare your financial results with similar companies and make an assessment about your firm’s value. Also, if the purchaser buys your company, they can take over your system and use the same accounts and policies to operate the business.
Businesses handle their accounting using the accounting cycle, and the process is repeated each month and year. Generally speaking, accounting requires a firm to collect source documents (receipts, invoices, etc.), post accounting transactions, record adjusting entries, and generate financial statements. You can read about the 8 steps in the accounting cycle here.
Here are the most important accounting concepts you need to know, and how these concepts impact a business valuation:
Accrual accounting requires businesses to post revenue when earned, and expenses when incurred to produce revenue. Matching revenue with expenses provides the financial statement reader with a more accurate picture of profitability, and accrual accounting disregards the timing of cash inflows and outflows.
Assume, for example, that a home builder purchases wood in January for a house that is built and sold in April. The wood material cost is posted as an expense in April, along with the revenue generated from the sale.
Accrual accounting is used when producing financial statements for a business valuation.
Adjusted trial balance
A trial balance is a listing of each account and its current balance, and accrual accounting requires firms to make adjustments before financial statements are produced. The adjustments are posted to match revenue with expenses, so that company profit is correctly stated.
Say, for example, that a restaurant pays $6,000 in insurance premiums on June 30th, and the premiums are paid for six months of coverage. The owner would debit prepaid insurance (an asset account) for $6,000 and credit cash $6,000 for the payment.
The premium payment is an asset, because the restaurant does not have to pay the expense in the future.
Each month, the owner recognizes one month of insurance expense by debiting insurance expense $1,000 and crediting (reducing) prepaid insurance $1,000. This same entry is posted for a total of six months.
These entries post insurance expense to the month that the insurance coverage was in force, and disregards when the cash payment was made.
Normalizing adjustments to financials
Some expenses may not comply with accounting standards, and those expenses will be removed when a potential buyer analyzes your financial statements. These changes are referred to as normalizing adjustments.
This is the most sensitive issue you’ll face as a business seller, but you have to consider the buyer’s point of view.
Assume, for example, that the business pays for 100% of the vehicle cost for a family member who only works part-time in the business. Let’s also assume that a CPA audits the financial statements and determines that 100% of the vehicle cost is not an allowable tax deduction. The CPA may suggest, and situations vary, that 40% of the vehicle cost is a business expense, since the family member only works 2 days per week, which is 40% of a full five-day work week. The remaining 60% is a personal expense that should not be represented in the accounting records of the business.
The buyer would compute an offer price for the business based on the audited financial statements, which would remove some of the expenses.
Have a CPA review your financial statements for accuracy and completeness. You’re better off making changes to your financial statements before presenting your records to a potential buyer.
Financial statements: Including past years
A business valuation requires trend analysis, including trends related to sales, accounts receivable balances, and the change in profit levels over time. Trend analysis helps a potential buyer see where the company is headed, and any potential red flags that must be addressed.
For this reason and several others, an owner needs to provide financial statements for the past three years, and possibly five years, if accurate records are available. Some buyers also like to see pro forma financial projections at least 12-months out and beyond to see the projected growth trends of the company.
Accounting software can help you post accounting transactions accurately, produce reliable financial statements, and backup your data on the cloud. Consider using software now, so that you can provide accurate financial statements in future years.
Goodwill: Defined, how goodwill is created
Goodwill is created when a parent company buys a subsidiary, and the parent pays more than the fair market value of the net assets (assets less liabilities). Goodwill is an asset account in the balance sheet, and goodwill amortization reclassifies the asset balance into an expense account over time.
If your business has a goodwill balance, a potential buyer will want more details on the original goodwill transaction, and how the goodwill amount is being amortized over time. The buyer will also dive into the remaining value of goodwill to determine if it is under or over-valued.
Getting help: Working with a CPA
Consider hiring a CPA to review your accounting transactions when you start your business, and you may hire a full-time accountant as your firm grows and becomes more complex. Using a CPA ensures that your transactions and financial statements comply with GAAP requirements and makes the valuation process much easier.
You could also hire a bookkeeper to help record the day-to-day transactions and reconcile your accounts. There are many bookkeepers who specialize in different accounting software and industries. The bookkeeper can keep your financials up-to-date, and your CPA can review your financials on a quarterly or semi-annual basis to ensure accuracy. In time, this can help save costs and also allows you to accurately track the trends of your business to help make better decisions.
Reviews and Compilations
In some cases, a prospective buyer may want a CPA firm to perform a review or compilation of your financial statements.
As explained here, a compilation is a cursory check of your financial statements, and the CPA firm provides a letter explaining that a compilation was completed.
A review, on the other hand, is more involved than a compilation. In this type of engagement, the CPA firm will make inquiries about your financials, and the accounting principles used to generate your financial statements. The accountant will also perform analytical procedures to understand the relationships between account balances.
In addition to your financial statements, the CPA firm performing a review will require your most recent trial balance, monthly bank reconciliations, and other documentation.
A potential buyer may want to see a compilation or review report on your financial statements.
How to Value a Business: The Valuation Process
The valuation that a buyer and seller ultimately decide on can involve dozens of factors. A business valuation also involves people, and you need to understand how some individuals can impact your firm’s value. Here’s an overview of the valuation process:
Professionals and Their Roles
There are several experts who are involved in most business sales, and each has some level of impact on a company’s valuation:
Business Broker: A business broker is familiar with the buying and selling process. They are familiar with the market and can provide a valuation to help sell your business. In addition, brokers will help to prescreen buyers, negotiate offers and help close the deal.
Accountant and/or Tax Preparer: As discussed earlier, you may have an accountant work in your business directly, or you may have them simply review your accounting activity and financial statements each month. Most businesses also use an accounting firm to prepare the business tax return. Accounting requires judgment, and the judgments your accountant makes will impact the financial statements, and ultimately the valuation.
Attorney: A business may use one attorney for day-to-day business transactions and contracts, and a second attorney for the business sale documents. If a firm has a legal contingency, an attorney may be required to assign a dollar value to the financial impact of any contingency, and the dollar amount will impact the valuation.
Wealth Planner: A wealth planner will help you to evaluate investment options to save on taxes and maximize the money you receive from the sale of your company. They can also help create an estate plan to protect your investments.
Having an experienced team is very important to get the best price and terms on your business. Each of these professionals has a role to play in a business valuation and sale.
Role of the Business Broker
The professional who may have the most involvement in your business valuation and sale is a business broker. An experienced broker can add tremendous value to a company sale, and he or she may perform these tasks for a seller:
Ask industry peers and your network of professional contacts to help you find a business broker.
Factors That Impact Valuation
A business valuation is based on both financial and non-financial data, and a buyer may value some forms of information more than other metrics. A seller, also, may consider some measurements to be more important than others. Finally, keep in mind that the true value of a business involves opinions and judgment.
This section discusses many of the tools used to assess the value of a business, and why buyers and sellers consider this data to be relevant to a sale.
Earnings Before Interest, Tax, Depreciation and Amortization (EBITDA)
Earnings before interest, tax, depreciation and amortization (EBITDA) may be the most common valuation metric, and you’ll hear about companies that are priced as a multiple EBITDA (“3 times EBITDA”, etc.).
The earnings total refers to net income, which is defined as (revenue less expenses), and the earnings balance includes all expenses. EBITDA takes earnings and adds back the expenses incurred for interest, tax, depreciation and amortization. Consider each of the line items individually:
Interest expense: Interest incurred on all loan balances.
Tax expense: Federal, state, and possibly local taxes paid on company earnings.
Depreciation expense: Assets are resources used in a business, and fixed assets depreciate as they are used up over time. A $20,000 piece of machinery, for example, might be depreciated at a rate of $4,000 year for five years.
Amortization expense: Intangible assets, such as a patent or copyright, incur amortization expenses as they are used to produce revenue. Assume, for example, that a company buys a patent for $200,000 and accounting standards dictate that the patent must be amortized over 20 years. The firm will post amortization expense of $10,000 per year.
After adding back (removing) these expenses, the EBITDA balance is larger than net income.
Capital expenditures: Weakness of the EBITDA method
While EBITDA is widely used and understood for valuations, it has an important flaw that business owners need to know. EBITDA does not account for the cost of replacing assets over time, and this cost may be substantial for some businesses.
Here’s an example: Bob owns Lakeside Restaurants, a business that operates three restaurant locations. Each location’s balance sheet lists over $400,000 in assets, including furniture, fixtures, ovens, and refrigerators. Over time, these assets will need to be replaced – and EBITDA does not account for asset replacement.
Assume, for example, that the Downtown location has a number of assets that are near the end for their useful lives, and the store posted a large amount of depreciation expense in the last 12 months.
It’s possible for the Downtown location to produce the same level of revenue, even with older assets. Since EBITDA adds back the depreciation expense, the potential buyer does not consider the aging group of assets.
The balance sheet will report the declining book value (cost less accumulated depreciation) of fixed assets, but EBITDA does not reveal the issue to a buyer. Both net income and EBITDA should be considered for a valuation.
Profit vs. cash flow
Generating a profit does not immediately translate into a higher cash balance. Most small business owners minimize profits to reduce tax burdens. However, when selling a business the opposite is true. A business needs to show the higher operating profit of the business in order to generate higher valuations and terms.
A valuation should also consider the cash inflows and outflows of the business, because no company can operate without a sufficient level of cash.
A potential buyer will pay close attention to the growth in sales, compared to the increase in accounts receivable. If sales are growing at 10%, and the accounts receivable is increasing at a 25% rate, a business will eventually run short on cash. The company is selling more, but the average customer is paying more slowly.
Eventually, a cash-strapped business may have to borrow money to operate, and incur interest expenses. Alternatively, a firm could sell equity and raise funds from an investor.
Profitable companies that can also generate cash inflows quickly, combined with reducing their cash outflows, are the most valuable to a buyer.
Trends in profits and market share
A potential buyer analyzes several years of financials to assess trends in your business, including profit trends. If, for example, a particular product’s sales are increasing, how can the buyer grow sales even more?
Also, a buyer will consider the size of your market, and your company’s position in the market. If you operate in a growing market in which no company has more than a 5% market share, the buyer may see an opportunity to grow sales, which makes your business more valuable.
Potential buyers will also consider the diversity of your product offerings. If your sporting goods store sells equipment for both summer and winter sports, for example, you can manage a slowdown in one particular product line. If, on the other hand, you only sell baseball and golf equipment, you’re more at risk if these sports decline in popularity.
Here are some other factors that impact a valuation:
Return-on-investment (ROI) and relative risk: Many buyers make a formal estimate of the return earned on the investment, and compare that to a formal calculation of relative risk.
Customer concentration: A number of small businesses start by serving the needs of a few key customers. Over time, however, you need to diversify your customer base to increase your firm’s value to a buyer.
Reputation: If a seller can demonstrate a strong reputation in the market, brand awareness, and a powerful social media presence, the business is more valuable to a buyer.
Management team: An experienced management team can make smart decisions to increase profits and grow sales, and retaining talented managers has value to a buyer.
Location: Being located in an area that is growing or in a prime location can affect your valuation. Being located in a rural area can reduce the number of buyers that are interested in your business, in turn negatively impacting your valuation.
Growth: Selling your business when things are good and your business is growing is important when valuing a company. If you have a business model that is growing or your business is in a growing industry this can significantly impact the value of your business.
All of these factors play a role in the valuation of a business.
Estimates vary, but it can take six-months or longer to complete a business sale. Your timeline can vary greatly, depending on the size of your firm, how well your records are organized, and the current state of the economy.
Once you start to identify buyers, you need to consider how much information you’ll provide to them, and in what form. The structure of the sale has a big impact on the sale price, and you should work with your business broker on negotiation strategies for the sale.
There is another issue that has a big impact on the valuation of a business, and that is whether the buyer purchases the entire company (an equity purchase), or specific assets of the company. Note these important differences:
Assume, for example, that Riverbend Furniture, a manufacturer, buys 100% of Standard Furniture, a competitor. An equity purchase means that Riverbend is buying the entire company based on the Standard’s equity (assets less liabilities). If Standard’s equity is $2 million and Riverbend pays $2.5 million, $500,000 is posted to Goodwill on Riverbend’s books.
If Standard has agreements with customers, vendors, or suppliers, those agreements can be assumed by the buyer. Also, the buyer may be able to avoid a transfer tax on an equity purchase.
An asset sale allows a seller to collect on their accounts receivable balance, and the buyer to specify what seller liabilities they want to assume.
If, for example, a seller has $500,000 in cash, $1.5 million in fixed assets and $2 million in receivables, the seller can include the fixed assets in the sale, but exclude the cash and accounts receivable.
As a result, the seller delivers the business free and clear, meaning they take the cash and accounts receivable balances, and pay off the liabilities.
A business valuation will be impacted by the type of purchase the parties choose.
Selling your business may be the culmination of years of work and effort, and the sale may be the most important financial decision you’ve ever make. Put a team of professionals together who know what they are doing and can guide you will help to maximize the sale price of your business.