Network: November 1991
In your Business for Sale column, you often cite an industry standard for determining a business's value. Do such standards exist for service companies? I run a property-management company. My only hard assets are a computer system and an office, but I've built goodwill and a national clientele. Would valuation take that into account?
Santa Fe Accommodations
Santa Fe, N.M.
Your years of work will count little in a traditional valuation, according to Thomas Horn, author of Business Valuation Manual (Charter Oak Press, Lancaster, Pa., 1989). But if it is possible to transfer your personal knowledge of the market to the new owner -- which usually means sticking around after the sale and structuring an earn-out -- then some valuation methods can account for it.
Richard Green, president of National Business Search, in Dallas ("Are Service Companies Different?", February 1991), suggests using a multiple to get a quick estimate of your company's value. In this instance, he'd "use two times reconstructed cash flow, which is the sum of pretax profit, excess owner's compensation, excess benefits, depreciation, and nonrecurring expenses." If the business is extremely profitable -- over $1 million -- use a multiple of three. To find out the standard multiple in other service industries, ask colleagues or call the Business Appraisers Institute at 407-732-3202.
Tom Horn recommends two valuation methods in particular. The capitalization-of-income method asks you to project your company's income and expenses, including owner's salary, for 12 months based on past history. Don't beef up projections just because your industry's growing, Horn says. "That's the potential the buyer's buying into." Base those projections on your last year or, if the numbers fluctuate, weight them and average them. Then divide the net operating income after tax by the rate of return an investor would currently expect from any other investment of equivalent risk -- say, 15% in this case. (That's a capitalization rate.) Reduce the resulting figure by the amount of any liabilities the company's purchaser would assume. The result is the value of the company.
Another method Horn recommends is to consider what you're selling as a group of intangible assets: steady customers. You might expect the buyer to pay for five years' worth of net income from those steady customers. Perhaps they yielded $100,000 net income last year. But each year some of those customers turn over, and that income shrinks -- say, by 20%. So really the net profit is $80,000 in the first year after the sale of the business, $60,000 in the second year, and down to zero in the fifth.
Then, too, you have to discount for present value, since that income will be worth less each year out than it is today. Present value is a function of the capitalization rate and can be figured out by using a present-value table or the present-value function on some financial calculators. So the $80,000 the buyer can expect from your steady customers in the first year is worth only $69,600. And the second year's $60,000 will be discounted to $45,360. All totaled, last year's $100,000 net is really worth $152,720 to today's buyer.
Someone already established in your business is more likely to agree to such a valuation. And you're probably better off selling to that buyer. Why? Because given today's economy, you'll probably have to finance the sale yourself. Payment will depend upon the business's success, and a knowledgeable buyer can make it succeed. If you sell to someone else, stick around for your benefit and the buyer's. And if you can get a cash offer, take it, Horn says, even if it means lowering your price. n -- Michael P. Cronin