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Business Valuation Overview

  • Business Valuation Overview

Business Valuation Overview

By Jack Findaro, Co-founder and Managing Partner of Vetted Biz

Introduction

I want to start off by welcoming you to Vetted Biz. We help small business investors find, vet, and finance small business investments, whether they be independent businesses or franchise businesses. We believe in empowering the individual, in this case, small business investors, through transparency and data. Our team at Vetted Biz works to consistently and effectively communicate our findings that come as a result of continuous research and analysis.

The Vetted Biz platform was designed with the small business investor/owner front and center. Unsurprisingly, a major area of focus for financial valuations for small businesses.  Understanding how to properly conduct a small business valuation is of utmost importance when looking into investing in a small business or starting your own small business. We define the term “small business” as an entity with less than 50 employees and under a $5,000,000 value.  The average small business is significantly smaller with a value of $300,000 and less than 10 employees.

Our journey began several years ago when my brother and business partner, Patrick Findaro  and I founded our first company, Visa Franchise, with the goal of helping high net worth individuals obtain investor visas through franchise and small business investments. Since our humble beginnings, our team has helped hundreds of individuals alongside their families find and analyze franchise and small business investments. We realized there is a lack of clear guidance for individuals looking to see how much a small business is worth. Here we aim to summarize our findings that have come about through years of experience and a deep-dive review of the foremost information resources that currently exist on the topic of business evaluation in order to give you, the small business investor, the necessary tools and terminology for understanding the process of business valuation. Every entrepreneur should know what their business is worth!

What is Business Valuation?

Business valuation is a process and a set of procedures used to estimate the economic value of an owner’s interest in a business. In essence, the goal of business valuation or company valuation is to use established methods and assumptions in order to figure out the value of a business based on the specified interest in the company as of a specified date.

Business valuation and company valuation, particularly when considering small businesses, is easier said than done. Unfortunately, business valuation is not an exact science due to a multitude of factors that I will go over in detail. However, while not perfect, the various methods of business valuation enable a small business investor to have a better understanding of the value of the company they wish to purchase before making what is typically the most important investment decision an individual can make in their life. In the end, it is much better to be approximately right than completely wrong.

 

How is Business Price Different from Business Valuation?

“Price is what you pay; value is what you get.”

Warren Buffett (source)

It is important to understand the difference between price and business valuation. In essence, the price of a business is what an individual is willing to pay for the business. Price is impacted by timing, negotiation, economic demand, luck, financing, and emotion, in addition to other factors. The price of a business can even be affected post-closing through adjustments related to continued business performance and the discovery of false representations and/or warranties.

Value, as previously defined, is very much focused on the economic value as it relates to the individual. That individual could be the business seller or the business buyer. Each one will likely assign their own worth to the business which will almost certainly be different from the price of the business. The key principle to keep in mind is to figure out the value of the business first before figuring out the price. A business buyer’s goal will be to find a business that is undervalued relative to its price. If a business buyer overpays for a business by paying too high a price relative to the determined value of the business, then it will be more difficult for the business buyer to earn their desired financial return.

Our goal is to provide the potential business buyer the knowledge to decrease the chances of making an investment that they later regret.

Small Business Valuation

The Financial Accounting Standards Board defines a business as the following:

“A business is an integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return in the form of dividends, lower costs, or other economic benefits directly to investors or other owners, members, or participants”

This specific wording is focused on the definition of a business as it relates to accountants. However, as it pertains to business valuation, a small business exists when:

  1. Employee and client relationships are transferrable
  2. Technical knowledge and/or processes are transferrable
  3. The capability to generate income in the future exists

The below data table, as found on the U.S. Small Business Administration (SBA) website, shows the size of employer firms by receipt (revenue/sales) size.

(INSERT TABLE FROM EXCEL)

Small businesses comprise the majority of the firms in the U.S. For instance, 96.5% of all businesses have less than $10,000,000 in sales, while 93.6% of all businesses have less than $5,000,000 in sales, and 75.5% of all businesses have less than $1,000,000 in sales.

The focus of the business valuation methods we have researched has been on small businesses as the business valuations for small and very small businesses tend to have their own unique challenges when compared to the valuation process for very large and/or public companies. For our purposes, we will define the criteria for small and very small businesses as the following:

Small business: Less than $5 million in sales

Very small business: Less than $1 million in sales

The biggest challenge pertains to the data of small businesses, which we will cover in-depth below

Challenges to Small Business Valuation

There is no magic bullet for small business valuation. Small business valuation is not as simple as some may expect due to a variety of issues. The biggest obstacle to valuing a small business can be summed up in two words – accurate data. Data is the biggest input driver behind calculating the value of a company. Without the proper data, it becomes extremely difficult for a business buyer to decide on which valuation method to use, much less calculate the value of the small business they are interested in potentially investing in.

This information gap in the small business for sale market has been a significant inspiration behind the Vetted Biz platform. It is the reason why we focus so much time and energy on finding businesses that have verifiable data as it is absolutely necessary in order to ensure that a business buyer is as informed as possible before making their investment decision. Transparency for both the buyer and seller of a small business increases the chances that an agreed upon price can be found and a deal executed. Without proper, verifiable data, it becomes exceedingly difficult for a business buyer to justify investing a large sum of capital into a small business.

The lack of data may not even necessarily be due to nefarious actions or due to the small business owner looking to hide the information from potential buyers. In fact, many small business and very small business owners manage their business day-to-day based off of a few key metrics, such as sales, cost of goods sold, and available cash.  Interestingly, the business owner might not just be able to operate their business in such a way, but rather operate the business quite successfully! Additionally, while many small business owners are moving towards online bookkeeping software such as QuickBooks Online (QBO), which is a significant help when auditing the data of a small or very small business, many small business owners still use inaccurate, old-fashioned bookkeeping practices such as using excel spreadsheets or maintaining transaction logs in a notebook.

Even when accepting the assumption that the data is verifiable and accurate, there is a strong chance that even that will not be enough. In particular, a business buyer will need to figure out how the data might be distorted. Common examples of how the data can be distorted include:

  • Non-business-related expenses on the profit and loss statement such as auto expenses, meals and entertainment, travel, etc. (typically due to tax shielding by the business owner)
  • Less than fair market salary going to the owner
  • Family members of the owner on the payroll
  • Benefits to the owner and/or their family

These items will need to be taken into consideration when calculating the Seller’s Discretionary Earnings (SDE) of the business as that will significantly impact the business valuation for any company, especially the valuation of very small businesses with less than $1,000,000 in sales. For very small businesses, terms like owner compensation and owner earnings are commonplace for Seller’s Discretionary Earnings. 

Choosing the proper business valuation method is also particularly important to keep in mind for a small business buyer. Since small business valuation is not an exact science, it is important to make an informed decision regarding with method(s) to use based off of the characteristics of the business. Choosing the wrong business valuation method can do more harm than good, which is why Vetted Biz aims to demonstrate which method is most preferrable based off of which circumstances.

Calculating Business Valuation

There are four primary methods of business valuation. A potential business buyer should view them as tools which can and should only be used when certain conditions are met. Similar to how one would not use a hammer to fasten a screw, not just any method should be used for a business valuation. One must understand the characteristics of the business, such as the type of business, longevity of the business, and historical financial data availability, among others, before deciding on the method to use.

While three of the four methods are very widely accepted across the existing business for sale market, one of the four methods in particular appears to have significant strength due to its focus on return on invested capital (ROIC) for a potential business buyer. The four business valuation methods can be summed up below:

Each business valuation approach has its pros and cons which must be taken into consideration based off of the business at hand. Below we can view a summary of each one.

Economic Approach to Business Valuation

The economic approach to business valuation places a strong emphasis on the return on invested capital (ROIC), typically referred to simply as “the return,” of a business investment. The financial return of a business is typically the biggest consideration a business buyer has when deciding if he or she should invest in a small business (as should be expected when investing tens or hundreds of thousands of dollars!).

It should be noted that a business seller will also typically weigh the return on invested capital they receive from their business investment that they own/operate when deciding if they should sell the business. After all, they would likely need to find a suitable replacement to what can be a very significant return. The findings of renowned author, speaker, business consultant, and accountant Greg Crabtree places the return on invested capital of a profitable business with 15%+ profitability in terms of net income at a minimum of 50%. More often than not, the return for a business of 15% or more net income is above 75%. How many investment opportunities exist where an investor can achieve a 50% annual return? (Hint: not many.)

Let us take a look at how the economic approach to business valuation is used in practice.

How is it calculated: profits divided by total investment in the business

When to use it: best company valuation method for existing businesses with 2-3 years of financial history available when the near term (2-5 years) economic outlook for the business looks steady

Pros

Cons

Income Approach to Business Valuation

The purpose of the income approach to business valuation is to calculate future cash flows then calculate the present value of those future cash flows by using a discount rate. The glossary published on Business Valuation Resources defines discounted cash flow as “a method within the income approach whereby the present value of future expected net cash flows is calculated using a discount rate.” The goal of this busines valuation approach is to enable a business buyer to make an informed investment decision and better understand what the projected income is worth at present time.

The key concept to keep in mind here is the time value of money, which, in essence, is the notion that money you have now is worth more than the identical sum in the future due to its potential earning capacity. The future projected cash flows are “discounted” to account for the time value of money, the required rate of return, and the amount of risk involved for the given investment.

How is it calculated: This is a multi-step process. The steps are below:

  1. Project future business earnings (typically 5 or more years into the future) or cash flows.
  2. Determine discount rate.
  3. Assign a value for the business at the end of the period. This could be the expected sale price of the business, also referred to as the terminal
  4. Discount the future business earnings or cash flows to present value by inputting the variables into a DCF calculator or excel model. The calculated value is the net present value.

When to use it: Best used for turnarounds and startups where the prior historical financials are not as relevant Additionally, best for individuals that plan on being “investors” in the business instead of directly operating the business.

Pros

Cons

Market/Comparables Approach to Business Valuation

The market approach to business valuation values the subject business based off of the selling price data from recently sold similar businesses. The idea is that it is similar to how homes are valued in the real estate market. Typically, homes are valued relative to recently sold homes in the area, with the recently sold homes’ data adjusted to be more comparable to the subject home to be sold. By applying this same principle to the business valuation market, the goal is to calculate a business valuation that reflects the fair market value, or the “going rate,” in the market within which the business is located.

A key consideration here is to utilize aggregated comparables data, adjusted for an apples to apples comparison. If data from only a few specific recent transactions in the market are used as a comparison, then it is quite likely that other, unknown factors that are impossible to verify, specific to those deals, might have heavily impacted the sales price. That is the reason why a large, accurate database is necessary for the market method of business valuation.

The subject business’s financial data is also very relevant for this business valuation method. It is key to find an accurate cash flow metric, usually the seller’s discretionary earnings (SDE) for very small businesses, to multiply by the comparables multiplier. After all, it will be counterproductive for a business buyer to calculate an inaccurate valuation by making an error on the primary input variable (near-term expected cash flow).

How is it calculated: Choose the appropriate expected future cash flow then multiply that figure by the appropriate multiplier

When to use it: if the subject business is generic and the market has a large amount of accurate comparables data available to use. Additionally, it helps to answer the question of ‘does this make sense?’ if there is a different valuation or price to compare it to.

Pros

Cons

Asset Approach to Business Valuation

The asset approach to business valuation values the assets of the business minus the liabilities. The asset approach is the fourth primary business valuation approach, and it also happens to be the simplest business valuation method. The glossary published on Business Valuation Resources defines the asset approach as “a general way of determining a value indication of a business, business ownership interest, or security using one or more methods based on the value of the assets net of liabilities.” We will go over the various adjustments that might be made to the assets and liabilities in order to calculate the net assets, which is equivalent to the equity of the business (assets – liabilities = equity).

It is typically only used as a valuation “floor,” or lowest value that a business buyer would value the company they are looking at purchasing. Additionally, the asset approach to business valuation might be used due to a liquidation, either orderly or forced, as the business is not expected to be a going concern moving forward. In essence, the specific business will not be operating into the future, so the business buyer will need to understand the value of the net assets.

The most popular approach to this would be to value the assets at fair market value, then subtract the liabilities at fair market value. This is referred to as the adjusted net assets method, which falls within the asset approach. By valuing both assets and liabilities at fair market value, the business buyer can have a strong understanding of the remaining equity value of the business.

How is it calculated: identify the fair market value of the assets (both on and off balance sheet) and then subtract the fair market value of the liabilities

When to use it: Best used for a business buyer that is only interested in the net assets of the business or a business seller looking to liquidate their business as quickly as possible

Pros

Cons

Summary

Small business valuation can be complex at times. Hopefully the summary explanations here are helpful in determining which approach might be best to use for a given business valuation situation you might be facing. We have created additional materials which can more thoroughly explain each of the various small business valuation methods. Please feel free to send us your feedback on any of the information. Finally, we wish you good fortune (literally) on your entrepreneurial journey!

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