When you own your own company for a while, you start to wonder what it’s worth, how much you can sell it for.
Many business owners believe their business is worth more than it really is. The reason for that is they look at their company from the inside out, naturally understating the risks and weaknesses and overstating the strengths and growth prospects.
Many business owners don’t consider what their personal involvement in the business is worth.
The concept of value to the current owner could also be the result of a sentimental attachment to the company, especially if the company was started from scratch and built up over the years.
So building value in your company tip #1—don’t create a company that won’t be easy to sell because it’s dependent on you remaining with it.
Value has three different perspectives. There is the value to the current owner, the intrinsic value of the company as a standalone entity and the strategic value of adding your company to the buyer’s existing operation.
The value of a company is based on its ability to generate cash flow now and in the case of the sale, more specifically in the future.
How are future cash flows determined? From the historical financial statements.
Building value in your company tip #2—make sure your historical financial statements are accurate.
When a professional valuates your business, they do it based on a concept of fair market value.
This concept has some assumptions that probably don’t hold true in the real world. For example, that the transaction is completed via cash on closing, that neither party ‘has to’ transact, that the buyer and seller have the same knowledge and that the market is unrestricted and no buyer is excluded.
The reality is that many sales are completed using holdbacks, promissory notes, share exchanges, salary buyout arrangements.
Perhaps the seller needs to sell due to health reasons and the buyer may need to buy to keep the industry flush.
The seller usually better understands their own business and the options available to it. Some buyers may be excluded due to timing, regulatory or access to financing issues.
When we talk about price, we also need to talk about liquidity, the ability to convert value into cash.
For example, it would take longer to convert a company that has inventory into cash, than it would for a company that only provides services.
Buyers may be looking for companies that are very liquid and don’t require a huge upfront investment to finance the assets purchased, and may pay a premium for these kinds of companies.
There are several ways of valuing a company and they are all subjective.
The most popular basis is earnings before interest, taxes, depreciation and amortization (EBITDA).
Another step in the valuation process is that earnings need to be normalized. What this means is that valuation is normally based on the last five fiscal periods.
Sometimes during these periods events may have happened in the company that are not expected to occur in the future called ‘discretionary spending,’ so the valuator will isolate these events and adjust the earnings accordingly.
An example of this are the salaries paid out to shareholders and related parties that were recorded to reduce taxable income.
Another example may be rental payments made for a building owned by the shareholder.
Perhaps the company’s books indicate obsolete or unused assets that are not required for the operation of the business.
When the earnings become ‘normalized,’ they can be thought of being similar to other companies operating in the same industry.
Building value in your company tip #3—keep discretionary spending isolated in the bookkeeping records and keep them to a minimum.
Once the earnings have been normalized and the EBITDA has been calculated, a valuation multiple is calculated to determine the possible value of the company.
These multiples can be influenced by several factors such as competitive advantage, revenue stability and diversification, management team, supply risk, competitive landscape, company size, growth expectations and capital expenditure requirements.
Building value in your company tip #4—focus on building those factors which will improve the valuation multiple that are controllable—competitive advantage, customer diversification, obtaining skilled employees, a history of sustained growth, and the ability to finance with debt rather than equity.
