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Article Author:

How to Value a Closely-Held Business, Part 1 of 2

By Stella Y. Su, MBA, CPA, ABV
Senior Manager, Corporate Finance
ssu@BlackmanKallick.com, 312-980-2912 

In the article, "Should you sell your business during troubled times," which appeared in the Fall 2001 issue of Corporate Finance Edge, we discussed whether you should sell your business during troubled times. This article addresses a critical aspect of the selling process: valuation.

After you have weighed the pros and cons of leaving your business and decided to cash out, you want to know how much you can get from your business. Your goal: to sell it at the highest price possible.

To accomplish this, you need to know how the market perceives the value of your business. You can determine this by performing an objective business valuation to help you understand how you stack up against your competition, what differentiates your products or services from your competition's, and how your business can benefit a buyer.

You want to be well-prepared going into negotiations with investors or buyers, have realistic expectations, and arrive at a transaction price and a deal structure that realize your initial objectives of selling the business.

Virtually all businesses or business interests may be appraised under four alternative premises of value:

• As a going concern
• As an assemblage of assets
• As an orderly disposition
• As a forced liquidation

Here is the process used for valuing a profitable business for sale, as well as several approaches to valuation:

Preparing for a business valuation

Before calculating how much you can expect to get for your business, you need to collect and organize relevant information to reach a good understanding of your business, the industry your business operates in and its financial position. This helps ensure that your final valuation results will be meaningful and reliable. Here are a few things you can do to prepare for a business valuation.

• Review the business and legal structure, products and services, and operations.
• Understand the industry and competition.
• Gather financial data, including historical financial statements, tax returns, budgets or forecasts, and other information, such as inventory, equipment, receivables and payables.
• Analyze the company's financial ratios and compare them to industry standards.

Choosing a valuation approach

There are several valuation approaches you can use to help arrive at a reasonable range of values where a willing seller and an informed willing buyer can expect to meet.

Income approach

Discounted economic income methods. This approach is the core of valuation theory—the value of an asset is the present value of the expected returns. In other words, the value of your business is how much an informed buyer is willing to invest today to receive extra earnings from the business in the future.

The discounted cash flow method is used to translate the future earnings, or cash flows, the buyer expects to receive into the amount the buyer needs to invest right now. The method starts by forecasting future cash flows for a given number of years. The present value of these cash flows is then calculated using a discount rate. The discount rate is an opportunity cost—the expected rate of return an investor would have to give up by buying the business.

Your business most likely also carries additional assets and liabilities that do not contribute to the earnings of the operation. These additional non-operating assets net of the additional non-operating liabilities bring extra value to the buyer. Thus, the value of the business is the present value of the cash flows plus the present value of the residual net non-operating assets.

Capitalized returns method. If you do not expect the future operations of your business to change significantly from its current normalized operations, you can use the capitalized returns method. This is done by first calculating the normalized earnings or cash flow stream, then dividing it by a capitalization rate.

This capitalization rate differs from the discount rate in the discounted economic income methods described earlier due to factors such as the business's expected growth, its expected life, and the potential for fluctuation in its growth rate. The capitalized returns method assumes that the business's future earnings grow at a predictable rate; thus, it is commonly used to value real estate rental properties.

Market approach

The guideline company (capital market) method. This method is based on finding comparable public companies in a similar line of business and studying how they are valued by the capital market. After compiling guideline companies' data, the value measures (or multiples) can be developed by dividing the price of the guideline companies' stock on the valuation date by some relevant economic variables observed or calculated from the guideline companies' financial statements.

The most commonly used variables are net sales, net income, net cash flow, EBIT (earnings before interest and taxes), EBITDA (earnings before interest, taxes, depreciation and amortization), and book value. The multiples then can be applied to your business's related data to arrive at a preliminary value range for your business.

The final value range is determined after adjusting for the uniqueness of your business, such as its size, marketability of the stock, and the degree of control of business interest.

The merger and acquisition method. This method studies similar companies and how they are valued in actual merger and acquisition transactions (i.e., what kind of multiples were paid when similar businesses were sold). The initial value can be determined by weighing different transactions and would then be adjusted for the uniqueness of your business.

Asset-based approach

Under an asset-based approach, the business is valued on the basis of tangible net worth at market plus a bonus for goodwill. This approach starts at the historical cost-based financial statements, then revalues the appropriate individual assets and liabilities—including off-balance-sheet assets and contingent liabilities—for their market values.

It assumes that an asset's value is indicated by the cost of reproducing or replacing it, after taking into account physical deterioration and obsolescence. The value of the business is the value of its tangible and intangible assets less the value of the business liabilities.

A different approach

The excess earnings method. This method was developed by the U.S. Treasury Department. It estimates the business's intangible value by analyzing the excess earnings not generated by the net tangible assets. The total value of the business is the value of the net tangible assets plus the excess value.

Which valuation method is best for your company?

There is no uniform approach for valuing a business. A start-up company tends to use the cash flow method as there is no track record of business financial performance and future cash flow levels are expected to differ significantly from one period to the next.

A mature business with identifiable public competitors can use the guideline company method to estimate value multiples. By applying appropriate valuation methods or
consulting a finance professional, you can get a more realistic view of the market value of your business and better plan your exit strategy.

For more information on how to value your business, contact Stella Su at 312-980-2912. Read Part 2: "How to value a closely held business—Valuation adjustments and applications"

This publication is part of Blackman Kallick’s marketing of professional services, and is not written tax advice directed at the specific facts and circumstances of any person and/or entity. Contents of this publication are of a general nature, and you should not act on this information without obtaining professional advice from your business advisor that is appropriately tailored to your individual needs and circumstances. This written advice is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.