If beauty is in the eye of the beholder, then the worth of a business lies in the eye of the market.
For the market is really what decides the price an owner will get for their business when they go to sell – the scenario most have in mind when they ask what their business is worth.
Determining that value, the most probably selling price (MPSP), is an art that’s goes beyond straight valuation. You'll benefit by engaging a certified business broker with expertise in both.
Obtaining a formal appraisal before you are ready to sell can help build a roadmap for increasing value and minimizing taxes. The end result is more money in your pocket.
A formal appraisal can also provide the necessary valuation to buy out a partner or split assets in a divorce, for estate planning, an asset freeze for tax planning, or roll over into a family trust.
At Sunbelt we start by formally appraising the value of the business to determine Fair Market Value (FMV), using methodology of the International Business Brokers Association (IBBA), the Institute of Business Appraisers (IBA) and the National Equipment and Business Brokers Institute (NEBB). Sunbelt has staff certified by each; I am a Life Member of IBA and teach business valuation for IBBA and NEBB.
From the FMV, we determine the MPSP. This calculation represents a reasonable price, factoring the true (recast) earnings past and future, what the market is willing to pay, and motivation. The seller can then negotiate on an informed basis.Value: is looked upon in current dollars; is the risk-adjusted amount; is not negotiated, but arrived at objectively based on determined value.
Price: does not consider risk and is not time-sensitive; is derived from value; may be negotiated.
Recasting financial statements
A seller’s expectations of price need to be in line with market reality.
Frequently though, financial statements of small businesses do not reflect the business operations. They are often prepared to minimize the tax burden for the company and its owners. A first step in valuation is to recast, or normalize, line by line, the most recent balance sheet and three to five years income (profit and loss) statements.
Recasting provides a realistic value of the assets and liabilities and shows the true earning capacity of the business.
For an owner-operated small- to medium-sized business, metrics based on income--seller discretionary earnings (SDE) and Earnings Before Interest Taxes Depreciation and Amortization (EBITDA)--are important factors in determining the business’s value.
Valuations also incorporate methodologies based on assets (the fair market value of tangible and intangible assets) and on market (comparable ratios of sold businesses).
Sunbelt staff use some 14 methodologies to determine business value; our access to specialized databases and brokerage archives is of great advantage in assessing a business against the industry, marketplace and other like businesses.
Looking at business patterns, systems, competition, markets, quality of service or product, staff and operational factors can help us assess risk of future earnings. But before we even consider any benchmarking, we need to normalize the company’s earnings starting with the true cash flow from operations. Fittingly, SDE is also known as discretionary cash flow (DCF).
In recasting, we “add back” expenses considered discretionary, extraordinary, non-recurring or non-cash. Discretionary means not necessary to support the revenue of the business; extraordinary means excessive, above normal levels; non-recurring means a one-time expense; and non-cash is usually tied to depreciation.
We also add back interest expense as this is the cost of capital and may be different for the new owner. We do the same with income tax.
Recasting requires rethinking
Although recasting is a standard practice in business valuation, it can take buyer and seller a while to adjust to the concept. A fair representation of the business is essential to both.
Sellers need to understand that these are valuation, not tax-deriving documents, and that all things being equal, a better bottom line will lead to a higher business valuation. Without recasting, an owner may understate cash flow from operations, arriving at an asking price for their business that is too low.
A buyer needs confirmation that the adjustments to earnings are real and validation that the cash flow is sufficient to pay their salary, service the debt incurred to buy the business, and build or reinvest in the business and provide a reasonable return on their invested capital.
All must be substantiated to the satisfaction of both parties, their lawyers and accountants at due diligence.
In Selling a Business: What is Your Business Worth Part 2, we show a recasting using the example of a fictional company.