The Mystique of Business Valuation for Privately Held Companies
As a Business Valuation and Merger and Acquisition firm, we often receive the following question from entrepreneurial business owners – how do I know what my business is worth? Business owners are commonly looking for an estimate of value for partnership matters, succession planning or to determine if they should consider selling now or sometime in the future. There are many unique factors to consider when valuing any business. The following will provide some background and take some of the mystique out of the valuation process.
Multiple of Seller’s Adjusted Net Cash Flow
The most widely used method to value privately held companies is based on adjusting or recasting of a business’s financial statements. This is also referred to as adjusted EBITDA (Earnings before Interest, Taxes, Depreciation, and Amortization). Financial statements are prepared for tax purposes, not business sale or business valuation purposes. It is critically important to “read between the lines” of the financial statements to determine the true earnings capability of the company. At Sun, we thoroughly review each line item to identify any one-time or non-recurring expenses, normalized compensation, shareholder fringe benefits and perks, non-cash expenses, and more. There are over 50 potential adjustments that we look for during this process. The goal is to determine the true earning capability of the business by adding back all the non-essential, non-recurring, or discretionary expenses to the net profit.
Once the adjusted earnings or EBITDA is determined, the next step is to apply a multiple of earnings or discount rate. This multiple is impacted by a vast number of risk factors, intangibles, and value drivers. During our valuation process, we typically review and analyze approximately 30 different value driver categories to determine how the company is positioned. Examples of risk factors and value drivers that influence valuation are: years in business and trend, proprietary content, industry life cycle, industry stability, customer base concentrations or dependencies, supplier dependencies, product or service differentiation, management quality and tenure, employee dependencies, impending regulation, and many others. Each of these risks is unique but has one common trait – an ability to either bolster or cast doubt on the predictability of earnings and future cash flow. As a result, the better a business can mitigate or control these potential risks, the more positive the impact on valuation.
It is important to determine the predictability and sustainability of earnings. We generally will utilize a comprehensive questionnaire to obtain the information needed to evaluate these factors. A few examples of questions include:
· Why is the business more/less profitable than a comparable company in the same industry?
· What degree of dependency does the business have on the current owner, vendors, employees, key customers, etc.?
· How reliable are the historic financial statements of the business?
· What is happening in the industry that casts doubt on the future income of the business?
These intangibles play a significant role in the valuation process, which is why one cannot solely examine financial information and arrive at a proper valuation.
Market Comparables & Industry Rules Of Thumb
There are a variety of resources available to research cash flow multiples that may be relevant or specific to your business. These include well known guides such as the Business Reference Guide and private transaction databases such as Pratt Stats and Bizcomps. These databases track thousands of completed private transactions and the valuations that were achieved relative to sales or earnings. The appropriate multiple of earnings and gross revenue using the Industry Comparable method is determined by reviewing similar private transactions that have taken place within the same or similar industry and applying the average and/or median multiples incurred in these transactions to the earnings and revenues of the subject company.
Business owners many times refer to common “rules of thumb” that are used in their industry. A rule of thumb valuation basically consists of using a simple formula that estimates the value of a business through a set of established and very general business pricing guidelines that relate to specific industries.
We find these Rule of Thumb methods can be misleading as they do not take into account the individual characteristics, strengths, and weaknesses of each different and unique company. Even if companies appear to present similar financial information, whether it is the mix of business, vendor contracts, management team, customer base, and concentration, or countless other factors, no two companies can be considered mirror images. This hinders an exact comparison. Additionally, due to the quality and accuracy of the financial reporting in the non-public, middle market sector, information is limited and adjusted earnings calculations commonly differ from company to company.
Private company valuation is both an art and a science. In addition to what was discussed, there are many other factors that impact business valuation, including strategic value driven by synergies with complementary businesses and potential acquirers. Ultimately, at the end of the day a business is worth what an acquirer is willing to pay for it. It is, however, critical to have a realistic understanding of the value of your company when addressing succession planning, partnership matters, exit strategy options or other important initiatives.