Your spouse looks like a million bucks, and so does your business. Do you agree with the first but not the second? It may be time to determine the value of the business that you built, but how does one arrive at the value of a small to medium-sized business when its stock is not sold on the New York Stock Exchange? Small businesses must use other methods.
It is a truism that "whatever a willing buyer will pay determines the price," but for the sake of planning and negotiating, the approximate market value is important. The challenge is that there are a number of methods available to set a value, but each depends on the situation. Common sense dictates that a business is worth more when the sales are strong or the owner is retiring or both. This differs sharply from a business having a fire sale because of a poor market, mismanagement or death of the chief executive officer.
A banker's vantage point: When a bank lends money it is usually collateralized by the value of the company. When a banker values your business for lending purposes, only part of the assets' value is used: the "liquidation value." The bank will analyze the assets to estimate their worth under a possible forced sale. Accounts receivable are set at 75 percent to 80 percent of the value for those that are less than 90 days overdue. Inventory is generally valued at 20 percent to 50 percent. High-technology type inventory always gets a lower loan value because of the risk that newer technologies will make it less valuable. Real estate (i.e. buildings) gets higher marks -- 75 percent to 80 percent of the appraised value is the rule of thumb.
Equity investors: Value estimates are also necessary to obtain -- money from venture capitalists, or for the sale of stock to individuals. In the negotiations between buyer and seller, the estimates may substantially differ from each other due to the methods used. While the value of the hard assets (e.g. real estate) is relatively easy, "earnings-based valuations" should include projections of the company's future earnings potential, market situations and industry shifts. The person making the evaluation must have a basic understanding of the business.
The purpose of the buyer's investment and the existing strength the company will influence the final stock price. The price calculation may be adjusted upward if the investor wants a controlling percentage of the stock. Conversely, if the buyer will own only 5 percent, then the offer price will probably be lower.
Regardless of the buyer's purpose or the methodology used, every valuation must take into account future earnings capacity. The analyst projects the future profits for the firm after making certain assumptions about the industry and the economy. The projections for the business will be influenced by the analyst's regard for management's abilities and the industry's situation.
There are some rules of thumb that can be applied. For instance, a professional practice such as a medical group will sell for about one year's revenues. Alternatively, a radio station will be valued at a set number of dollars per listener.
P-E method: One well-known price setting method is called the price-earnings (P-E) method, which can be a challenge for a privately held company. Some library research must be completed to find a number of other companies in your same line of business that are publicly traded. Alternatively, the use of a business broker may be helpful since he might know the price of similar local businesses sold that were also privately held.
To calculate the price-earnings ratio, the business' bottom line is adjusted to include all the perquisites that are charged to the business but are actually for the personal benefit of the owner. This includes such items as excessive incomes, extra travel allowances and club memberships. The average of the past five years of adjusted bottom-line figures is used after the numbers also have been adjusted for inflation. Then the P-E from recent stock sales is multiplied times the average of these adjusted annual profit figures to get the suggested selling price.
Adjusted book value: This process is based on the balance sheet. The fair market value of total assets is reduced by the liabilities. Determination of the fair market value of the assets varies. For instance, if the owner has died, the value of the accounts receivable could be set as low as 25 percent of the total. People tend not to make payments in this type of situation. Alternatively, there may be some strong adjustments for goodwill.
With any valuation method it is obvious that this is not an exact science; it is difficult to attach just one price to a company. As in art, the beauty of an object is in the eyes of the beholder just as the value of an object is in the eyes of the ultimate buyer. Even a simple valuation method such as applying the stock value of recently sold shares could cause problems if those shares were sold below value at a time when the company was in distress.
The bottom line: If you consider selling all or just a part of your business, keep your calculations to yourself or the negotiations might be bogged down in the minor details of your calculations.
Patrick Rossello, president of the Business Consulting Group in Towson, is a member of a number of local advisory boards and an instructor at Loyola College. Send questions or suggested topics to him c/o Money At Work, The Evening Sun, 501 N. Calvert St., Baltimore, Md. 21278.