Many sellers of privately owned businesses overvalue their companies. This mistake is a major reason why businesses fail to sell. However, there are solid techniques and procedures that can be used to help both buyers and sellers calculate an appropriate value for any particular business. Above all, buyers and sellers should realize that valuation is art and science, which is one reason a seller’s valuation is often quite different from a buyer’s.
I recommend that my clients seek professional advice from an outside valuation firm or from M&A experts at an investment bank. The pros understand business-value drivers that are unique to sellers and buyers, the value of the business’ intellectual property, and how investment decisions are made by venture capital and private equity firms, and strategic and financial investors.
There are three generally accepted methods that should help sellers and buyers formulate a reasonable valuation. They are asset-based, income-based and market-based. Each can produce different valuations, so they should be used to triangulate a range, while still allowing for other factors that are unique to the business to boost or lower the final valuation.
Here’s how they differ:
Asset-based valuation methods estimate the value of a business as the sum total of the costs required to create another business of equal economic value. They are useful for calculating a business purchase price allocation, an important element of structuring a deal. The two central methods under the asset approach are the asset-accumulation technique and the excess-earnings technique.
The asset-accumulation technique is a framework for tabulating the market value of the business’s assets and liabilities. The difference is the business value. Note that this method differs from the typical cost-basis accounting on a balance sheet. Important off-balance-sheet assets include intellectual property, customer lists, customer contracts and licensing agreements. The liabilities side of the balance sheet accounts for such things as pending legal actions, judgments and the costs associated with regulatory compliance.
The excess-earnings technique is an established way to determine the value of business goodwill and total business value. It has been used by the U.S. Treasury Department since the 1920s. It is used for business purchase price allocation in legal disputes, IRS challenges and to prove that the business is worth more than its tangible asset base.
Income-based valuation methods determine the business value based on its income-producing capacity and risk. The two main techniques that are used are capitalization of earnings and discounted cash flow income streams to calculate business risk. If a business has consistent earnings year over year (an uncommon situation), then both techniques are equivalent. You can use the current year’s business earnings and an earnings growth rate as your business valuation inputs. The capitalization rate is then simply the difference between the discount rate and the business earnings growth rate.
However, if the business earnings vary materially over time (the more common situation), use the capitalization multiple of earnings technique by discounting its cash flow. Because you can model reasonably accurate earnings projections only so far into the future, make your business earnings projections only out three to five years. Assume that, at the end of this period, business earnings will continue growing at a constant rate. Discount your projected business earnings at this point. Capitalize the earnings beyond this point. This gives you the residual or terminal business value (that point in the future when the investors hope to cash out).
Market-based valuation methods help you estimate the business’ value by comparing recent selling prices of businesses similar to yours and comparing the multiples paid based on the earnings of the other similar businesses – usually earnings before interest, taxes, depreciation and amortization. Both types of methods compare the subject business to similar companies that sold recently. Valuation comparables from M&A transaction data for public companies are usually more reliable than comparable data from privately companies. However, in reality, no two businesses are exactly alike. Therefore, each business’s unique characteristics should be factored carefully into these comparable transaction analyses.
A final point to remember: The art of any successful valuation is bringing together the subtle components and important intangible variables – such as the quality of management, the quality of earnings, a highly skilled labor force and other variables – along with the application of various valuation methodologies.
Gary Miller / SDR Ventures Gary Miller is the managing director of SDR Ventures Inc.’s Consulting Division, where he helps middle-market private business owners prepare to raise capital, sell their businesses or buy companies and develop strategic business plans. He can be reached at 970-390-4441 or email@example.com.