M&A POLL

Will Business Values Increase Over Next 12 Months?

M&A NEWSLETTER

FREE ARTICLES

ABOUT PRINCETON

SEARCH

TWITTER M&A

Joomla Extensions by ENYtheme

M&A Home -> Valuation Articles

Valuation Articles

BUSINESS VALUATION FROM AN INVESTOR'S PERSPECTIVE

Look at the Buyer's Alternatives to Find the Real Valuation of Your Business

Abstract

No one can tell you exactly what your business is worth except for someone ready, willing and able to buy or invest in it. But, with that said, by looking at your business from the perspective of a business buyer or investor, and their alternative investments, you will be able to see how much your business is worth.

ost every business would like to know what the real value of their business is. The truth is an accurate answer can only be found out through an exhaustive process of selling your business or trying to raise funds. Traditional standard valuations do not really provide a true value for a small business, mainly due to the subjectivity involved.

With that said, you can get close. In order to get as close as possible to an accurate valuation of your business, sometimes it is best to forgo the traditional business valuation template, (which in most cases is fairly useless,) and instead put together multiple scenarios that will help you to understand the value of your business to a buyer as compared with other alternative investments or assets the buyer is considering. This exercise will have an added benefit outside of understanding of your company’s value, by also helping you to understand what you should focus on in order to make it more valuable in the years to come.

Just like you make an investment, buyers will be looking at buying your business versus alternatives. High Net worth investors will look at your business objectively as an investment or source of income. Strategic buyers will have a choice of buying your business or trying to grow organically. Or let the competition buy the company and spend the money on marketing. We will look at each buyer type, and how they will look at your business.

The majority of small businesses exit through a sale, and therefore one of the best ways to put a value on a business is to determine the price someone will pay for your business. In that respect, a lot of the information below will be with relation to selling a company.

Passive Investors

Passive investors are those that will not participate in the day to day operations of the business. These might be high net worth individuals such as “Angel Investors”, small funds, or possibly a financial institution. The value they will put on your company will be based on two characteristics:

1. What return can they get from the business?

2. What interest do they have in the industry?

These investors will typically have investment portfolios that contain a wide range of investments, from assets such as stocks, bonds, real estate, commodities, to other business opportunities, charities, etc. Each of these instruments will have an expected return associated with it, and the principle rate of that return is based on the risk of that particular instrument.

When you are seeking an investment from this group, you are really competing against other investments they would like to make. In other words, they are going to invest this money, is it going to be purchasing stocks, real estate, or equity in your company? To understand the value of your business, you need to look at these other investments as your competition, and compare the rates of return for these alternatives and compare them to the rate of return on an investment in your company.

Although this is not a pure science, the rate of return on a $250,000 investment could be described as follows:

Instrument	Rate	Risk/Liquid	Investment	Expected Value - 5 yrs
Government Bond	2.7%	No risk/illiquid	$250,000	$285,622
Bank CD	3.0%	No risk/illiquid	$250,000	289,818
Stocks (taxes deducted)	5.5%	Some Risk/liquid	$250,000	$314,163
Real Estate (income producing – no leverage)	10%	Little risk.illiquid	$250,000	$375,914
Aggressive Growth Funds	12%	Risk/	$250,000	$406,301
Angel/Strategic Investor (50% of equity)	15%	High/non-liquid	$250,000	500,000 (assuming $1 million value)
Outside Investor (50% of Equity)	32%	High/non-liquid	$250,000	$1,000,000 (assuming $2 million value)

Let’s try to use the above chart in an example. Let’s assume you are trying to raise $250,000. In your chart, you are projecting approximately $230,000 in earnings in 2012. Let’s assume 5 years is 2014. The business will need to be worth $2 million by that time.

There are a couple of items to keep in mind.

Every investor will beat up your projections, and chances are they will knock them down.

The exception to this rule is the Angel or Strategic Investor who understand your business, or would like to add substantial value to it. They are in it for more than just a return on their investment. They enjoy working with small companies. It is very difficult to find angel investors, and hard to determine what value they will put on the company, since it typically not an objective calculation.

Most companies are valued based on a multiple of earnings. Let’s define earnings as the amount of cash someone from the outside would see come to their benefit assuming they were able to take over the business and run it themselves. So you would add health insurance, car payments, taxes, etc back to the earnings to make it higher.

For a business with “average” risk, most buyers will value the company based on a number that is (arguably) 3.5x’s the “adjusted earnings number”. (more on this multiple below) Therefore by the date you are thinking of realizing your “goal” valuation number you have to make sure that your earnings are that goal valuation number divided by 3.5. If you compare this to the chart above, I believe you will find the logic behind this multiple makes sense.

You will face an enormous amount of scrutiny if you are presenting a sudden increase in your earnings to an investor to justify a higher than 3.5x’s multiple valuation, so be careful. You will need to back up any number you put in front of a potential buyer or investor with concrete evidence and facts.

Institutional Investors and Funds

A typical venture capital company will look to make a tremendous multiple on their investment, because you have to pay for the failures they invest in and they can still have a 20% return to their investors. Therefore, they will typically look for an annual return of 40% on any of their investments. In addition, they want to know they have a rock solid exit within five years, whether through the public markets, an industry consolidator, or a Private Equity Fund.

Institutional investors will only be interested above a certain revenue level, and knowing that there is a clear and predictable liquidity event as an exit. Private Equity companies will not invest in any company that has less than $1 million in EBITDA in the vast majority of cases. The Public Markets are even worse, where you typically need $3 million minimum in EBITDA to make it worthwhile.

Strategic Acquisitions

This is very difficult to estimate, since strategic acquires can be interested in a business for so many different reasons. They are almost always the investor or buyer type that will give you the highest valuation for your business. This is for a number of reasons, including:

Lower risk since they understand your business, or at least the industry
Potential synergies since some of the business functions are probably redundant
Do not want your business to fall in the hands of another competitor, especially a well-funded or aggressive one that might cost them substantially when competing with them

What a Multiple of Earnings Means

The multiple is the amount multiplied by the earnings or the revenue that will compute to the price. In other words, if you were to use a 3.5 multiple of earnings, and the business is earning 100k, the price paid for the business will be $350k. If you are using a 0.8 multiple of revenue, and the company has $1 million in revenue, the price for the company will be $800k. The question is what multiple will an acquirer put on your business? As discussed above, it is mainly determined by risk. Unfortunately there is no concrete formula or absolutely definitive answer since no two businesses are alike. This subject will be discussed in other articles.

Conclusion

Your business is an investment to a potential buyer or other. You need to look at other investments as your your competition in order to understand your value. By putting yourself in their shoes, and asking the question about how much you would be willing to pay for your business, you can begin to determine the real value of the company.

Disclaimer

The Information Presentation Is Provided "As Is". Princeton Capital Strategies, Llc Does Not Warrant The Accuracy Of The Materials Provided Herein, Either Expressly Or Impliedly, For Any Particular Purpose And Each Expressly Disclaims Any Warranties Of Merchantability Or Fitness For A Particular Purpose.

SURPRISING WAYS GEOGRAPHY MAKES A DIFFERENCE WITH M&A

Recently, BizBuySell reported on the Businesses sold, by Business Brokers in CT as well as the rest of the US, as well as businesses sold by owner. The results were based on businesses for sale during the third Quarter of 2008. I found a startling fact when I compared the CT statistics from business brokers with statistics from business brokers across the US.

On BizBuySell, Business listed for sale across the US had a price that averaged .92% of the revenue of such businesses for sale, and a price that was equal to 346% of their cashflow. Contrast that with businesses for sale in CT, and business brokers and others listed those companies with a price that averaged 73% of revenue, and 279% of cashflow. Why would the business multiples used for valuing CT companies by business brokers be so much lower? What affect does this have to business owners everywhere who are trying to get the maximum value for their companies?

I do not know the disparity of the highest average multiple of cashflow by state vs. the lowest multiple of cashflow, but it is obviously significant. Remember, this is not a one to one proportion, so a business with a cashflow of $500,000 in CT is worth on average about $1.4 million, and the same business somewhere else is worth about $1.75 million. That is a significant amount of money. Assuming CT is not the state with the lowest multiple, and the average of the US is obviously not the highest, the difference on a $500,000 cashflow business could be as much as 2x's, or $1 million.

The possible reasons are too long to mention. The reason could be the cost of living, unemployment rates, cost of space or office rates, etc. The important issue is what you can you or your business broker do about it to make your business more valuable, whether it is in CT, NY, or anywhere else in the US.

The way to make your business valuable is to make it as portable as possible. A business that can be run from anywhere can be sold to someone in a geography where businesses are valued at a higher multiple. Your business broker or business intermediary should be marketing that business in their home state such as CT, but also in every state in the US. The more portable the business, the more likely you can get a buyer who is willing to value the business based on a higher multiple.

Princeton Capital Strategies, LLC

www.PrincetonCapitalllc.com

WHAT WILL MY BUSINESS SELL FOR?

As a business owner, before you decide whether or not to sell your company with a Business Broker, or Mergers & Acquisitions (M&A) Intermediary, you want to have an idea what your company is worth. It is very difficult to get a realistic value for what a business is worth for many reasons.

First, there are no two businesses that are alike, and therefore there are no real comparalbes. In addition, there are many many unkowns regarding the future of any business. There are other unkonwns as well including employees, machines/system, etc.

To get to a ballpark figure, if you have an S corporation with less than 50 employees, and less than $75 million, most buyers will use a number based on the total amount of "benefit" that the owner takes out of the business. This is called the seller's discretionary earnings, the "adjusted EBITDA", or the Earnings Before Interest Taxes, Depreciation, and Owners Benefit (EBITDO). This is not a standard number, and almost all buyers will computer it differently. To attempt an oversimplified definition, it is all the aggregate of all the extras that an owner receives, in addition to their salary and draw.

Most buyers base their bids on a multiple of this cashflow number. The multiple depends upon the amount of earnings the buyer expects to achieve over the next 3-5 years, and the risk involved in attaining that earnings amount. The more your business can show a history of steady earnings, and a system that acts as an annuity, the more value a buyer will assign to your company.

Buyers will "multiply" this number by a "multiple" to determine the price they would like to pay for the business. The multiple numbers range significantly. Some buisnesses will sell for a multiple of 1-2. Other companies will sell for a multiple 4-5, and even higher. Most companies sell somewhere in the middle, between 3-3.5x's earnings. Therefore if you can compute the amount of your "adjusted EBITDA", start with a number close to 3-3.5. Then being honest and objective, what are the risks to the continued success of your business? How likely is it you (or the new buyer) will continue to grow by 10% annually over the next 5 years? What are the inherent risks to your business?

Once you have the answer to these questions, you can use that information to determine where you are on the range, closer to 2-2.5, or closer to 3.5-4. That should give you a ballpark as to what your business is worth on average.

Princeton Capital Strategies, LLC

www.PrincetonCapitalLLC.com

Value Beyond a Business Broker

HOW TO MINIMIZE THE BUYER'S RISK AND RECIEVE A HIGHER VALUE FOR YOUR BUSINESS

When you are selling your business, you are typically trying to get the highest value for that business. The biggest impediment to getting full value for your business is the risk, whether real or perceived, that the buyer feels exists with buying your business.

As a business broker in the NY CT area we experience this during almost every sale. They buyer is determined to pay less value for the business, due to their idea of the riskiness of future earnings of the busienss. The business seller understands the risk, and is confident the risks are minor. How does the business seller mitigate the risk for his buyer, or guarantee that his business for sale will not fail?

This is a very complex question, and not one that we can easily answer in a couple of paragraphs. The business might be running fine, and would be running fine well into the future, but the new owner that just bought the business is now in control, and might unwittingly make decisions that decrease revenue and profits. How can the exsisting business owner guarantee anything when the do not have control? There are two methods many business sellers use.

One - partition out the expected revenue/earnings of the business, so that the existing owner cannot be penalized too much for bad decisions which they have no control over. In other words, if the new owner spends a considerable amount on a new product that flops, but the traditional business continues to crank along, that should not effect any earnout or future payments to a large degree. By compartmentalizing how the earnout is computed will negate a tremendous detraction.

Two - Share on the upside. If you as a business seller are expected to take on risk on a potential downturn in business, you must also share in any upside the business experieinces during that time. The business seller must set a benchmark of standard expenses, and get paid for profits (or revenue) that exceeds those benchmarks. Certainly the owner of the business for sale will not receive 100% of those additional earnings, but should share in some of the profits.

We mentioned these are complex agreements, and there are. It is very important to write them out completely, and allow for contingencies or unforeseen events. In the end, this will help the business owner receive maximum value for their business for sale because it mitigates some of the risk for the buyer.