Simple Business Valuation
Best Practices to Use When Valuing a Business to Sale or to Buy
Whether you’re selling a small business or buying one, it’s essential that you have an accurate understanding of the company’s current, and future, value. There are a number of factors to consider when it comes to business valuation.
The process can begin by asking basic, yet important, questions about the business at hand. How much of the company’s revenue is recurring? Are there contracts with customers/clients?
Does the business have unrecorded assets/liabilities, such as intellectual property or customer relationships? Can the business survive without the existing owner? Do the assets of the company have actual economic value or just sentimental value?
No two business valuations will be the same, but small business owners and potential owners should keep the following best practices in mind when going through the process of placing a value on a business.
- Be careful not to overly rely on a "rule of thumb." This method of business valuation uses a simple formula to estimate the value of a business through a set of established, general business pricing guidelines. This can result in a valuation that is much too high or too low depending on the specifics of a particular business. The owner of an optometric practice, for instance, could use a “monthly net revenue multiplier,” typically ranging between 3 to 7 times, to come up with a rough estimate of the value of the practice. But after arriving at a rough range of values from $300,000 to $700,000 for a practice generating monthly net revenues of $100,000, the owner may still be searching for the value.
- Know what to place importance on. It’s essential not to place too much emphasis on the reported book value of a business—valuation is about more than just this number. To get an accurate valuation, don’t ignore the unrecorded assets, as well as the liabilities, of a business. For example, a trained workforce, a customer relationship and a trade name all provide value to a business but don’t directly appear on the financial statements. Contingent liabilities, such as environmental cleanup costs and pending lawsuits, may not appear on a business’ financial statements either.
- Understand the difference between “cash flow” and “income.” Cash flow is the amount of money that a business receives and spends during a particular period of time. Income is what remains from sales revenue after all expenses are subtracted. While both reflect the economic benefit of owning the business, a potential buyer generally focuses on cash flow when considering buying a business. To help to understand the difference, one might view income as analogous to “scoring” and cash flow as analogous to “winning.”
- Don’t forget to make appropriate adjustments to the historical financial statements for things such as discretionary expenses and non-recurring items. In order to correctly estimate the value of a business, it is crucial to determine the “normalized” economic benefit that the business can be expected to generate in the future. Therefore, anything that is not representative of the normal operations of the business should be removed from the financial statements. This generally includes legal expenses for non-recurring lawsuits, expenses related to disaster cleanup and rent paid in excess of fair market rents.
- Make sure to pay attention to the assets that are often overlooked and should be considered closely. This includes inventory (which is often written off completely), backlog and work in process, as well as any unrecorded or barter revenue. Other factors that are frequently ignored are whether the business has a favorable lease or a workforce already in place. One should consider an asset of a business for which an incoming owner would perceive value and ultimately pay for.
- Don’t ignore intangible assets. Brand recognition, customer/client base, talent, proprietary processes and years in business are non-financial assets that won’t show up on a balance sheet, but they are extremely important when performing a business valuation. This is particularly the case for service businesses which rely heavily on customer relationships and brand value.
If you are enlisting a CPA who is Accredited in Business Valuation (ABV), to value your business, keep in mind that you’ll need to have the following documents prepared:
- Your tax returns for the last three to five years Trailing 12 months as of the most recent month and for one prior year Accounts receivable listing Depreciation list Schedule of discretionary expenses Unrecorded revenues Barter revenues Year to date financials (if the valuation is done on an interim basis)
While it may be fairly easy to come up with a “ballpark” idea as to the value of a business, taking the time to explore the many nuances of the process can mean the difference between striking out, and hitting a home run.
Kevin R. Yeanoplos, CPA/ABV/CFF, ASA is director of valuation services for Brueggeman and Johnson Yeanoplos, P.C., a Phoenix firm that specializes in business valuation, financial analysis, and litigation support. Yeanoplos has extensive experience, having valued over 1,000 businesses for a variety of purposes, including divorce and other litigation, gift and estate taxes, mergers and acquisitions, and ESOP's. He was in the charter class of those earning the ABV and the CFF credentials.