One of the key aspects of a formal succession plan is determining the value of the business. Through our Formal Succession Planning program we are able to help ground business owners in the reality of what they have so they can plan for the next phase of their lives.
There are four major components to take into consideration when trying to determine the value of your business or farm;
1. Type of valuation methodology that is right for you
2. Timelines of the sale and how that can impact the ultimate price
3. How this impacts your potential buyer
4.Getting an actual business valuation done.
It is also important to note that a business valuation is not the same as an asking price. Dollar amount is not the only thing in the Purchase and Sale Agreement that should be taken into consideration.
Business Valuation Method
There are a number of different methods to valuate a business. The method selected for your business or farm is determined by the industry and the type of sale you are using for the transition from one owner to the next. Here are a list of the most common types of methodologies and some examples of the types of industries that would use them.
- Discounted Cash Flow (DCF) Method
The DCF method is based on a projection of the future cash flows of the business. This is most commonly used when a business owner is selling an operating business to a new owner, and takes into consideration inflation to determine a net present value.
- Book Value
The book value method is based on taking the value of the shareholders’ equity of a business from the balance sheet statement, total assets minus total liabilities. This is commonly used by businesses that have stopped operations or are assessing an asset sale option.
- Earning Multiplier
The Earning Multiplier is a basic calculation that can be used by medium or large businesses, and franchises, that are selling to professional buyers like Private Equity Groups. It is used to compare companies that have reliable profit and consistent input costs to predict future revenue.
- Times Revenue Method
The Times Revenue Method is a basic calculation that can be used in niche markets like tech that professional buyers believe they can grow the revenue quickly through some form of market advantage or when raising venture financing. The equation is a total revenue times multiplier for that industry and economic environment.
- Market Capitalization Method
The Market Capitalization Method is based on taking the company’s share price multiplied by the total number of outstanding shares. This is most commonly used by publicly traded companies.
Timeline
Timelines of your sale come into play for two main reasons; if you should spend money on getting a professional valuation, and how it can help you drive up the price of your business through the transfer of goodwill.
As many of us have experienced through running our businesses, especially during the pandemic, market conditions can change dramatically year over year. If a business owner has more than 3 years before they want to sell, we do not usually encourage that they spend a considerable amount of money on a business valuation because a lot could change before they go to transition.
The second thing to take into consideration in a business valuation is if you wish to get full compensation value for your Goodwill. If that is the case, then you will need to mitigate this risk for your buyer by staying on for a longer mentorship period.
Buyer Perspective
A business owner could ask whatever they like for a business, but that does not mean someone is going to buy it. There are multiple factors that come into play when a buyer is looking at a business, primarily:
- What is of real value in the business that will ultimately receive a return on the investment in the future?
- Will the opportunity cost of capital be returned in five years or less? Too often we hear business owners say: “If someone came in with more money, energy, and a little bit of marketing then this business would be a huge success.” Although that may be correct, that potential buyer could invest their money and time into a number of different activities and realize a return. If the business will not pay for itself in five years or less, then a buyer is unlikely to purchase it.
- Is it bankable? The biggest barrier to purchasing a business is finding financing. Many institutions will not lend on goodwill because it’s risky. As a business owner, you have years of experience managing the ups and downs, plus have those personal relationships with all of the customers. The potential buyer may really love the business and can see the opportunities, but if they are using leveraged financing, then a business owner has to understand that lenders may require some safeguards like vendor financing or holdbacks.
Chartered Business Valuation
Many business owners get fixated on the price of a business, but there are many factors which contribute to the value of the business. Engaging a Chartered Business Valuator after completing your formal succession plan can help you negotiate a better position in the value of your business. It is important to keep in mind that a business valuation is a range that the business could be worth, and different components of the business could help you drive up the total return on investment that you receive from the business or farm.