Step by Step Guide to Calculating Your Business’ Worth
It happens all the time. I meet with a business owner who tells me about what he or she does. They tell me how many employees they has and how much revenue they generates. He or she might mention a profitability number, but probably not. At the end of this conversation I will inevitably get the “so, what is my business worth?” question. Even worse, I recently met with the business editor of a business publication and she said, “I hear businesses are trading for about six times now. Is that true?” I was amazed that someone who writes about business was willing to boil business valuations down to a single number. The answer to both of these people was “there’s a lot more that goes into valuing a business.”
I will outline some of the initial steps that are taken when we are valuing a business with the thought of taking it to market. The real valuation involves hundreds of items and is not nearly this simple. The information below should get you thinking about what you might want to assemble before that first conversation with your investment banker.
1. Assemble Financial Information
The first meeting with your investment banker will probably involve you sharing a couple of years of financial information. By financial information, we typically mean an income statement and balance sheet. If you have cash flow statements, bring those as well. If you are audited or reviewed by a CPA firm, bring those as well. If you have five years in easy reach, bring that information. The investment banker will use the data to look at things such as:
- Year-over-year growth/decline in revenue
- Margin improvement or decline
- Profitability improvement/decline
- Look for any unusual changes in margin or expenses
- Look at balance sheet changes over time
2. Think About Add Backs
Your advisor will also ask you a few questions about potential add backs to your financial statements. Add backs are items that are expenses in your business that a new owner would not incur. They can be ongoing items such as the cell phone for your son that is running through the business, or they can be one-time events, like the expenses not covered by insurance when the tornado tore the roof off your plant. You should come prepared with a list of what you believe to be add backs. Your investment banker may not accept all of them. For instance, you may believe that you are paying your plant manager too much and want to add that back to your financial statements, but in reality, it is unlikely that a buyer would immediately decrease the salary of a key employee.
3. Figure Out Capital Expenditures (CAPEX)
Your investment banker will ask you questions about what you invest back into your business each year. These are capital expenditures and they are generally categorized as “growth” or “maintenance” costs. Think about growth CAPEX as the money you put back into the business to grow revenues. For example, adding a new line in your facility. Maintenance CAPEX are the capitalized costs that involve keeping the revenue at its existing levels. These are items such as plant maintenance and repairs.
4. Assemble the Financials Specifically for the Sale Process
These will be compiled by your investment banker and they will be formatted and presented in a way that is very specific to the sale process. They will be presented in a way that shows the business in the best possible light on an ongoing basis. The financials will focus on cash flow or EBITDA (earnings before interest, taxes, depreciation and amortization) because these approximate the money available to the buyer to pay down debt and grow the business.
5. Think About the Next Couple of Years
Projections can scare some business owners but they will be an important part of marketing the business for sale and creating value. Valuation models are the most sensitive to input related to growth. This is because buyers will (hopefully) inherit the company and the cash flows you are projecting.
Your investment banker will want to go over your projections with you very carefully. It is important to walk a fine line when budgeting for the next couple of years. You don’t want to overstate what the business will do because failing to meet your budget during the sale process is very negative and very difficult to overcome. You also don’t want to understate what the business can do going forward because you want to get credit for any big boosts in revenue or profitability that might be on the horizon. Chances are that you will have to create a new set of projections, with the help of your investment banker because they will be different than the ones you provide to your commercial bank (usually very conservative) or use to incentivize your sales people (usually very aggressive).
6. Lay Out Your Customers by Spend
Rank your top 20 customers by revenue for the last couple of years. Look for large customers that have left and note why. Look for large customers that you have added and note why. Make note of customers that represent more than 20% of total revenue. Customer concentration is seen as a company vulnerability and customers that make up a large percentage of revenue will need to be addressed in the marketing materials prepared by your investment banker. If you have a customer concentration, even a small one, discuss it with your banker. The relationship needs to be thoughtfully explained in order to minimize the value reduction taken for a concentration.
7. Now Do the Same with Vendors
We once sold a business that appeared to be a perfect sale candidate after our initial analysis. Then, we had the business discuss its spend with all of its vendors and make note of any vendor where it single sourced an item. It turned out our client sourced a foaming nozzle from a company that had a patent on the technology. No one else could produce this foaming nozzle. If that company’s profits and products depended exclusively on this nozzle, the fact that it could be sourced from only one vendor, put that company at risk.
Take a look where you spend your money with vendors. If you don’t have multiple suppliers, could you get them? What sort of pricing power do your vendors have?
8. Think about “Pie in the Sky” Opportunities
Without any limitations, what could your business do? What other companies would you acquire? What products would you launch? Sometimes, there is a lot of opportunity in a business that a current owner may not be seizing but a new owner could immediately enjoy. This low hanging fruit is attractive to buyers and can make a business more valuable.
9. Get Smart on the Marketplace for Your Industry
Do not ask your neighbor what he or she sold their business for and assume that particular “market” value applies to your business. Your investment banker looks at many things going on in the marketplace when considering what demand for your business will be. Depending on what’s happening in the overall merger and acquisition economy, certain industries can be in favor or out of favor, certain size companies can be more attractive to buyers and even geography can play a role.
If you own a company that makes violins, the worst thing you can do is assume that you will receive the same valuation, or multiple, that your buddy at the club received when he sold his mining company two years ago. Valuations change every day and only someone who is watching how companies trade and talk with prospective buyers can give you a real read on the market.
10. Run the Right Process
The importance of running the right process on valuation of a business cannot be understated. Your investment banker will take all the assembled information and market knowledge and will set about a process that is designed to maximize returns for sellers. This includes many things but at its core the banker will:
- Make sure the information is presented in the best possible light
- The correct buyers have been identified
- Competition is created during the process
These are the things that maximize value for business owners, but are often overlooked by business owners. Most business owners understand their business’s performance, but do not realize how much of an impact variations in the approach to selling the business can have.