More to It Than Numbers
Business owners seek business valuations for many different reasons -- partner buyouts, divorces, estate planning, death of a partner, and, as Randall Lane points out in the July 2003 feature What's Your Company Worth Now? as a tool to run and improve a business. Another reason business owners seek valuations is to simply sell their companies. But arriving at a sales price isn't a simple process, and often proves to be more complicated than most small-business owners expect.
"For smaller businesses, it's really not rocket science, but for the small business owner it really is rocket science," says John W. Murphy, president of Atlantic Management Company, a Portsmouth, NH-based valuation and financial advisory firm. "A lot of analysis has to go into [pricing a business to sell]," he adds. Even though information on valuation methods abound, using them takes much more than pulling out your financial statements. Pricing a business to sell takes careful consideration of present earnings, future potential, and a slew of factors that business owners quite often don't recognize.
"There are couple of things that small business owners have to be able to do [to value a business], and they stink at both," says Michelle Miles, executive director of the Institute of Business Appraisers (IBA), a professional society based in Plantation, Fla., which provides business appraisal education and professional accreditation. "They have to be able to recognize the money they're taking out of the business and not reporting as income," she says. So, that money you're paying your cousin Chuck to work at your business, even though he's worthless, should be reported. Quite often, owners overlook these resources as less valuable, but still they are applicable to the value of their businesses.
Second, owners need to have a realistic view of the potential of the business. "Owners have to be objective about how strong a performer the business is in the market and the future of the company," Miles says. Where this gets most difficult, according to Miles, is when small family- owned businesses are trying to determine a price. Strong emotional ties to the business often cloud owners' ability to see it in a realistic light.
Beyond owners' characteristic shortcomings, many owners try to oversimplify the process. "Two businesses both netting $500,000 do not necessarily have the same value," says Jeff Jones, president of Certified Business Appraisers Inc., and chairman of Certified Business Brokers, both based in Houston, Texas. Assuming a business is worth as much, if not more, as a competitor's that recently sold, or determining a price based on an arbitrary number deemed acceptable to retire for the next 20 years are two mistakes Jones sees small-business owners frequently make. "I don't think the seller fully understands the perspective of the buyer," adds Jones. "The seller wants as much as he can get," he says, "but the value has to be supported by the business itself."
All Market Data Is Not Created Equal
Many business owners rely solely on what their competitors received for their companies or other industry data to determine a price. One set of market data that owners frequently use is industry "rules of thumb." Rules of thumb are generally used to get a rough, seat-of-the-pants estimate, according to Miles. Most rules look at an industry and derive an average upon which businesses in that industry are selling. Miles explains the downfall of using a rule of thumb this way: "If the average value of a pizza joint is 25% of gross revenues, why should the value of your pizza joint be the same, when the pizza comes hot, the crust is hand-tossed and the joint down the street, which a rule of thumb would say is also worth 25% of gross revenues, was just cited by the Health Department and has employees who never wash?"
According to Jones, the data that many rules of thumb rely on is inconsistent. "Rules of thumb are rules developed in an industry without any supporting empirical evidence," he says. "You're never really sure what the number represents."
The only resources Miles recommends if someone wants to use a rule of thumb to gain a basic perspective on what his or her small business might sell for are Tom West's 2003 Business Reference Guide (Business Brokerage Press), which contains discussions of value drivers for various businesses as well as the rules. "Tom West is highly qualified and well respected," she adds. And, Glen Desmond's Small Business Valuation Formulas and Rules of Thumb (Valuation Press, April 1993). "It discusses commonly used rules, but it also discusses business appraisal," Miles adds.
In contrast, market transaction data maintained in databases by such organizations as the IBA, Pratt's and Bizcomps, uses specific, detailed information on sales of businesses. For instance, the IBA's market database includes ratios that are expressed in terms of Business Selling Price to Annual Revenues (or gross revenues -- this is the P/G ratio), and in terms of Business Selling Price to Annual Earnings (or profits -- this is the P/E ratio). To use this data, an appraiser will plot the universe of transactions, and then place its subject company within that universe. The appraiser then takes the data, does further research on what it would take to set the business apart in the industry, i.e., better technology, strong capital structure, and then compares these value drivers to the subject company. If the drivers exist, the appraiser places the business in that market segment. From there, the appraiser applies the P/G and P/E ratios of the market segment to the company's adjusted earnings to yield the value of the business.
That Magic Number
To derive that magic number for a business, appraisers weigh the outcomes of many valuation methods, which helps explain the, what some might consider, high fees they command (See, How Much Should an Appraisal Cost?) But the complexity of the job commands professional guidance.
"Everyone looks for magic methodologies to value their unique businesses," says Jones. "The reality is there aren't any."
As an appraiser, Jones never relies on one method to determine a price. In fact, he uses five or six different methods before he arrives at a final figure. For example, Jones use methods within three different valuation approaches: the Asset-based Approach, a Market Approach, and an Earnings Approach. Doing this forces me to look at that company in five or six different ways," Jones.
