With few exceptions, our business is our most important asset. Most of us who own a successful small business have important reasons for wanting to know how much it is worth, even if it is not, at present, for sale.
It is wise to start thinking about and planning for succession long before you need to transfer ownership -- whether to the next generation or to another company.
In most industries, there are frequently used formulas that may help you figure the rough value of your business. For instance, a motel may be worth three times present annual room income. An accounting practice may be worth from 2 to 3 1/2 times retained annual fee income. A contract metal-working company may be worth book value of assets plus one year's earnings.
Such formulas are useful starting points but virtually useless for market-place valuation. Recognize them for what they are -- rough indicators for an "average" business in a given industry.
The basic approach of this evaluation method is similar to that used by some professional appraisers of small businesses. It assumes that a business is worth the value of its assets, plus a premium for goodwill when earnings are sufficiently high.
What is unique about this method is that it establishes a precise format for the redefinition of earnings as well as a discipline, through the use of a detailed form, so that the method can be followed by anyone familiar with basic business accounting.
There are 7 basic steps in preparing an accurate valuation of your business:
1. Prepare a STABILIZED INCOME ACCOUNT
2. Determine the VALUE OF TANGIBLE ASSETS
3. Determine the "COST OF MONEY" (annual investment cost of tangible assets)
4. Determine "EXCESS EARNINGS" (earnings as determined in Step 1 less "cost of money")
5. Calculate a MULTIPLE FOR EXCESS EARNINGS
6. Calculate VALUE OF EXCESS EARNINGS (excess earnings as determined in Step 4 times the multiple derived in Step 5)
7. Determine TOTAL BUSINESS VALUE by adding asset value (Step 2) to value of excess earnings (Step 6)
1. Calculate the "real earning power" of the business by preparing a STABILIZED INCOME ACCOUNT. Real earning power is defined as what you think earnings will be over a 12-month period beginning on the date of valuation. Do not simply estimate your entries that may have been distorted by such factors as accounting techniques used, nonrecurring circumstances that have affected earnings positively or negatively, and so forth. This "stabilized" or "adjusted" earning figure cannot be based on wishful thinking or used to disguise basic problems in a business (such as a chronically high cost of production due to inefficiencies). This statement of real earning power will be scrutinized carefully in the event of an actual sale, and it is best if all of the assumptions used to adjust income and expense entries are stated in writing in the evaluation.
Chart 1 shows a summary of reported earnings for a fictional company alongside the stabilized earnings. At the bottom of the chart are notes that explain why the adjustments were made (in a careful evaluation, the notes will be much more detailed, and possibly supported by other data, depending on the purpose of the valuation).
SMALL BUSINESS INC.
Stabilized Income Account
Actual, 1981 (Stabilized 12 months)
Sales n1 $650,000 100.0% $700,000 100.0%
Cost of goods n2 (197,600) 30.4% (212,800) 30.4%
Operating labor n3 (187,000) 28.8% (201,600) 28.8%
Gross profit n3 265,200 40.8% 285,600 40.8%
Sales expense * ( 86,750) 13.3% ( 92,400) 13.2%
Administrative expense * ( 52,650) 8.1% ( 42,000) 6.0%
Executive salaries n3 ( 40,000) 6.2% ( 49,000) 7.0%
Replacement fund or
depreciation n4 ( 11,700) 1.8% ( 21,000) 3.0%
Maintenance & repairs * ( 5,200) 0.8% ( 7,000) 1.0%
Unclassified * ( 5,200) 0.8% ( 7,000) 1.0%
Total overhead expense (201,500) 31.0% (218,400) 31.2%
Indicated pretax profit 63,700 9.8% 67,200 9.6%
n1 Sales will increase at inflation rate assumed to be 7.7%.
n2 Operating cost will remain at constant percentages.
n3 Executive (owner) salary should be increased $9,000 to reflect current salaries offered in comparable businesses.
n4 Replacement fund of $21,000 will be substituted for depreciation expense. This is ample to replace assets as they wear out.
* Minor adjustments were made through a detailed analysis of each line item or expense and reflect best estimates.
Other adjustments include replacing owners' salaries -- which fluctuate greatly in real-life circumstances -- with an owner's salary calculation based on what it would cost to hire a paid manager. Depreciation expense, an item that is often meaningless in past financial statements, is replaced with an expense called "replacement fund." Think of this as a sinking fund sufficient to build savings to provide for normal replacement as equipment wears out.
Note that stabilized earnings do not reflect interest expense, since interest expense can fluctuate according to the structure and the special circumstances of the owner. Instead, at a later stage we use a "cost of money" calculation following the procedure outlined below.
2. Calculate the VALUE OF ALL TANGIBLE ASSETS. A well-qualified appraiser may be needed to do this. This appraisal will cover value of land, buildings, inventory, furnishings, and equipment of all types needed to conduct the business.
Chart 2 summarizes the value of tangible assets of the company we are using for an illustration.
VALUE OF TANGIBLE ASSETS
Land $ 20,000
Working capital required 40,000
Total tangible assets $300,000
3. Step 3 involves determining the COST OF MONEY. As used here, it is a specialized term defining the annual investment cost of owning the tangible assets of the business (as defined in Step 2). It is a substitute for interest expense. The rate used may differ from the current prime rate or the actual interest rate that may have to be paid under any particular set of circumstances. If we were to base the valuation process on prime rate, it would lead to a situation where business values went up and down as wildly as the prime rate does; and the market just doesn't work this way. So we settle on a figure that is somewhat more stable. It is also somewhat lower than prevailing interest rates when most of the assets involved offer considerable tax shelter, as they do in this example. This may be called "the underlying interest rate." To keep it simple, we generally use a rate that is about four points above the inflation rate. At present, we are using a rate of 12%.
This "cost of money" figure applies only to the tangible assets of the business, as calculated in Step 2.
Chart 3 shows how we have made this calculation in our example.
COST OF MONEY
Value of tangible assets $300,000
"Underlying" interest rate 12%
"Cost of money"
(.12 X $300,000) $ 36,000
4. Step 4 is to determine a figure that we call EXCESS EARNINGS. This figure represents how much the business can be expected to earn after the cost of money (as defined in Step 3) is deducted from stabilized earnings (as defined in Step 1). It is a simple calculation, as shown in Chart 4.
Stabilized earnings $67,200
(from Chart 1)
Cost of money (36,000)
(from Chart 3)
Excess earnings $31,200
5. Step 5 is to determine an EXCESS EARNINGS MULTIPLE that is appropriate for the particular business being examined. This multiple will be used in the following step to determine what value to place on the excess earnings as calculated in Step 4. This multiple reflects the risk, stability, and other factors inherent in the business.
Chart 5 is the tool we use to arrive at a correct multiple. It incorporates, in shorthand, the basic values that the market places on the quality of earnings of a particular company.
CALCULATING THE MULTIPLE
Key to Rating Scale
Risk rating (from 0 to 6)
0 = continuity of income at risk
3 = Steady income likely
6 = Growing income assured
Competitive rating (from 0 to 6)
0 = highly competitive in unstable market
3 = Normal competitive conditions
6 = Little competition in market, high cost of entry for new competition
Industry rating (from 0 to 6)
0 = declining industry
3 = Industry growing somewhat faster than inflation
6 = Dynamic industry, rapid growth likely
Company rating (from 0 to 6)
0 = recent start-up, not established
3 = Well established with satisfactory environment
6 = Long record of sound operation with outstanding reputation
Company growth rating (from 0 to 6)
0 = business has been declining
3 = Steady growth, slightly faster than inflation rate
6 = Dynamic growth rate
Desirability rating (from 0 to 6)
0 = no status, rough or dirty work
3 = Respected business in satisfactory environment
6 = Challenging business in attractive environment
Rating formula (showing values used for Small Business Inc.)
Competitive situation 3.0
The industry 3.5
The company 5.0
Company growth 4.0
Excess earnings multiple 3.9
6. The multiple developed above will be used with the excess earnings figure, as shown in Chart 6:
VALUING EXCESS EARNINGS
Excess earnings $ 31,200
(from Chart 4)
Multiple (from Chart 5) X 3.9
Value of excess earnings $121,680
7. Finally, we are in a position to determine the value of the business. We do this by adding the value of the assets (Chart 2) to the value of excess earnings (Chart 6).
TOTAL BUSINESS VALUE
Value of assets $260,000
(from Chart 2) *
Value of "excess earnings" +121,680
(from Chart 6)
Total business value $381,680
* Note that the $40,000 used in Chart 2 for required working capital has not been included here. A new owner will have this amount available in addition to the purchase price.
The steps above, if followed carefully, offer a commonsense approach to valuation. They suggest (accurately) that a business is worth the market value of the assets that are necessary to conduct the business, plus, where appropriate, a premium if the business is especially profitable.
A closer examination will reveal that the methodology used to determine the premium to be paid for particularly high earnings is quite conservatively calculated. In the example used above, we arrived at a multiple of 3.9. This means that if the business is sold at the same price as the valuation suggests, the purchaser will receive a return on investment of 25.6% on the portion of the purchase price that is not backed up by tangible assets (payback in 3.9 years equals an annual return of 25.6%).
"Negative" excess earnings. Many businesses may have no excess earnings. In this case, the business is likely to be worth no more than the value of the tangible assets. After all, a seller cannot expect to charge a premium (known in accounting terms as "goodwill") if the business cannot generate more than enough funds to pay for the assets.
In some instances the figure arrived at for excess earnings may be a negative or minus figure. In such a case, the business is not even worth the value of its assets, and the best course may be to liquidate.
Every business is unique, and these comments must be qualified according to the circumstances of each. An example would be the business that provides an exceptionally nice life-style for a retired couple -- in a sense, a combined part-time job, home, and hobby. Placing a value on such a business is quite difficult and subjective. How much is that life-style worth? This article will not solve that problem. However, this method will be helpful in understanding some of the basic principles on which an agreement might be reached.
Summary form. At left is a summary form that can be used to follow this methodology to determine the value of a particular business. In all probability, an owner who follows this approach carefully and objectively will arrive at a conclusion of value that is quite close -- within 5% to 10% -- to what the business should sell for, given adequate time and effort to find a qualified, arm's-length purchaser.
It will be obvious that many of the steps involved will require quite a bit of knowledge and judgment about the particular business being examined. For example, a buyer and a seller, each using this method, may arrive at quite different opinions of the rating to be used for something so intangible as the "desirability" of a particular business.
However, if the method is followed closely, differences in judgment will generally lead to quite small incremental differences in overall value. Perhaps even more important is the process of getting all of these judgments, opinions, and assumptions written down in the disciplined form we have followed here. Then, a buyer and a seller (if they are not playing games with each other) can compare all of the instances where these judgments differ. This leads to a very important discovery -- that when the negotiations and discussions relating to a purchase and sale are focused on particular, defined items, it is usually not difficult to reach agreement. A buyer and seller should discuss the differences in such judgments and should arrive at a middle ground. Often, this is the only way to arrive at the facts behind a particular assumption.
Effect of terms. Finally, the actual price to be paid for a business will often differ considerably from its value as defined here if there are special terms available as part of the transaction. For example, it is worth paying a much higher price than indicated if a very low interest rate is available, the owner will carry a lot of "paper," etc. As a rule, a little work and help from a qualified CPA will help to place a value on the benefits of such special terms. Then, a correlation between the value as indicated by this method and the value of the special terms can be established, and appropriate adjustments made.
Real problems are emotional. The real problems that generally arise in negotiations are usually emotional ones. One party does not trust the other. Opinions of one party are so vague and general that they arouse suspicion. Such problems will almost always arise unless a careful, step-by-step approach to valuation such as this one is followed.
There are several exceptional cases in which this approach to valuation will not work, or in which it has limited value. Chart 8 shows some of the instances in which this method must be modified:
High-tech businesses These are generally valued by the condition of
the acquisition market -- exceptionally high if
the market is "hot."
"Information" businesses Very difficult to value. Often based on an
payment plus future payments depending upon
sales and earnings.
"Hobby" businesses These so-called life-style businesses are part
business, part fun. See comments
above on negative
High-leverage businesses Such businesses have special
qualities that make
them worth more than this method would indicate.
An example would be a business that has
exclusive rights or lines that might be expected
to generate much higher earnings if fully
Professional businesses Medical, accounting, legal practices, and other
professional businesses are generally
prevailing practices. Consult with appropriate
professional organization or consultants; often
based on percentage of future billings.
Start-ups Start-ups are hard to value. Some,
with exciting technical qualities,
can be worth
much more than asset value
prospects would suggest. The price will be
negotiated, and will depend on the needs of