Valuing the Business and Determining a Sales Price

Overview of Factors Affecting Business Valuation¹

There is no singular gold standard on business valuation. Nonetheless, there are many commonly used methods, metrics, and market factors that a seller should consider in valuing his or her business. Some factors that will affect the price of the sale include the seller’s personal needs, and the terms of sale. Additionally, in the cooperative conversion context, both the terms of sale and sales price will be affected by the need for worker-owners to receive wages immediately after the sale.

In addition, a seller’s personal needs may significantly impact the sales price. For instance, the seller’s desire to quickly complete the transaction and sever a future relationship may diminish the business’ value. By contrast, where the seller is seeking to stay on as a consultant, an employee, or a worker-owner, the business’ value will likely be greater, since the worker-owners will be able to draw from the seller’s experience in running the business.

In addition to the seller’s personal needs, the terms of sale can have a significant impact on the sale price of the business. Most sales of businesses are seller financed – meaning the buyer pays the seller in installments over time. The precise terms of sale, including the interest rate, repayment period and amount paid down, can have a significant effect on the final sales price. Typically, to account for the additional risk associated with longer-term financing, and for the disparity between the present and future value of money, the longer the timeline for repayment, the higher the purchase price of the business.

Last, in the cooperative conversion context, because most worker-owners will be relying on the business for their primary source of income, the sale price and terms of payment must result in cash flow to cover operating expenses, seller related financing, and salaries. The need for these cash flows can affect both the overall business valuation and the final terms of sale.

Appraisal and Valuation Approaches

There are three basic approaches to business valuation used by professionals: income based valuation, asset based valuation and market based valuation.² While the final sales price agreed upon between the buyer and seller may not correspond precisely with the number resulting from any of these approaches, each of the approaches can provide the parties with useful benchmarks, and thus provide a reference point for buyer and seller during the negotiation process.

Income Valuation Methods

Income valuation provides a useful, but imperfect approach to affixing a value to a company. The utility of this approach in the employee-owned company context is questionable, since it assumes that the buyer is looking at purchasing the business merely as a source of investment income. Nonetheless, it can provide sellers seeking to convert their business to employee-ownership with a reasonable benchmark of valuation used by many businesses. Conversely the buyer can use this as a way to reduce the value of the business—i.e. if they know the seller has a much lower expected rate of return (i.e. below 10%). This may be a good method for employee committees to use in their negotiations with the seller.

There are two basic approaches to income valuation: the discounted cash flow or discounting method, and the capitalization method.³ The primary difference between the two methods is that the discounting method considers the return on investment over the life of the investment, whereas the capitalization method focuses on average returns within a single time period.

Discounted Cash Flow Method

Using the discounting method, an appraiser would determine what income the investor could expect over the life of the investment, and then discount each increment of the stream of income back to present value at a discounted rate of return, or discount rate.⁴

The main benefit of using the discounting method is that it accounts for the time value of money. This could potentially be beneficial for a buyer’s committee that is weighing the possibility of purchasing the business and wishes to determine whether the purchase of the business would make economic sense. Although, as previously indicated, income valuation approaches are likely less applicable in the cooperative conversion context. This may be particularly true of the discounting method, since the potential life of each cooperative member’s investment period might diverge significantly, based upon the number of years he or she would remain employed at the firm.

Capitalization Method

The capitalization approach is expressed by the formula: Business Value x Desired Rate of Return⁵ = Expected Annual Profits. To use this method of valuation, the seller must first identify a target annual rate of return that he or she expects would be attractive to an investment-oriented buyer, typically between 10% and 20%. The seller must then identify, with reasonable accuracy, the business’s profits for the next few years. After determining the annual profit, the seller divides this number by the desired rate of return. The resulting value would be the business’ sale price.

For example, a Seller who reasonably anticipates that an investment-oriented buyer would want a 20% annual return, and reasonably anticipates that the average annual profit over the next few years will be $50,000, would divide $50,000 by .2, for a business valuation of $250,000.

Market Methods

Guideline Public Company Method

The guideline public company method seeks to find public companies engaged in similar business as the private company being sold in order to find a potential free-market value of the equity. Using this method an appraiser or qualified seller would calculate valuation multiples from financial data of comparable public companies and apply the multiplier to the appropriate data from his or her company.⁶

This method is a bit more complicated than the other market methods and will likely require the assistance of a business appraiser. Furthermore, it is probably not applicable to most small companies, and should be limited to companies with annual revenues exceeding $5 million.⁷ Nonetheless, it can provide useful information for sellers, buyers’ committees and their attorneys in assessing the potential value of the company. If a seller is interested in learning more about this method of valuation, Shannon Pratt’s The Market Approach to Valuing Business is a great resource.

Sale of Comparable Businesses Method⁸

Ideally, a seller will look to market data on the sale of similar businesses to inform the ultimate sale price. This data, however, is not abundant and requires significant investment in time, and perhaps money, to obtain. Nonetheless, acquiring such data can be a great resource in providing the buyer with a reasonable estimate for what the business is worth. Resources for data on the sale of comparable businesses include trade publications, business brokers, Internet sources such as www.bvmarketdata.com’s BizComp Service, and personal networks. Professionals, such as brokers and appraisers, can greatly assist in obtaining data on the sale of comparable businesses.

Industry Formulas and Standards

Certain formulas have gained credence in particular industries, but these should be treated only as rough approximations of business value, since they may be too broad to deal with particular factors affecting the seller’s individual business. Common industry specific formulas include Sales or Earnings Formulas, which use some multiplier times gross sales or net earnings to identify a value, and Units Formulas, which use some multiplier times the number of customer contracts in place, or the number of machines in operation.

Asset Based Methods⁹

Another basis of valuation is totally up the resale value of the business’ tangible assets, and the value of intangible assets, such as leases, business name, intellectual property and customer lists. A company’s asset based value should not be confused with its book value, which is an accounting term, and which may reflect depreciation on assets, thus not reflecting the true collective value of the company’s assets. ¹⁰ Asset valuation will be affected by outstanding or potential liabilities, unless the seller agrees to assume sole responsibility for those liabilities.

Working with Professionals

While it is advisable for sellers to independently assess the value of their business, they are strongly encouraged and may find it necessary to seek professional assistance, which can greatly contribute to identifying a price range. Accountants can help organize and evaluate a business’ financial data, apply a pricing formula, and help present the pricing information in a compelling format. Brokers can help by tracking down information about sales of comparable businesses, and tailoring the information to current market conditions in the business’ community. Appraisers can assist with company valuation, and are typically astute at assigning accurate value to tangible property. Additionally, a good appraiser might be able to identify business shortcomings and suggest ways to increase the business’ value.

While professionals can greatly contribute to the valuation process, sellers must be mindful of the potential shortfalls and limitations of professional assistance, and make sure that the professional they have identified has experience and a reputation of honesty. For instance, sellers should exercise caution when working with brokers, who are often paid on a commission basis. The seller should be clear about what they are seeking – market data on comparable business sales. Moreover, when working with brokers, sellers should be leery of initial “free” appraisals that assign a very high value to the business, as this is often a ploy to lure the seller into working with the broker who may charge a lot, only to ultimately assign a more realistic value. When working with appraisers, sellers should be mindful that most businesses’ value exceeds the value of tangible assets, and accordingly should try to find an appraiser experienced in valuing nontangible factors such as favorable leases and goodwill. Bankers or real estate brokers might be able to help identify an appraiser with a good reputation. The American Society of Appraisers may be able to as well.