Considerations in Selling Your Business- Part 2: Valuing the Business
- Created: Wednesday, 17 August 2016 07:00
by Patrick B. Mathis, Shareholder at Mathis, Marifian and Richter, Ltd.
Valuing the Business
Focusing beyond the personal and family considerations discussed in Part 1 of this series, and assuming the decision has been made to move forward with the potential sale of the business, the next steps focus on the business itself and developing a plan for sale.
In most cases an analysis of the value of the company in the market place is a critical first step. Different businesses, and types of businesses, are valued in different ways in merger and acquisition transactions. In many cases, this difference in value depends upon the type of business, the buyer market, location, growth opportunities, and numerous other factors.
For example, a manufacturing company with a relatively steady level of annual income may be valued within the market place based upon a multiple of “earnings before interest, taxes and depreciation and amortization” (“EBITDA”). In this scenario buyers evaluate historic or potential future EBITDA and apply a multiple to that number to determine a value. Essentially, this is a calculation of the anticipated return on the buyer’s investment to buy the business. For instance, if the business generates an annual EBITDA of $1,000,000, and the industry multiple for this type of a purchase is five, the indicated value of that business would be $5,000,000. This type of approach is frequently used by buyers who are in the seller’s industry or investor buyers who are purchasing a business with a projected cash flow and are seeking a targeted rate of return on their investment.
Valuation of other businesses may be based upon the value of the assets held in the business. For example, a real estate development company holding parcels of undeveloped or developed land may be sold based upon the market value of those parcels, with little consideration for the historic income stream from the business. Similarly, a business which depends upon ongoing bidding and contracts, such as a construction firm or engineering firm, with few ongoing customer relationships, and consequently no guaranteed continuing income stream, may be valued by a buyer at a fair market value of the assets to be purchased, with minimal additional value for the goodwill of the enterprise.
Some industries also have a “rule of thumb” valuation approach. For instance, an industry standard for valuing dental practices or insurance agencies may be a multiple of gross income. Franchise businesses may also have a relatively standard approach to valuation of locations.
Finally, businesses which may initially appear similar may have significantly different values. For example, two businesses in the same industry, each with annual gross sales of $20,000,000, may have significantly different values if one of them nets $5,000,000 per year while the other nets $2,000,000. These differences in profit margin may be based upon the difference in operating costs resulting from one business operating in a less competitive environment, having a non-union shop, etc. but the ultimate value is tied to the anticipated income to be derived from a buyer’s investment.
Determining a realistic value is an important initial step in the sale of any business enterprise.