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What Factors Are Considered In A Small Business Valuation?



Posted By: Peter Siegel MBA: BizBen Founder, Lead Advisor.   Valuing a small business is not guess work. It's not what some other businesses of the same type may have or may not have been sold for, it's not even what a business owner "feels" they want or deserve. It is a formula based on many factors. Peter Siegel, MBA from BizBen & others discuss this topic.

Valuing a business is not guess work. It's not what some other businesses of the same type may have or may not have been sold for, it's not even what a business owner "feels" they want or deserve. It is a formula based on many factors, some of them internal and related to the specific business being valued, and some of them external and related to the market and the economy.

Having an in depth analysis of all pertinent factors done by a professional is so necessary and valuable to determine an accurate opinion of value.

Some of the internal factors that are taken into consideration are:

(1) historical performance;
(2) longevity and stability of the business;
(3) financial strength;
(4) profitability and earnings;
(5) discretionary cash flow;
(6) ownership and management strength and structure;
(7) operational structure and controls;
(8) size of operation, market share, and customer base;
(9) forecast and future projections;
(10) condition of the operation;

Some of the external factors that are considered are:

(1) the performance of the company compared to standard performance within the industry; (2) size of operation relative to the industry;
(2) its rank or position within the industry;
(3) its position within its market;
(4) industry trends;
(5) competition;
(6) economic factors
(7) government regulations

As you can see there are numerous factors that need to be analyzed in order to perform a formal valuation. Because it must be objective the use of an independent, qualified third-party valuation resource is essential.

Each business has its own individual characteristics, and different industries operate under a different set of valuation criteria. The first thing to consider are the elements of value that you will need to give the strongest consideration to. As an example, my expertise is in the vended laundry industry. We will look most closely at, the mix and equipment condition, the fit to the market and individual machine group performance. Next is the lease. Our industry requires a very long term lease, in order to make the model perform as needed and later sell, without erosion to your initial investment. So we will require Utility Bills, we will perform on site diligence and do detailed analysis of the findings. We will also look at the market area and the surrounding competitors, in doing this analysis. Frequently we will need to take a 2 - 3 week period to count the income and do general store observations of the operating system. We may (usually do) need to renegotiate the lease, which can take weeks, or even longer.

So there are stages of diligence. While these are necessary areas to examine, it can be frustrating for the Seller. We usually present a Letter of Intent to begin the process. This demonstrates a sincerity with the understanding that follow up negotiations may be required, based on the accuracy and acceptability of the initial information.

As stated, each business has its own unique qualities and evaluation criteria. I recommend using an industry expert to assist you with the due diligence. In some cases you might consult more than one type of expert, the equipment for one. An accountant is another. Someone that knows the market area and the business style can be of great assistance and shed light on the businesses potential. If you are not already familiar with the business model or how this business suits the specific market, you need to find someone that is. It will be important to know how much you may need to re-invest into the business to get it where you need it to be, in order to move it forward and continue to grow and expand. In my business it is quite common to purchase a business and then put in a hundred thousand or 2, or 3, or... into the business to redirect the model and increase revenues. This usually pays well for its self in our industry but in others, it may just be another unanticipated expense. You need to know these things.

This sounds heady, but you are likely investing a big part of your assets into this business and you want to protect it. You also do not want to be in a position where you spend the next several months or years trying to get out of a bad deal. That is worse than the loss of the money.

I do not recommend relying solely on the Broker for diligence, unless he is also an industry expert and you have a way of double checking the valuation and his work. You need to be sure you understand the findings and are ready for whatever challenges you may be facing. Remember, the broker is highly incentivized to get the transaction completed. You want to make sure to cover all of the bases. All done well, there is a great future opening up for you. Good Luck!

Each business has its own individual characteristics, and different industries operate under a different set of valuation criteria. The first thing to consider are the elements of value that you will need to give the strongest consideration to. As an example, my expertise is in the vended laundry industry. We will look most closely at, the mix and equipment condition, the fit to the market and individual machine group performance. Next is the lease. Our industry requires a very long term lease, in order to make the model perform as needed and later sell, without erosion to your initial investment. So we will require Utility Bills, we will perform on site diligence and do detailed analysis of the findings. We will also look at the market area and the surrounding competitors, in doing this analysis. Frequently we will need to take a 2 - 3 week period to count the income and do general store observations of the operating system. We may (usually do) need to renegotiate the lease, which can take weeks, or even longer.

So there are stages of diligence. While these are necessary areas to examine, it can be frustrating for the Seller. We usually present a Letter of Intent to begin the process. This demonstrates a sincerity with the understanding that follow up negotiations may be required, based on the accuracy and acceptability of the initial information.

As stated, each business has its own unique qualities and evaluation criteria. I recommend using an industry expert to assist you with the due diligence. In some cases you might consult more than one type of expert, the equipment for one. An accountant is another. Someone that knows the market area and the business style can be of great assistance and shed light on the businesses potential. If you are not already familiar with the business model or how this business suits the specific market, you need to find someone that is. It will be important to know how much you may need to re-invest into the business to get it where you need it to be, in order to move it forward and continue to grow and expand. In my business it is quite common to purchase a business and then put in a hundred thousand or 2, or 3, or... into the business to redirect the model and increase revenues. This usually pays well for its self in our industry but in others, it may just be another unanticipated expense. You need to know these things.

This sounds heady, but you are likely investing a big part of your assets into this business and you want to protect it. You also do not want to be in a position where you spend the next several months or years trying to get out of a bad deal. That is worse than the loss of the money.

I do not recommend relying solely on the Broker for diligence, unless he is also an industry expert and you have a way of double checking the valuation and his work. You need to be sure you understand the findings and are ready for whatever challenges you may be facing. Remember, the broker is highly incentivized to get the transaction completed. You want to make sure to cover all of the bases. All done well, there is a great future opening up for you. Good Luck!
Contributor: Business Appraisals, Valuations Advisor
Discount for lack of marketability and control - Over the years I have been asked to calculate discounts for lack of marketability and control for minority business shareholder buy backs. It bothers me that business owners in need of operating capital for their business will sell minority interests, but when it becomes time to buy out these minority interest they expect the value to be discounted (these discount can be as much as 40%). They are happy to take the investment money and at times not even pay any yearly dividends but reluctant to pay back the full value of the minority shares. I can see that if a minority shareholder tries to sell his shares on the open market these discounts may apply, but it also seems to me to be unreasonable for a stock buy back to go this route. If you or any of your clients are considering a minority investment in a business make sure the sale contract contains language that prevents the business from discounting minority share values upon buy back. If you are going through a buy back, get an appraisal on the business. Business owners tend to offer lower values on stock buy backs than the stocks are actually worth. My experience is that businesses buying back their minority shares tend to offer 50% or less for these shares before consideration of any minority discount.

Discount for lack of marketability and control - Over the years I have been asked to calculate discounts for lack of marketability and control for minority business shareholder buy backs. It bothers me that business owners in need of operating capital for their business will sell minority interests, but when it becomes time to buy out these minority interest they expect the value to be discounted (these discount can be as much as 40%). They are happy to take the investment money and at times not even pay any yearly dividends but reluctant to pay back the full value of the minority shares. I can see that if a minority shareholder tries to sell his shares on the open market these discounts may apply, but it also seems to me to be unreasonable for a stock buy back to go this route. If you or any of your clients are considering a minority investment in a business make sure the sale contract contains language that prevents the business from discounting minority share values upon buy back. If you are going through a buy back, get an appraisal on the business. Business owners tend to offer lower values on stock buy backs than the stocks are actually worth. My experience is that businesses buying back their minority shares tend to offer 50% or less for these shares before consideration of any minority discount.
The "Fair Market Value" (FMV) assumes that there is a market and what that market is. Usually, the market is an unrelated buyer and anticipates the sale of the entire business at a time chosen by the seller.

David MacMillan is correct in pointing out that there are variations on what the perceived market can be, based upon the circumstances of the "market" and the particulars of the asset being sold.

In the case of a divorce or dissenting minority owner situation, IF the business were to be sold it would be under duress, not at a time or under circumstances necessarily favorable to the business and, thus, would be based upon this less advantageous "market." -- The resulting Fair Value or Investment Value would typically be less than the FMV; sometimes, considerably less.

Similarly, there is particular value to majority ownership or a controlling interest in a business. When determining the value of a minority interest in a business, attention must be paid to the reality that a minority interest will almost always have far less value than a proportionate share of the FMV and, in fact, in some instances can be worth virtually nothing. The majority is usually under no obligation to place the business on the market for "partitioning" and, if forced to do so the resulting sale price could be much lower than the FMV. Also, the minority shareholder may not even have the right to sell his minority interest; but, even if he does, rarely would he find an investor willing to buy it.

This I refer to as the "Minority Shareholder Disadvantage," which I have had to address in several purchase negotiations I have facilitated over the years, both in my former legal practice in New Jersey and in my business broker practice in California.

This illustrates why business partners must consult with both a competent experienced business law attorney and business broker in advance of acquiring or embarking on a business enterprise to assure that issues of control, decision-making, dispute resolution, succession, and potential dissolution or sale are fully discussed and planned in advance. Without that the minority of partners could end up with little or no benefit or value from their investment of time, talent, and treasure.

The "Fair Market Value" (FMV) assumes that there is a market and what that market is. Usually, the market is an unrelated buyer and anticipates the sale of the entire business at a time chosen by the seller.

David MacMillan is correct in pointing out that there are variations on what the perceived market can be, based upon the circumstances of the "market" and the particulars of the asset being sold.

In the case of a divorce or dissenting minority owner situation, IF the business were to be sold it would be under duress, not at a time or under circumstances necessarily favorable to the business and, thus, would be based upon this less advantageous "market." -- The resulting Fair Value or Investment Value would typically be less than the FMV; sometimes, considerably less.

Similarly, there is particular value to majority ownership or a controlling interest in a business. When determining the value of a minority interest in a business, attention must be paid to the reality that a minority interest will almost always have far less value than a proportionate share of the FMV and, in fact, in some instances can be worth virtually nothing. The majority is usually under no obligation to place the business on the market for "partitioning" and, if forced to do so the resulting sale price could be much lower than the FMV. Also, the minority shareholder may not even have the right to sell his minority interest; but, even if he does, rarely would he find an investor willing to buy it.

This I refer to as the "Minority Shareholder Disadvantage," which I have had to address in several purchase negotiations I have facilitated over the years, both in my former legal practice in New Jersey and in my business broker practice in California.

This illustrates why business partners must consult with both a competent experienced business law attorney and business broker in advance of acquiring or embarking on a business enterprise to assure that issues of control, decision-making, dispute resolution, succession, and potential dissolution or sale are fully discussed and planned in advance. Without that the minority of partners could end up with little or no benefit or value from their investment of time, talent, and treasure.
Contributor: Due Diligence, Valuations Advisor
The standard of value in any valuation is critical to the outcome and it is not correct to assume that in each and every circumstance the standard of value should be Fair Market Value (FMV).

The standard of value to be used in Divorce and Dissenting Shareholder Actions, is determined by the attorney, and may be Fair Value (FV) or Investment Value. In these types of valuations (generally) sale of the business is not contemplated and so FMV is (for the most part) not an option. It is for the attorney to determine the standard of value in use locally, as not only does this vary State by State, but can vary in local jurisdictions (counties).

If an analyst uses the Fair Market Value standard to determine the value of the ownership interest of a minority shareholder then discounts will be applied for Lack of Control and for Lack of Marketability. However if the Fair Value Standard is adopted no such discounts will come into play... The difference in value can be 50% or more.

All tax related valuations, such as Gift and Estate tax, are by definition Fair Market Value propositions.

The standard of value in any valuation is critical to the outcome and it is not correct to assume that in each and every circumstance the standard of value should be Fair Market Value (FMV).

The standard of value to be used in Divorce and Dissenting Shareholder Actions, is determined by the attorney, and may be Fair Value (FV) or Investment Value. In these types of valuations (generally) sale of the business is not contemplated and so FMV is (for the most part) not an option. It is for the attorney to determine the standard of value in use locally, as not only does this vary State by State, but can vary in local jurisdictions (counties).

If an analyst uses the Fair Market Value standard to determine the value of the ownership interest of a minority shareholder then discounts will be applied for Lack of Control and for Lack of Marketability. However if the Fair Value Standard is adopted no such discounts will come into play... The difference in value can be 50% or more.

All tax related valuations, such as Gift and Estate tax, are by definition Fair Market Value propositions.
When I am assessing the value of a business, one of the most important steps in analyzing the profit and loss statement and balance sheet of the company. It's a complex process of comparing trends over time, regarding gross revenues, gross and net profits, cash flow, inventories, asset values, etc., etc. In addition, I want to compare all of these to other businesses in the same category. The best tool I have found and use regularly is from Finagraph in Seattle. It's free to business owners (banks have to pay for it) and can be really useful in improving the financial management of a business, in increasing its actual value, and in determining value for a potential buyer.

When I am assessing the value of a business, one of the most important steps in analyzing the profit and loss statement and balance sheet of the company. It's a complex process of comparing trends over time, regarding gross revenues, gross and net profits, cash flow, inventories, asset values, etc., etc. In addition, I want to compare all of these to other businesses in the same category. The best tool I have found and use regularly is from Finagraph in Seattle. It's free to business owners (banks have to pay for it) and can be really useful in improving the financial management of a business, in increasing its actual value, and in determining value for a potential buyer.
Another factor to consider in a business valuation is the purpose for which the valuation is being assessed. It could be for a potential purchase, for settlement of litigation (e.g., divorce, bankruptcy), for evidence in contested litigation, for purchase-money financing, for re-financing, for dissolution of a business, for merger into a strategic buyer, for retirement or tax purposes. In each of these circumstances, the process can be more or less complex, and the accuracy more or less critical.

In each instance, however, the purpose should primarily be to determine the "fair market value" (FMV) -- the price that a ready, willing, and able buyer will pay and that a ready, willing, and able seller will accept in an "arms-length" deal. Secondarily, the assessment can determine the intrinsic value to a specific buyer based on his/her particular circumstances and needs -- and this value may be significantly different from the FMV.

And, it's not simple. There are many factors to be considered and to be verified; and while "comparables" are useful, they are in no way as definitive or as helpful as they are in valuing commercial or residential real estate.

Another factor to consider in a business valuation is the purpose for which the valuation is being assessed. It could be for a potential purchase, for settlement of litigation (e.g., divorce, bankruptcy), for evidence in contested litigation, for purchase-money financing, for re-financing, for dissolution of a business, for merger into a strategic buyer, for retirement or tax purposes. In each of these circumstances, the process can be more or less complex, and the accuracy more or less critical.

In each instance, however, the purpose should primarily be to determine the "fair market value" (FMV) -- the price that a ready, willing, and able buyer will pay and that a ready, willing, and able seller will accept in an "arms-length" deal. Secondarily, the assessment can determine the intrinsic value to a specific buyer based on his/her particular circumstances and needs -- and this value may be significantly different from the FMV.

And, it's not simple. There are many factors to be considered and to be verified; and while "comparables" are useful, they are in no way as definitive or as helpful as they are in valuing commercial or residential real estate.
Contributor: Business Appraisals, Valuations Advisor
Over the years I have seen many appraisals from many different appraisers. I have been totally surprised by the wide variations of methods and the accuracy of these appraisals.

Appraising businesses accurately is not an easy task. There are about five different methods that can be used along with variations in the purpose of the appraisal. None of these methods addresses the total value of a business by its self. One method might look at cash flow value another at asset value and another at a capitalization rate. It is up to the appraiser to pick the appropriate method or give each of the methods used a percentage of the final value. Purpose also changes, as an appraisal done for the sale of a business will be different than one done for a divorce. Also, the IRS has certain requirements that must be followed for any appraisals submitted to them for such things as change in corporate structure or family trusts.

Financial statements and tax returns can create problems. Financial statements are always different, and tax returns don't always match the financial statements. I can spend hours going through the documents, talking to the business owner or the business' accountant looking for answers. To do an accurate job on the appraisal I have to understand these documents completely and how they relate to each other.

There is a wide variance in the quality of business appraisals mostly because of lack of experience. It is easy to pick up an accounting book and find the different methods of doing an appraisal, picking out a formula and plugging in some numbers. This process doesn't necessarily give you an accurate appraisal. Most accountants know this and turn to an experienced Business Appraiser for an appraisal. Also, be aware that there are appraisers that stuff the appraisal with irrelevant and highly technical information to exaggerate the complexity of the appraisal or over inflate the appraisal to make an owner feel he has a high value business. With a growth in the internet, we now see "fill in the blanks do it yourself" business appraisals. It is not possible to get an accurate business appraisal this way. There is no way to provide a short cut to an accurate business appraisal.

I use a blended method of appraisal consisting of cash flow, asset value and market analysis. This blended method evaluates all items that create value in a business. I never have to guess if I am using the correct method or find percentages to use for each component.

Over the years I have seen many appraisals from many different appraisers. I have been totally surprised by the wide variations of methods and the accuracy of these appraisals.

Appraising businesses accurately is not an easy task. There are about five different methods that can be used along with variations in the purpose of the appraisal. None of these methods addresses the total value of a business by its self. One method might look at cash flow value another at asset value and another at a capitalization rate. It is up to the appraiser to pick the appropriate method or give each of the methods used a percentage of the final value. Purpose also changes, as an appraisal done for the sale of a business will be different than one done for a divorce. Also, the IRS has certain requirements that must be followed for any appraisals submitted to them for such things as change in corporate structure or family trusts.

Financial statements and tax returns can create problems. Financial statements are always different, and tax returns don't always match the financial statements. I can spend hours going through the documents, talking to the business owner or the business' accountant looking for answers. To do an accurate job on the appraisal I have to understand these documents completely and how they relate to each other.

There is a wide variance in the quality of business appraisals mostly because of lack of experience. It is easy to pick up an accounting book and find the different methods of doing an appraisal, picking out a formula and plugging in some numbers. This process doesn't necessarily give you an accurate appraisal. Most accountants know this and turn to an experienced Business Appraiser for an appraisal. Also, be aware that there are appraisers that stuff the appraisal with irrelevant and highly technical information to exaggerate the complexity of the appraisal or over inflate the appraisal to make an owner feel he has a high value business. With a growth in the internet, we now see "fill in the blanks do it yourself" business appraisals. It is not possible to get an accurate business appraisal this way. There is no way to provide a short cut to an accurate business appraisal.

I use a blended method of appraisal consisting of cash flow, asset value and market analysis. This blended method evaluates all items that create value in a business. I never have to guess if I am using the correct method or find percentages to use for each component.
Contributor: Business Appraisals, Valuations Advisor
Appraisal Requirements

For an appraisal system to work it must address the following:

1. the profitability of the business
2. the tangible assets of the business
3. the presence of intangible assets
4. the value derived should represent the market value
5. have flexibility to allow for the terms of a sale.
6. simplicity - Usable and understandable.

The first step was to determine what components in a business have value. These are some of them:

1. a functioning business with modest growth
2. skilled employees
3. working equipment
4. adequate usable inventory
5. a quality product or service
6. a profit
7. collectible receivables
8. a broad customer base with no very large customer
9. some new product development capabilities
10. a good reputation (name) in the market place
11. a clean, adequately sized work area
12. a financially sound operation with a good accounting system
13. the business located correctly for its market place
14. a good base of suppliers

After building this list it has to be divided to fall into a profit/asset based appraisal system. They are categorized as follows:

1. Profit based items.
a. business profit
b. a functioning business
c. business size - gross sales
d. intangible assets

1. skilled employees
2. a quality product or service
3. a broad customer base - customer list
4. new product development capabilities
5. a good reputation - business name
6. good financial management

2. Asset based items:

a. inventory
b. equipment
c. receivables
d. contracts
e. patents
f. trademarks
g. real estate

Appraisal Requirements

For an appraisal system to work it must address the following:

1. the profitability of the business
2. the tangible assets of the business
3. the presence of intangible assets
4. the value derived should represent the market value
5. have flexibility to allow for the terms of a sale.
6. simplicity - Usable and understandable.

The first step was to determine what components in a business have value. These are some of them:

1. a functioning business with modest growth
2. skilled employees
3. working equipment
4. adequate usable inventory
5. a quality product or service
6. a profit
7. collectible receivables
8. a broad customer base with no very large customer
9. some new product development capabilities
10. a good reputation (name) in the market place
11. a clean, adequately sized work area
12. a financially sound operation with a good accounting system
13. the business located correctly for its market place
14. a good base of suppliers

After building this list it has to be divided to fall into a profit/asset based appraisal system. They are categorized as follows:

1. Profit based items.
a. business profit
b. a functioning business
c. business size - gross sales
d. intangible assets

1. skilled employees
2. a quality product or service
3. a broad customer base - customer list
4. new product development capabilities
5. a good reputation - business name
6. good financial management

2. Asset based items:

a. inventory
b. equipment
c. receivables
d. contracts
e. patents
f. trademarks
g. real estate
An observation regarding Dave MacMillan's analogy --

If several people are willing to pay $18,000, $20,000, $22,000 for a 2004 Lexus then that does establish what the market will bear, despite any other determination of the car's intrinsic value. I agree that if most people are paying $15,000 for a 2004 Lexus and there is one outlier at $20,000, then the typical buyer in the market values a comparable Lexus at $15,000, not $20,000. But, if the "expert" determines that the 2004 Lexus is worth no more than $15,000 because of whatever criteria that expert is applying, and the mode (most common) purchase price is $20,000, then the "expert" is wrong and the market is right.

The same dynamic is true for businesses--the "value" of a business is determined by a complex variety of factors, unique to each buyer. It's not simply applying a formula, or a percentage, or a ratio; and, ultimately it is determined by an arms-length transaction between a willing and able buyer and is a willing and able seller.

An observation regarding Dave MacMillan's analogy --

If several people are willing to pay $18,000, $20,000, $22,000 for a 2004 Lexus then that does establish what the market will bear, despite any other determination of the car's intrinsic value. I agree that if most people are paying $15,000 for a 2004 Lexus and there is one outlier at $20,000, then the typical buyer in the market values a comparable Lexus at $15,000, not $20,000. But, if the "expert" determines that the 2004 Lexus is worth no more than $15,000 because of whatever criteria that expert is applying, and the mode (most common) purchase price is $20,000, then the "expert" is wrong and the market is right.

The same dynamic is true for businesses--the "value" of a business is determined by a complex variety of factors, unique to each buyer. It's not simply applying a formula, or a percentage, or a ratio; and, ultimately it is determined by an arms-length transaction between a willing and able buyer and is a willing and able seller.
Contributor: Due Diligence, Valuations Advisor
Without question what a buyer pays for a particular business is determined by his or her strategic interest , personal lifestyle , and the outcome of negotiation. This determines the transaction value in a single transaction and becomes known at the end of the process.

Sellers want to know what their business is worth (hypothetically) before going to market and buyers need to benchmark to the fair market value, before deciding if their strategic interest supports paying more.

If I manage to offload my 2004 Lexus for $20,000 to somebody that just has to have it, that is the transaction value and gives little or no guidance to the world as to what people will pay for this kind of asset.

Most small business sales are at an advertised price . This has to be determined before the fact, using hopefully something other than the A x B methodology that is the standard fare of too many brokers.

Without question what a buyer pays for a particular business is determined by his or her strategic interest , personal lifestyle , and the outcome of negotiation. This determines the transaction value in a single transaction and becomes known at the end of the process.

Sellers want to know what their business is worth (hypothetically) before going to market and buyers need to benchmark to the fair market value, before deciding if their strategic interest supports paying more.

If I manage to offload my 2004 Lexus for $20,000 to somebody that just has to have it, that is the transaction value and gives little or no guidance to the world as to what people will pay for this kind of asset.

Most small business sales are at an advertised price . This has to be determined before the fact, using hopefully something other than the A x B methodology that is the standard fare of too many brokers.

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