How a Business Is Valued

Contents

1. Three approaches and the records behind them
2. Multiples, rules of thumb and the seller’s number
3. Why the purpose changes the number

Brent O’Mara works with business owners and multigenerational families, and business succession, a subject the work often reaches, begins with the question of what the company is worth. An appraiser begins with the materials. A business broker’s column in the New York Times describes a prospective seller arriving with tax returns and financial statements, a list of his largest customers and the names of likely buyers, which is the file any method starts from.¹ Iowa State University Extension adds the balance sheet, which records the assets of a business and their value, the liabilities against them, and the difference, which is net worth; an income statement records what happened between two balance sheets, and a cash flow statement records the money that moved.⁸ CPA Practice Advisor notes that many companies cannot produce these cleanly, because personal and business expenses are mixed or the books were kept for tax purposes rather than to show the business as it is, and that an owner who estimates worth from revenue or from what a similar company reportedly sold for does not have a valuation at all.⁵

Three approaches and the records behind them

The Small Business Administration sets out the three methods in a sentence each. The income approach looks at projected revenue and accounts for the risks to it; the market approach compares the business with similar ones that recently sold; the assets approach subtracts total liabilities from the total value of all assets. It adds that intangible items, brand presence, intellectual property, customer information and the projection of future revenue, belong in the count.⁴ Accounting Today gives the same list as asset based, income based and market based approaches and calls valuation a highly subjective field that depends on sound methodology, a great deal of data, and the ability to use more than one method at once.³

The asset approach is the easiest to see on paper. Iowa State’s guide explains the two ways a balance sheet can price an asset: the market approach, which uses current sale value and so estimates what the owners would have if the business were liquidated on the date of the statement, and the cost approach, which uses original cost less depreciation plus improvements and so tracks the profitability of the business over time without giving an accurate sale value.⁸ The guide also notes that a sale which triggers tax is often shown at a net value after that tax, and that the cost approach tends to understate what a long held asset would fetch.⁸ For an operating company the income approach usually matters more. A second New York Times column by the same broker states that the most common approach to valuing a small business is a multiple of earnings, and that if the cash flow of the business cannot support the purchase price, including mortgage payments where real property is involved, the business may not sell at all.²

Figure

The three approaches to value

	What it measures	Where it tends to be used
Income approach	Projected earnings or cash flow, discounted for the risk that they fail to arrive	Operating companies whose worth lies in what they earn
Market approach	Prices paid for similar businesses that sold recently	Industries with enough sales to compare, and brokers' rules of thumb
Asset approach	Total assets less total liabilities, each valued at the date of the statement	Asset heavy businesses, farms, and companies worth more closed than running

Multiples, rules of thumb and the seller’s number

The market approach, for most small companies, means multiples. The broker’s 2010 column describes a specialty subcontractor with about $7 million in sales, $725,000 in earnings before interest, taxes, depreciation and amortization, and $900,000 in seller’s discretionary earnings, whose owner asked $8 million. That price was eleven times his earnings measure, or almost nine times discretionary earnings, when similar businesses for sale around the country were priced at three to four times, so the asking price was roughly double what buyers would consider.¹ The column quotes a survey of brokers and merger advisers in which, asked about their biggest challenge, the largest group named seller value expectations.¹ It also lists rules of thumb from an annual brokers’ guide to asking prices: three to four times discretionary earnings plus inventory for a small manufacturer, forty percent of annual sales plus inventory for a retail auto parts store, ten times earnings before interest, taxes, depreciation and amortization for a wind farm.¹ There is no true comparable sale for a small company, the broker writes, but multiples for similar businesses in the same industry and region are the next best thing.¹

The second column shows the opposite error. A snack bar owner in her late sixties, running the business almost alone and working twelve to thirteen hour days, had priced it first at $1.5 million and later at $450,000, by her own account because she needed enough to retire on. The broker’s point is that a price set by what the owner needs, rather than by what a willing buyer would reasonably pay, rarely sells, and that a business built entirely around its owner is closer to a job than to a company a buyer can run.² CPA Practice Advisor makes the same observation from the buyer’s side: when every client relationship and every decision runs through the owner, the value falls because the buyer knows the company will struggle without that person.⁵

Figure

Rules of thumb from a brokerage pricing guide

1. 01
   ManufacturingThree to four times seller's discretionary earnings plus inventory, for annual sales of one to five million dollars
2. 02
   Retail auto partsForty percent of annual sales plus inventory
3. 03
   Commercial printersTwo and a half to three times recast earnings before interest, taxes, depreciation and amortization
4. 04
   Retail apparelOne and a half times seller's discretionary earnings plus inventory
5. 05
   Wind farmsTen times earnings before interest, taxes, depreciation and amortization

Why the purpose changes the number

A valuation is prepared for a reason, and the reason shapes the work. Kiplinger describes a professional valuation as essential for sale negotiations, estate planning and retirement projections, and as a reality check on whether the owner’s retirement plan will work at all.⁶ Inc.’s estate planning guide notes that a professional business appraiser can produce a valuation that stands up to Internal Revenue Service scrutiny, and that the cost of an appraisal should be driven by its purpose, the appraiser’s professional standards and the appraiser’s overhead.⁹ Accounting Today lists what goes wrong without a qualified appraiser: receiving more or less than fair market value, understating or overstating taxable income, failing the disclosure rules on a gift tax return, and creating cash flow problems for the entity or its owners. The common mistakes it names are confusing enterprise value with equity value, using a method too simple for the company, borrowing outdated market multiples from some earlier deal, and not knowing how a partial interest of less than the whole is affected; a good appraiser, it adds, should address discounts for lack of control and lack of marketability on such an interest and document the work in a report that meets professional standards.³ Kiplinger notes that an owner need not sell everything at once, since some keep part of their equity, stay on in an advisory role or phase out gradually, each of which changes what is being valued.⁶

Nebraska has its own example. The University of Nebraska at Omaha’s Nebraska Business Development Center recounts how the owners of a package store in St. Paul, Nebraska, read in 2013 about the center’s valuation work for a regional grocer, asked for the same assessment of their own store, spent 2013 to 2015 working on its value and on possible deal structures, and sold it to an employee in January 2016.⁷ That path, in which the eventual buyer is already on the payroll, is the subject of management buyouts, and the price agreed is often paid over time through the arrangements described under earnouts and seller financing. Where the company’s buy sell agreement already exists, its price clause may have settled the method years earlier.

The limit of the subject, honestly stated, is that the three approaches rarely agree, and nobody should expect them to. An income approach prices the future, an asset approach prices the present, and a market approach prices what strangers paid for something similar, so a company can be worth more as a going concern than as a pile of equipment, or less. The number also depends on whether it is being prepared to sell the company, to price a gift or to file an estate return, each of which the tax rules treat differently, and on the owner’s and the family’s individual circumstances, so the work is for qualified professionals, an appraiser first and tax and legal advisers alongside.