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What Every Business Owner Should Know About Valuing Their Business
By Stanley Feldman, Timothy Sullivan, and Roger Winsby
Any entrepreneur who contemplates buying or selling a business or who wonders what their company might be worth should read What Every Business Owner Should Know About Valuing Their Business by professional business valuation experts Stanley Feldman, Timothy Sullivan, and Roger Winsby.
Feldman, Sullivan, and Winsby tell us that most small businesses are too small to be sold for anything more than net asset value. We learn that of the 24.5 million businesses in the U.S., 17.1 million are owned by only one or two people and are often part-time endeavors operated from home.
These ultra-small businesses typically have zero value as a going concern, because they are often highly dependent upon the owner's labor and they have limited income potential.
Using an ultra-small-lawn-care business as an example, the authors point out that an entrepreneur wishing to start a lawn-care business would probably just purchase the necessary tools and start a new company, rather than purchase an existing company. These ultra-small businesses have little "goodwill" value beyond the value of their net assets.
Small businesses with several employees and an established client base often have value as a going concern. These companies often sell for more than net asset value. The amount paid above the net asset value is called "goodwill."
Because buying or selling a company is probably the biggest financial decision you'll ever make, you should understand the valuation process and consider utilizing the assistance of professional business appraisers. The authors tell us that professional business appraisal is costly, often ranging from $5,000 to $25,000 to appraise a company.
Using several case studies, Feldman, Sullivan, and Winsby discuss the main business valuation methods used today, including:
1) Valuation based upon earnings, which typically involves adjusting reported earnings appropriately and determining a proper industry-specific multiple of earnings for which the business should sell. Often, "similar" businesses are examined to see the valuations given to those companies.
2) Valuation based upon revenue, which usually involves determining an appropriate number that is multiplied by the company's revenue to determine company value.
3) Valuation based upon discounted cash flow, which involves estimating the future stream of free cash flow the business is expected to provide and then discounting this stream of cash flow to the present. Sometimes, the basic discounted cash flow calculation is further adjusted to allow for a small company's lack of liquidity or other factors.
Feldman, Sullivan, and Winsby write: "There is a growing consensus among professional valuation experts that the discounted cash flow method produces the most accurate valuation results for an ongoing, established business if there are no current transactions of very comparable businesses."
What Every Business Owner Should Know About Valuing Their Business shows the valuation of several specific businesses, including an insurance agency, an environmental consulting business, a law firm, and a metal fabrication company.
Each case study provides a current tax return for the business (one company is a C-corporation; two are S-corporations; and one is a partnership), and each company valuation demonstrates several aspects about the valuation of different types of businesses.
For example, for O'Toole Insurance Agency, we learn several things:
1) An important part of valuation is convincing the other party that there is a reasonableness to your valuation.
2) Large expenses can be incurred in valuing a business and preparing it for a sale. In one failed transaction, the buyer and seller collectively spent $44,880 in accounting, appraisal, and legal fees, and, in the end, the deal fell through.
3) Sometimes, it's important to separate different parts of a company for valuation purposes. O'Toole Insurance Agency owned its building and rented space to other occupants. If the potential buyer only wished to purchase the insurance business, the insurance business would need to be separately valued from the property and rental business. Also, because the new agency, sans building ownership, would need to pay rent, the insurance company earnings would need to be lowered by the new rental expense.
4) Discretionary expenses and "missing" expenses must be examined, and adjustments might need to be made to reported earnings when valuing the company. Feldman, Sullivan, and Winsby point out that many business owners incorporate discretionary expenses into their business in an attempt to lower taxation. These expenses reduce taxable income, but can be eliminated without compromising the earnings power of the company. (Some buyers might be willing to accept that the true earnings of the company are higher than taxable earnings due to these discretionary expenses, thus increasing the true value of the business.)
Feldman, Sullivan, and Winsby include a solid chapter about maximizing the value of a business. The authors say business owners planning for the sale of their businesses must start thinking less about minimizing taxes and more about maximizing company value. Over a period of several years, owners should prepare for the eventual sale of their company by making their operations more transparent and disentangling personal expenses from business expenses.
Suppose, for example, an entrepreneur incorporates $30,000 in discretionary expenses in his business, including expensive club memberships, that really aren't necessary business expenses. Assume these "expenses" generate little or no added sales and don't really help customer retention nor benefit non-owner employees. If the business sells for eight times earnings and we use the taxable earnings for valuation, this $30,000 in discretionary expenses will reduce the company valuation by $240,000.
Feldman, Sullivan, and Winsby write: "A dollar saved on taxes can cost $$$ in lost value."
The authors also discuss the possibility that expenses the owner claims are "discretionary" are, in fact, necessary. For example, the club memberships may be crucial to meeting potential clients. The authors tell us that a new owner who does less networking might need to increase advertising expense appropriately. And, thus, it's useful to examine the advertising expenses of similar companies.
What Every Business Owner Should Know About Valuing Their Business discusses other "life business events" such as divorce, death, transition planning, and portfolio diversification. There is also an excellent discussion of the different types of business structures, such as S-corporations and C-corporations.
Overall, I highly recommend What Every Business Owner Should Know About Valuing Their Business to entrepreneurs buying or selling a business.