Certain concepts are really hard for me to grasp. Infinity. Light. The space-time continuum. Retirement. Business valuation.

As a business owner, I can get by without fully understanding the meaning of “infinity” and “light-year.” But “business valuation” might hit home, especially when it comes to understanding “retirement.”

None of my college courses taught me how to value my own business. Why? Maybe the professors themselves didn’t understand it.

Once I attended a seminar on business valuation. I was interested in the subject and in removing my dark cloud of ignorance. But I was lost. I just sat there critiquing the presenter’s style and the quality of listeners’ questions – wondering if I was the only one in the dark.

Later, someone told me that the presenters of these seminars really don’t want you to “get it” anyway – because then you wouldn’t need to hire them. In other words, their whole objective is to convince you that you have no chance of getting it and need to hire them to do it for you.

My frustration turned to complete apathy. Later I was in the bookstore and saw a little book called A Concise Overview of Business Valuation; $35 later I wondered if I was on another path to disappointment.

But I was not disappointed. The book is clear and succinct, and offers a commonsense approach to business valuation. Chapter by chapter, Perkins helped me understand basic concepts of business valuation. Although I have no mistaken belief that I can now value a business with confidence, I can honestly say that the dark cloud has lifted.

I also see that I need to work on building value in my own business.

After reading the chapter on “Value Drivers,” I recognize characteristics of my business that, according to Perkins, drag down value. The good news is that they are things I should be able to change.

Click here to order your copy of Concise Overview of Business Valuation for only $34.95

Also, available in a downloadable PDF version. Save on postage and download Now >>

When a business owner hires Acquisition Advisors to represent him/her in the sale of his/her business, our typical task is to maximize value. But many business sellers fail to fully comprehend that “value” can mean much more than money. That, if they will think about it, “value” can be extracted in many forms other than cash, such as:

• notes payable
• earn-out agreements
• releases of liability
• waiver of contingent liabilities
• ongoing benefits, such as insurance coverage
• employment or consulting agreement for the selling owner
• seller’s retention of rights, freedoms or certain assets (in whole or in part)
• employment agreements for employees
• agreement to lease certain real estate or other assets
• agreement to retain the business in a certain community

The list can literally be endless.

In the sale preparation process, Acquisition Advisors works with the seller-client to determine all the types of “things of value” the seller might enjoy or find value in. Then, we prioritize. For example:

1. cash at closing
2. long-term “market” lease of seller-owned real estate
3. firm obligations to pay cash post-closing
4. employment agreements for top 3 executives
5. earn-out agreements
6. release of contingent liabilities

Once the “buckets” are lined up, in order of preference, the task is to begin filling them up. Using the priority list above, the first task is to maximize the cash at closing payment. Once we’ve exhausted what the buyers are willing and able to pay in cash at closing, we go for bucket #2, and so on.

So what we mean when we say “maximize value” is anything that is of value to the seller. It can be much more than cash. In fact, it should be much more than cash because the buyers have a limited amount of cash they can provide at closing, but they always have many other “things of value” they can provide, and will provide, if properly and skillfully provided with the opportunity and motivation.

How do you know whether an offer is “high”?

How do you determine what price is absolutely the highest sale price possible?

One-of-a-kind assets include real estate, businesses, original art, custom jewelry, and to some degree, used airplanes and automobiles. But the hardest to value is the business. Few comparable-sale data are available for small and midsize private company purchases/sales. In these cases, the only way to determine market value is to offer the asset broadly to the marketplace and solicit offers.

Offering it “broadly to the marketplace” does not necessarily mean offering it to the world, but rather to persons or organizations that are likely to have both an interest in and the financial capability of purchasing the subject asset. Moreover, to get the highest price, one must introduce it to buyers that will place the highest value on it. That is, buyers that will tend to have the greatest amount of interest in the asset and – again – the financial capacity to pay a premium price.

The buyer willing and most able to pay the highest price will typically be the buyer that is able to generate the most money from it. So to maximize sale price, it makes sense to identify buyers with characteristics (i.e., aptitudes, capabilities, assets, rights, relationships, etc.) that might make our asset, when owned by them, even more valuable.

“Offering it” means making the members of the target audience aware that the asset is available for purchase. Interested buyer prospects will also need to gather and assess the pertinent facts and characteristics. Typically this means the seller accommodates the buyer, at least to some degree, either directly or through a representative. When the asset is a business, the seller will be the primary source of information (directly or indirectly through a broker). That’s because many of the important facts about the business:

• Cannot be readily observed just by looking at or researching the asset
• Are known only by the owner-seller and, to a lesser degree, by his or her key employees.

This makes for a very interesting relationship. The seller will have a financial incentive to highlight the positive and downplay – or even hide – the negative. So the business buyer approaches cautiously. And naturally the buyer will discount the offer in accordance with his or her level of certainty. If the buyer thinks the seller is not fully disclosing and, therefore, “there might be something I don’t know about,” the buyer’s willingness to pay will decline.

In attempting to obtain the maximum price for an asset, it’s critical that the buyer be able to gather relevant facts. Furthermore, especially in the case of a business, the buyer needs to feel comfortable that all the relevant facts – both value-enhancing and value-diminishing – have been disclosed, because there is always an inverse correlation between risk and price. As a buyer becomes more clear and certain of the asset’s characteristics, the buyer’s perceived “risk of the unknown” falls and, therewith, willingness to pay rises. This is why it is so very important that a buyer trusts the seller and that the buyer believes the seller is honest and has disclosed each and every material fact about the asset.

Getting the Best Price

Let’s say that you’ve done the above-mentioned things well and you’ve received an offer. If you have a one-of-a-kind asset and no real comparables, how will you know whether the offer is just fair, good, or really great?

Have it appraised? Well, an appraisal is simply one person’s estimate of value. The appraiser could be way off the mark in either direction. Always keep in mind that the appraiser does not know the value. Similarly, the appraiser does not determine the value. An appraiser simply gives an opinion of value. Granted, if the appraiser is well qualified to value the asset at hand, it should be an informed opinion. But for one-of-a-kind assets that have few comparables, like a business, the only way to really determine the market price is by going to the market.

How about running a present value calculation to determine “fair price”? You know, discounted cash flows? This method requires two pieces of data that are very difficult to accurately peg:

• Future cash flows to be enjoyed by the owner of the asset
• Rate of return (aka discount rate) that is “fair” for the asset

Yes, the present value of discounted cash flows is a nice financial tool, but it certainly cannot tell us what the market will actually pay. Does it estimate what the market will pay? Maybe. But I wouldn’t base my sale decision on some financial jockey’s calculation of net present value, at least not when hundreds of thousands of dollars, or maybe millions, are at stake.

So back to our question. If you have an offer for a one-of-a-kind asset, such as a business, how can you figure out if the offer is a good one? Obviously, it’s not easy. There is always the possibility that someone “out there” would be willing to pay an even higher price – if only they were aware of the opportunity. But the seller can rest easy to the extent that his asset – in this case his business:

• has been offered broadly to “highest and best” buyer candidates
• has been offered in a manner that should garner maximum price
• multiple offers are obtained

Multiple offers provide a context in which each offer may be evaluated.

The market for any asset will reflect a bell curve. The horizontal x axis represents price from low to high (left to right). The vertical y axis represents the number of data points for each value on the x axis. At the top of the bell curve, where price is moderate, there are many data points (i.e., offers to purchase). This is the most commonly offered price. But as price moves away from the center, fewer and fewer buyers are represented.

Chart 1 depicts a typical distribution of data points within a bell curve. That is, 68% of purchase offers will be pretty close to the average. So if 15 offers are received, 10 will be in the middle section.

A normal distribution of data means that most of the examples in a set are close to the “average,” while relatively few examples lie to one extreme or the other.

As the seller of an asset, we are less concerned about the left part of the graph. These offers are low. Offers to the right are our more attractive offers. The farther right the better. But we can see from the graph that just 16% of all offers lie to the right of the crowded middle section. The simple point I’m making is that if a seller hopes to obtain a price that lies in the upper 16%, he or she will have to count on luck, shrewdness at targeting a highest and best buyer1, or the lower-risk approach of garnering multiple offers and thereby increasing the likelihood that one will lie to the right in the top 16% of the market. The problem with both the luck and the rifle-shot scenarios is that the offer(s) obtained might indeed be “high,” but you won’t really know because you don’t have a context (i.e., other offers) to judge them in.

1 Another problem with the rifle-shot strategy is that, even if a seller can actually identify and skillfully approach the buyer that is most capable of buying at the highest price, the lack of competition from other buyers will almost always work to the favor of the buyer (i.e., allow them to buy for less than their maximum). This is because the seller cannot know the absolute maximum price that the buyer will pay. So, the only way to extract it is through skill and intense competition.

How Many Offers Are Enough?

Statistically speaking, 12 is the number where diversification begins to take meaningful hold. So for whatever asset you may be selling, it’ll take at least 12 offers for your bell curve to begin to take shape. You’ll be able to lay your offers out and get a pretty clear picture of where the mean (middle) is and where the outliers are.

Pursuing a Top 2% Sale Price

Statistically speaking, a top 2% sale can be considered “the very best price possible.” Unfortunately, for one-of-a-kind assets, the only way to really know whether an offer is top 2% is to get at least 50 offers from qualified buyers. For many asset types, such as small and midsize businesses, this will not be possible. Even so, every additional offer – be it the 3rd, 7th or 11th – provides meaningful context for the other offers and, therein, considerable added comfort and clarity.

To illustrate, here are the 30 offers received for XYZ Company.

As you can see, most of the offers are packed on the middle of the curve. In fact, the middle of the curve was actually determined by the offers themselves (that’s how this works!). Keep in mind that price is on the horizontal axis, not the vertical axis. The bulge in the curve is created by the number of offers – not the price of the offers. In this example, the bulge in the curve is created by the stack-up of offers in the $10 range. As the graph illustrates, we received a whopping six offers for $10. As the offer prices deviated from 10, however, they occurred less frequently. Just four offers were received for $11, just three for $12 and only one for $14 and $15. Obviously, we will try to sell our asset to the person that offered $15. If that fails, we’ll go to the $14 offer.

If the owner of XYZ had just gone to the two buyers that he knew about and, therefore, received only two offers for, say, $9 and $11, two things would have occurred:

1. the seller would have no way of knowing whether these offers were “good”
2. the seller would have sold for a lot less than would have been possible

What? You say maybe you could get the $11 offer to move up to $12 or $13? Well, yes, that is possible, but it’s pretty hard to do. For one thing, the buyer that offered $11 may be completely unable to pay $13. To get $13 you need to find a buyer that has the motivation and ability to pay $13. But again, this is hard for the seller to figure out on his or her own. So the rational approach is just to let the numbers work for you. That is, go to many buyers and increase the likelihood that a few will be willing and able to pay more than the rest.

Finally, let’s say that a seller goes to just two buyers and one offers $14 – a top price. The problem is that without the context provided by multiple buyers (i.e. offers), the seller will not know how good this offer is. He might naturally assume, “Hey, if I received $14 right out of the gate then surely I can get more”. I’ve seen sellers use this logic and work themselves right out of great sale opportunities.

Again, multiple buyers clear up a whole lot of questions for sellers.

Use Competition to Elevate Values

People are competitive. It is no surprise that motivated buyers, when presented with competition, will tend to pay more. This is why auctions work so well. The good news is that if you are a seller and you’ve offered your asset as we’ve suggested herein, all you have to do is let the buyers know about one another. Of course, there’s a right way and a wrong way to go about this, but it can be done. Acquisition Advisors has found that after receiving initial offers and making each subtly aware of the presence of other highly motivated buyers – some of which may be competitors – inviting suitors to rebid has proven to raise prices considerably. The effect is to shift the entire bell curve to the right as in the following graphic.

Timing of Offers Is Everything

The value of every asset type ebbs and flows over time. And so the timing of a sale can have substantial impact on value. Unfortunately, it is exceedingly difficult to accurately ascertain where one is in the cycle at any given time. Equally as difficult is predicting where prices will head in the future. So although the timing of the sale can and will greatly impact price, awareness of this reality does not prove very useful. What is within our control is the timing of when we receive offers relative to other offers received.

When our goal is to sell a one-of-a-kind asset for maximum value, we need more than just multiple offers. We need these offers to “come in around the same time.” This is the only way we will be able to choose the best of the lot. Buyers will not typically “wait around” very long as we shop for an even better price. Offers get stale, things change, excitement wanes and the window of opportunity closes.

Getting all offers within a set time, say three weeks, is also critical for using the power of competition. Competition can work only when competitors go head-to-head at the same time.

A Price Must Be Paid

Selling an asset as described herein takes a considerable amount of energy. It can also require a considerable amount of resources, experience and expertise to garner maximum price. This is why sellers of high-value, one-of-a-kind assets almost always delegate the task to a skilled broker. To be sure, the broker will charge a fee. Some sellers will attempt to avoid the fee by doing it themselves. Assuming the seller has the time and energy and is willing to dedicate it, at least one of the bases is covered. As for the expertise, experience and resources, the seller may be able to do okay depending on the type of asset being sold and, of course, the owner-seller’s expertise, experience and resources. In the case of a business, very few business owners can even begin to do justice representing themselves.

Why have I gone into such depth on this question of how the owner-seller of a one-of-a-kind asset can be sure he or she gets a fair price? Because I’ve seen many people fret and toil over the uncertainty. I’ve seen it tear apart people, partners and families. I’ve seen business owners waste thousands of hours, squander a lifetime of credibility, and needlessly put loyal employees through years of uncertainty – all because they desperately wanted to sell for a high price but did not fully understand the dilemma. And if they did understand the dilemma, they did not avail themselves of the solution – a broad, thorough and time-focused buyer search that brings multiple offers and creates competition.

What’s the lesson? If you have a high-value, one-of-a-kind asset that you wish to sell, get expert assistance. Choose a firm or broker that:

• specializes in the asset that you wish to sell
• is willing and able to put the hard work in
• has some enthusiastic references that you can actually talk to
• will package your offering professionally and comprehensively
• has a vision for “highest and best buyers” for your asset and knows how to identify and reach them
• will orchestrate the buyer search in a manner that will generate multiple offers received at about the same time
• will address the confidentiality needs and concerns directly and smartly

Choose well and your net price will be considerably higher than it would have been otherwise. It’ll also go much more swiftly.

The truth is, there is much confusion when it comes to profits and earnings. A recent Wall Street Journal article recognized this fact, stating that there are a “host of names for … earnings and there is no uniform standard by which to understand them, causing much confusion among investors.” Because of this, the definition used should always be clarified.

This article will explain the various types of “profits” used, and the definitions of each. With an understanding of the terms and definitions we can put any particular business sale multiple into proper perspective. To begin, review the most recent year’s income statement for XYZ Company that accompanies this article. How much profit did XYZ make? This is a trick question.

Profit comes in many forms. Gross Profit. Operating Profit. Net Profit. Taxable Profit. Earnings can be taken to mean the same as profits. The names and definitions are almost endless. In the box below is a list of commonly used terms that refer to the profitability of a business. Now, you are at your country club and Jack Taylor tells you for the 10^th time this year that he sold his company for 10 times earnings. This time, to his surprise, you ask him what he means by “profits.” After he gives you a flip answer like, “You know, the green stuff you put on the table in Vegas,” you inquire as to what type of earnings is he referring. He probably doesn’t even know himself. But you will. If he sold for 10 times his after-tax profit, then the price was $6,000,000. We see on the accompanying table below that XYZ Co. reported Pre-Tax Profit of $600,000. When we look at the income statement and footnotes, we see that adjusted seller’s discretionary cash flow (SDCF) was $3,650,000. Consider this number and the definition of SDCF and you might come to believe that Jack Taylor didn’t obtain the premium of which he boasts.

We could estimate, assuming this year was a typical year except for the lawsuit expense and assuming that his company was not a C corporation and thereby subject to double taxation, that this company generates $300,000 in annual after-tax income to the owner. This is pre-debt service and as long as the owner utilized leverage his take-home would be less. Again, it does not appear that he sold for a premium.

In summary, the next time you hear a sale multiple you’ll know that it tells us almost nothing unless we know the definition of profit used. Similarly, the sale price is almost meaningless unless you know the terms.

($000′s)

Income Statement
XYZ Company

Revenue …………………………………………..$10,000

Cost of Sales ……………………………………..($3,000)

Gross Profit …………………………………………$7,000

Operating Expenses* …………………………($5,000)

Operating Profit ………………………………….$2,000

Non-Operating Expense** …………………($1,000)

Pre-Tax Profit ……………………………………..$1,000

Tax ……………………………………………………($400)

After Tax Profit ……………………………………..$600

* Operating Expenses include $1,000,000 of salary to the owner, $400,000 in owner perquisites and $250,000 in depreciation.
** Non-Operating Expense is $500,000 in interest and a $500,000 legal bill to settle a dispute.

Miscellaneous Profit Calculations¹
(From the above income statement)

Operating Profit ……………………………………$2,000

Pre-Tax Profit ……………………………………….$1,000

After-Tax Profit ……………………………………….$600

EBIT ……………………………………………………$1,500

Adjusted EBIT² ……………………………………..$2,000

EBITDA………………………………………………..$1,750

Adjusted EBITDA² ………………………………..$2,250

SDCF² ………………………………………………..$3,650

¹ For additional profit calculations, see each “profit” line on the accompanying XYZ income statement.
² Non-recurring expenses added back.

Glossary of terms

Gross Profit – Revenue minus direct expenses (Direct expenses are often referred to as cost of goods sold.)

Operating Profit – Gross Profit minus Operating Expenses (Operating expenses are often referred to as sales, general and administrative expenses.)

Pre-Tax Profit – Operating Profit minus any non-operating expenses (except taxes).

After-Tax Profit – Profit after all expenses have been deducted including taxes.

Net Profit – See “After-Tax Profit.”

Profit – A general term for profitability.  Examples include gross profit and net profit.

Earnings - A term for profit. Generally considered to mean net profit or after-tax profit.

EBIT – Earnings Before Interest and Taxes.

EBITDA – Earnings Before Interest, Taxes, Depreciation and Amortization.

Seller’s Discretionary Cash Flow (SDCF) – EBITDA plus owner compensation plus all expenses that are non-recurring and any expense that is not necessary for the ongoing operation of the business.

Owner Earnings – See “SDCF” above.

Taxable Income – See “Pre-Tax Profit.”

Normalized Earnings – “Normalized” refers to the act of adding back to profit all excess owner compensation (salaries that are not “fair market”) and any expenses that are non-recurring or unnecessary for the ongoing operation of the business.

• The cash to which the buyer is referring is cash generated from operations, as opposed to cash generated from any changes in assets or liabilities; and
• The business was valued based on an estimate of the cash the business will generate from operations on an annual basis; and
• To justify the price, the business should generate 1/365th of such on the first day of ownership; 30/365th during the first 30 days of ownership; 90/365th in the first 90 days; etc.

The only way for the above to actually hold true in an acquisition is if the buyer pays his price in cash and, in exchange, receives the entire business including:

• All assets necessary to operate the business – cash, accounts receivable, inventory, accruals, furniture, fixtures, equipment, etc. (at “normal” levels with no deficiencies); and
• All “normal” non-interest bearing liabilities of the business – typically accounts payable and accruals – are assumed by the buyer.

Only via this “deal structure” will cash flow be “normal” and in line with the purchase price. For example, every business needs some cash to operate. If XYZ business requires $5,000 in cash but such was not “left in the business” by the seller, the buyer will have to contribute the $5K on his first day of ownership. Now if the buyer paid full price for the business, he has now paid full price plus $5K. He’s over paid.

For another example, let’s say the working assets of XYZ average $500,000 and the working liabilities average $350,000. XYZ, thereby, needs $150,000 in working capital. Buyer “B” has valued XYZ … based on its annual “profit” (i.e., cash flow) … at $1 million. The seller, however, wants to keep for himself all working assets and pay off all working liabilities. As such, the buyer will inherit a business that, on the first day of operation, has no current assets and no current liabilities. The impact of this deal structure will be that the operating cash of XYZ will be hindered, over the first month or two, for a negative $150K. In other words, the buyer will have to contribute $150K into the business for working capital. The buyer, in effect, paid his target price of $1 million plus $150K to cover the impact of the deal structure. And deal structure strikes again.

Businesses should be valued on the operating cash flow they will generate. If the deal structure impacts the cash flow, such as delays when the operating cash will begin to flow, then the purchase price should be modified accordingly.

Because businesses are often valued based on their earnings, the business seller has a natural desire to present the highest historical profit as possible. A great way to do so is “add backs,” and one such type is classifying certain expenses as “extraordinary.”  Without a firm definition, this exercise quickly becomes a fishing expedition.

However, the litmus test is what the investor will accept as “extraordinary.” Of course, it is incredibly naive to think that the investor will simply look at the bottom line profit that the seller presents, after recasting, and accept it as fact. In reality, he or she will want to walk carefully through all items that contributed to historical revenue, expenses and profit. When it comes to classifying certain expenses as “extraordinary,” the buyer will ask “Could this ever happen again in the future?” If the answer is yes, then he will reject the add-back.

So, was the loss of a valued employee extraordinary?  Well, how often does this occur in business? A large bad debt loss? A large product return?  Distributor failed to allow a return of excess inventory? Bad economy?

The Accounting Standard Board says for an event to be considered extraordinary, it must be “infrequent in occurrence” and “unusual in nature.”

Infrequent in occurrence: The event could not reasonably be expected to occur in the foreseeable future.

Unusual in nature: The underlying event or transaction should possess a high degree of abnormality and be of a type clearly unrelated to, or only incidentally related to, ordinary and typical activities of the entity.

In summary, the standards for classification as extraordinary are stringent. The Wall Street Journal recently noted an accounting textbook that quipped, “The only items that could qualify are ‘such items as a single chemist who knew the secret formula for an enterprise’s mixing solution but was eaten by a tiger on a big game hunt, or a plant facility that was smashed by a meteor.’”

By way of example, the accounting standards board ruled that companies affected by the Hurricane Katrina disaster could not classify such expenses as extraordinary. They argued that in the southern region, hurricane damage and disruption expenses meet neither the “unusual in nature” nor the “infrequent” hurdles. Granted, six hurricanes hit the U.S. in 2004 alone.

By contrast, business expenses incurred from the 1980 Mount St. Helen’s eruption were deemed by the Financial Accounting Standards Board (FASB) to qualify for treatment as “extraordinary” based on the fact that it had been 130 years since a volcano had erupted in the U.S.

Test #1: Is the business able to pay fair compensation for the talent and labor contributed by each owner?

Test #2: Can all post-purchase debt be comfortably serviced via normal “commercial” terms?

Test #3: Will the equity holders receive a fair return on investment?

So XYZ Company is worth $12,000,000?  OK, let’s see if it passes the three tests of reasonableness. To do this, you’ll need.

1. Beginning Balance Sheet: Should be a “best guess” of what it will look like on the first day after the hypothetical purchase/sale before any purchase-related debt or equity.
2. Ten-Year Projections: These must include annual income statements, balance sheets and statements of cash flows.
3. Debt Service Requirements: Projected until all purchase-related debt is repaid.

Below is the summary balance sheet and income statement for XYZ Company.

At the top of the table is the proforma beginning balance sheet (day 1 of new ownership). Below it is a proforma income statement and estimate of cash flow for the first year of ownership before any interest or principal payments on debt (purchase-related or otherwise). For simplicity, we will assume each year will perform as year one (i.e. flat income and cash flow in each year post-purchase).

Test #1: Fair Compensation for the Talent and Labor of Each Owner-Employee?

Business owners are notorious for sacrificing pay. However, why buy a business that cannot pay fair compensation to the owners for their talent, time and effort?  What is “fair?”  It’s the compensation that could and would be obtained “on the open market.” If you could get a job for $50,000 per year working full time, the business should be able to pay you this “fair market rate.”

So the first test is, “Can the business afford to pay the working owners a fair price for their labor?” This test is met when, in your projections, you burden the business with fair compensation for all the owner-employees and the business will still make a profit and have positive cash flow from operations.

Test #2: Will Projected Cash Flow Cover the Debt Service?

Businesses are purchased with debt and equity. The senior obligation is to debt. The second test of reasonableness is whether the business will generate enough cash to comfortably make all of its debt payment obligations … both interest and principal.

To estimate this, you need more than the price of the business. You need to know how the purchase price will be paid – the “deal structure.”  Because investors typically want to borrow as much as they are able (equity is scarce and more costly than debt), it makes sense to first estimate the amount of bank debt that could be borrowed against the assets of the business. To do this, take the proforma balance sheet to your banker. Below we have applied common loan-to-value rules of thumb to XYZ’s assets.

As calculated, $6,500,000 can be borrowed against the assets of the business. Loan terms on business purchase transactions, non-real estate, are typically five to seven years. We’ll use seven for our example and assume that the bank wants all of the debt repaid over the seven years (as opposed to leaving the A/R and inventory portion on a revolving line of credit) at a 7 percent rate.

The remainder ($5,500,000) of the total price must come from equity, seller financing, or a blend of the two. Now every seller will say, “I won’t seller finance”, but the numbers hardly ever work when there is no seller financing. And, studies show that 80 percent of private businesses that sell do so with seller financing. (By the way, of the company’s sales that do include seller financing, the most typical percent of the price is 50%). For this example, let’s assume that the buyer and seller agree to split the balance of the purchase price that cannot be borrowed from a traditional lender. That places $2,750,000 in seller financing and $2,750,000 in cash contributed by the buyer (i.e. equity). So, the equity piece comes to 23% of the total purchase price. This is in the range of what we actually see in the real world (most deals have 20% to 30%).

Because the seller debt will be subordinate to the bank financing, it is more risky and merits a higher rate of interest than the senior debt. Let’s say three points over prime or 9 percent.

Now, add to your projections the debt service obligations for both bank and seller financing, as in the accompanying table. For explanations of the other calculations in the table, study the notes.

¹ Projected cash flow is derived via projections. Cash flow here is after tax and all expenses except purchase related debt.

² To keep our analysis on an after-tax cash basis, we adjust the interest expense to after-tax. Doing so calls for a reduction of interest expense because interest is tax deductible, so the real cash cost of the interest is 60 percent of the gross or pre-tax cost (calculated by using a 40 percent blended federal and state tax rate).  For example, bank loan interest expense in year one is $420,000, times 60 percent (calculated as one minus the tax rate of .40) is 25 percent.

³ Annual bank loan principal is simply the borrowed amount ($6,500,000) divided by the loan term (seven years).  No tax adjustment is needed as principal borrowing and repayment does not impact taxes.

⁴ Seller loan interest is derived by using common terms for seller financing – seven year note at prime plus 3 percentage points (we used 9 percent). See note 2 above for the rationale for adjusting to after-tax.

⁵ Seller loan principal is the annual amount of principal that must be paid on the seller note ($2,750,000 divided by 7).

⁶ “Free cash flow” is the excess cash generated each year after all obligations are met (compensation, taxes, interest and principal). This is the number that contributes to the investors (buyer) return on investment (calculated in this case via the IRR method).

⁷ Interest coverage ratio is an important indicator of the ease to which cash flow is able to pay interest burden. Banks, in the worst case, want to be sure interest can be paid. The coverage here is healthy.

⁸ Debt service coverage ratio shows the ease to which the business is able to meet its total principal and interest obligations. A ratio of 1.0 would indicate there is just enough cash to meet the P&I burden. Lenders and investors want a cushion for safety, of course, and 1.5 is a common threshold of safety.  Anything above 1.5 is even healthier. As we can see, debt service coverage begins at a healthy 1.5 and then slowly improves in the later years.

*  Beginning in year eight, free cash flow is $2,500,000, as all debt service will be paid by end of year seven. This is also after fair compensation to the owners.

Test #3: Will the equity holders receive a fair return on investment?

Well, what is a “fair return” for an equity investment in a private company?  We know that over the past 80 years in the United States, holders of equity in publicly traded companies have earned per year, on average, 11 percent and 18 percent for large cap and micro cap stocks, respectively. Given that equity stakes in private companies tend to be much more risky, slower growth, volatile and illiquid, return on investment should be higher. Generally, private equity stakes should yield at least 25 percent, if not higher.

So, what do we estimate the return to equity would be on XYZ Company at the $12,000,000 valuation and using the deal structure example above?  Using your financial calculator or Excel, you can take the projected annual free cash flow from the table above, apply it to the initial cash invested ($2,750,000) and you will get a 38 percent after-tax internal rate of return. This substantially exceeds our minimum threshold of 25 percent, so the estimated value of XYZ of $12,000,000 meets the third test.

This article is adapted from an article titled “The Justification of Purchase Test” by Rand M. Curtiss, which appeared in the fall 1999 issue of Business Appraisal Practice. Note: In an attempt to keep this example simple, some liberties have been taken. Before you make investment decisions, consult an expert.

The Case: Tim Frame owns 80 percent of Frame Services, Inc., a business that provides medical billing for doctors’ offices. Scott Hope owns 20 percent. Through a personal relationship, Tim has been presented with an opportunity to provide pension administration and actuarial services for a large insurance company. The proposed contract is for four years and will pay $350,000 per year. There are also circumstances that make it extremely unlikely that the contract will extend beyond the four-year term.

Tim wants to set this contract up separate from Frame Service, Inc. and he wants to own 100 percent of it. So, Tim turns to us for assistance.

Question 1: Does Scott have a right to 20 percent of the new venture or not? What are the issues here? In other words, does Scott need to be bought out at all?

Answer: This may be more of what we call a soft issue, meaning it has more to do with the relationship between Tim and Scott than a legal issue. What is the understanding between Tim and Scott?

We must also “drill down” into how this opportunity really arose. Meaning, from where did this “personal” relationship come. Did it develop through the business of Frame Services? Sure, the new opportunity is a service not performed by Frame Services, but carving it out into a new entity or venture and excluding Scott from ownership might not sit well with Scott. It could create problems between Tim and Scott. It could even lead to a lawsuit.

Following lengthy discussions, we agreed that Scott should be considered a 20 percent owner in the to-be-established venture.

Question 2: What is the net cash that will be received from the project?

Answer: The agreement will pay $1,400,000 in four equal payments to be received at the end of each of the first four years. Tim explains that this is the net cash he estimates from the project. In other words, he estimated the annual cost of the project and subtracted them from estimated annual revenue to arrive at $350,000 in net cash per year.

Tim did not estimate income taxes, however, so in talking to Tim and his accountant we estimate the annual taxable income to also be $350,000. We established a tax rate of 30 percent (state and federal), yielding after-tax cash of $245,000 per year [$350,000 x (1 - tax rate)].

Question 3: What is the value of the new opportunity? Tim should get a handle on this before he accepts the project regardless of the situation with Scott.

Answer: The value of the opportunity is based on the net cash that will be derived from it. However, a dollar held today is more valuable than a dollar received in the future. Why? First of all, a dollar held today can be invested to earn more money. Secondly, there is a risk that the dollar will never be received. After all, what if the person who is supposed to pay the dollar fails to do so?

So, to compare apples to apples, we value all things in terms of present value (i.e. dollars today). Doing so allows us to directly compare the value of, say, $100 today, $200 paid over the next three years and $1,000 over the next 15 years.

Tim’s opportunity promises annual after-tax cash of $245,000 over four years, but there is no guarantee. For starters, the proposed agreement states that Tim’s customer will be obligated to pay only “as long as the services are provided in a satisfactory manner.” Sounds like something that could be open to interpretation and potentially provide the customer with an “out.”

Aside from this, the company is large but it will not provide information about its financial condition. We pulled a Dun and Bradstreet (D&B) report on the company and found no cause for concern, but D&B is not always up to date and even the most seemingly stable business can run into problems, e.g. Enron and  WorldCom.

In summary, to compensate for the time value of money and risk (combined), we chose a discount rate of 20 percent. As such, we “discount” at 20 percent per year the payments expected to be received in the future.  Here is the calculation:

Note: Discount factor rates are found in the backs of most finance textbooks, on the Internet, and are included in A Concise Overview of Business Valuation (see www.TheBusinessOwner.com)

In summary, we estimate the project to be worth $634,060.

Question 4: If Scott has a right to 20 percent of the new venture and Tim wants to buy him out, what would be a fair price?

Answer: Now that we have estimated the value of the entire project, we’re within reach of placing a fair value on Scott’s 20 percent interest. Clearly, we could simply multiply $634,060 times 20 percent to obtain $126,812. One could argue compellingly that this is the value of Scott’s share. However, one could also argue that Scott is in a weak position to bargain because his ownership interest is too small to really influence the business or dictate when and if profits are distributed. Also, Tim is really the only buyer for Scott’s shares. Legally, Tim could choose to not distribute profit to shareholders, not to employ Scott, and not to buy Scott’s interest. For reasons such as this, minority interests trade at a discount.

In conclusion, we suggest that Tim use $126,812 as the maximum he would be willing to pay for Scott’s 20 percent of the new venture. A 35 percent minority discount would also be fair, placing the value at $82,428.

This article was written by the experts at Acquisition Advisors, all rights reserved. Acquisition Advisors is the M&A firm of choice for buyers and sellers of mid-size U.S. companies. They can be reached at (877) 525-4321 or visit www.AcquisitionAdvisors.com for more information.

Value What?

The first step is to clearly define what is being valued. If the subject of the appraisal is a going concern (an ongoing operating business), then it is the income stream of the business that is being valued.

A business is nothing more than a group of assets – people, ideas, processes, products, equipment, etc. – that produce an income stream. To the extent there are assets not necessary for the generation of the profit stream, these assets should be excluded from the appraisal. If there are assets not actually owned by the business but necessary for the generation of the profit stream, then these assets need to be contributed to the business by the owner or the cost of acquiring the assets must be subtracted from the value.

It must also be determined whether the appraisal is of the assets or the equity of the business. An appraisal of the assets assumes the seller would retain all non-working/non-interest bearing liabilities of the business and, in a hypothetical sale, pay them off with funds received from the purchaser of the business. If the equity of the business is being valued, it is assumed the hypothetical buyer would get all assets of the business and assume all liabilities as well. This should not be confused with how the business is purchased as in the legal question of whether it is an asset purchase or stock purchase.

Value to Whom?

The answer can be an individual, investment group or another company. Once this question is answered, all the factors contributing to or detracting from the value of the subject business for the particular buyer must be considered. This type of value is referred to as investment value.

Example: To determine the value of XYZ Company for Mr. Tenor, we need to consider all the objective and subjective characteristics of XYZ Company as they relate to Mr. Tenor and his own particular assets, interests, situation, capabilities, fears, etc.  Mr. Tenor may have a lifelong dream of owning XYZ Company and may have a particular aptitude that would allow him to place substantial value on the business. On the other hand, Mr. Tenor may see ownership of XYZ as a burden he has no interest in bearing at any price.

What Definition of Value?

The value definition explained above is investment value. An alternate value definition is fair market value. To explain, Mr. Seller may only be willing to sell his business if he is offered more than the value that it has to him. This is simply the investment value to Mr. Seller. However, Mr. Seller may want to receive “as much as I can get.”

Selling a business for maximum value can be a frustrating task. First, what is the maximum value of a business? The reality is nobody knows. How will Mr. Seller know if a particular offer he receives is the highest obtainable? If the price is the highest obtainable offer today, what about tomorrow?

Business sellers enter into a confusing and frustrating dilemma when the goal is value maximization. Add the possibility that the maximum value might include some seller financing. Mr. Seller must then consider, assuming the buyer’s ability to pay will to some degree come from future profits of the business, whether the buyer will be able to run the business successfully. Faced with the “what is maximum value” dilemma, many sellers decide to go for fair market value.

Fair Market Value

The price at which an asset would change hands between a willing buyer and willing seller, both of whom are reasonably knowledgeable of the pertinent facts and neither under any compulsion to act.

The technical process for estimating fair market value can be complex. However, the definition is straightforward. The essence of the meaning can be readily understood by simply taking a few moments to ponder the definition.

Value as of What Date? The fourth basic question to be answered before a business can be valued is “value as of what date?” Of course, one could always assume the answer is today. However, this is not always the case. In litigation, we often want to know what the value was on a particular date in the past. For instance, the date of damage, breach, loss or death. Conversely, in finance we often need to predict what the value will be at some date in the future, such as when we expect a business or asset to be sold.

This article was written by the experts at Acquisition Advisors, all rights reserved. Acquisition Advisors is the M&A firm of choice for buyers and sellers of mid-size U.S. companies. They can be reached at (877) 525-4321 or visit www.AcquisitionAdvisors.com for more information.

Want to learn more about Business Valuation visit ConciseOverviewofBusinessValuation.com

Despite the fact that value and valuation are a foundation of our economic lives and free-market system, the concepts of business valuation remain misunderstood and are frequently misapplied. It can be said that only a few people possess a true working knowledge of valuation.  They do so by combining their knowledge and market experience with risk capital.

There should be little wonder why valuation is shrouded in confusion. Aside from basic microeconomic theory, our high schools and colleges don’t teach it. Contrary to common belief, the basic curriculum for accountants and attorneys does not include business valuation. Most graduate business schools only cover the valuation of publicly traded securities, which is only partly relevant and misleading to the valuation of privately-held mid-size businesses. Many would be surprised to find that bankers are not trained in business valuation and would rarely, if ever, look at business value when assessing a loan.

Business valuation demands that you consider three important questions: Value to whom? Value as of what date and what is the definition of value? Consider the following:

Value Is Subjective:

Valuation is not and cannot be exact – it is subjective and will be a different number for two different people. It is like beauty, as they say, “in the eyes of the beholder.” What is the value of the watch your wife gave you? What is the value of your father’s 1971 Lincoln Continental that has been sitting in your backyard for the past eight years?  What is the value of your business to a buyer who could grow the business and increase profit margins if it were combined with his or her own business?  And how do you quantify that value?

Few people are exposed to real and representative business sale data:

The fact that few of us buy and sell businesses means that few have sufficient experience to offer a meaningful valuation. Businesses are not bought and sold as frequently as real estate or cars. And when they are, the data is much more complex and usually confidential.  In addition, data becomes out-of-date quickly, as fluctuations in the health of the economy and industry cycles cause significant fluctuations to the price multiples buyers are willing to pay.

High interest and little factual data breeds misinformation:

For whatever reason, people in our culture are immensely interested in other people and money. Business sale transactions involve people and a lot of money, so there is much interest in the sale price of a business. Business sale data is rarely made available so misinformation fills the void.  This phenomenon is well documented in research studies. Add to this the fact that the buyer or seller may allow or even encourage inflated and inaccurate information that may put him or her in a favorable light.

Complexity of business sale transactions and the importance of “terms”:

Unlike cars and houses, businesses usually don’t sell for 100 percent cash at closing. And it is common for the price to be contingent on certain events occurring after the date of sale.  As such, the actual sale price is often very difficult to determine and is different from the cash price paid at closing. In these cases, the actual sale price can only be determined after all contingent events occur and the payments of the “terms” are made.

Each Business is One-of-a-Kind:

Most things we buy have identical or close substitutes. Even a used car or most houses can be considered to have close substitutes. This makes the valuation task easier because we can compare it to others with similar characteristics. In contrast, businesses are unique. They rarely have close substitutes. Therefore, applying the “comparable sales” method is more challenging. There is no definite answer unless the business is sold. And even then, unless a seller hired a skilled professional and secured multiple offers, there is no guarantee that the price paid was a fair value.

And since the valuation task is often separate from the sale of a business, the most you can hope for is a fair value estimate. If you are preparing your business for sale, your priority should be to hire a firm that is capable of finding the highest and best buyers, securing multiple offers and giving you the peace of mind that the final sale value you agree to has been tested in the market with a thorough and professional process.