How Much Is My Company Worth?
When business owners think of selling, one of the first things they wonder is how much money is their business worth. Experts have written dozens of books on the subject, but some professionals provide business valuations after making just a few simple calculations. Business brokers who use outdated technology or old standards to sell businesses may mean money left on the table in the process. To avoid losing money on a sale, consider a comprehensive business valuation.
Business valuation is a complex process that varies from one type of company to the next with the aim of determining the value of a business. In this equation, a business’s future performance, cash flow, financial leverage, and assets all factor in. There are also elements that are harder to measure, like customer loyalty, trade secrets, name recognition, and industry trends. Valuation takes both tangible and intangible standards into account to ensure a company is sold for the right price.
Evaluating the Market
One reason it can be difficult to assign a dollar amount to a business is that market conditions continually fluctuate. What your business is worth today won’t necessarily be accurate tomorrow because value changes along with supply and demand.
For example, in recent years, SasS (software-as-a-service) companies have become extremely attractive to buyers. In the past, the money was in hardware, but cloud technology has changed that. The industry has shifted to designing for user-friendly experiences and offering online pricing and free trials to attract more buyers.
Companies like Google and Yahoo are quick to purchase software that looks promising to keep it out of the hands of competitors. Because SaaS companies are perceived as “hot,” they sell for more.
Understanding Valuation Mechanics
What any business is worth depends on what income it’s producing now and what it will produce in the future. All calculations are designed to predict what the business will one day be worth and what it will bring in between the date of purchase and the time it achieves maximum value.
Business valuation is complicated because most businesses don’t generate the same income year after year. For example, if you buy a business that had $2 million in profits last year, you’re not guaranteed the same amount this year. Most valuations analyze growth rate and set value based on the prediction that the same rate will continue.
Companies with high growth rates have a higher value than companies that show a relatively unchanging income stream. If you bought the business with $2 million profit last year, but it showed a 25% growth rate, here’s what happens with that profit over the next five years.
Year 25 percent growth Profit in the Year
1 + 500,000 $2,500,000
2 + 625,000 $3,125,000
3 + 781,250 $3,906,250
4 + 976,562.50 $4,882,812.50
5 + 1,220,703.12 $6,103,5115.63
In the above example, the company generates more than triple the profit from the starting point. It’s easy to see how companies with high growth rates are attractive to buyers, especially if they can be obtained close to their current value.
Understanding Discount Rates
The value of $2 million today is not the same as it will be several years from now, so the individual doing the valuation will use a discount rate. The discount rate is the interest rate used in discounted cash flow analysis to predict what future cash flows are worth in the present. The discount rate attempts to calculate the risk involved with future cash flows. The greater the uncertainty, the higher the discount rate.
In the case of the $2 million, assuming a discount rate of 17%, the present value of that year’s profit would be $1,660,000.
Predicting Future Performance
A business’s future value is not based on how it performed in the past, but on how it is predicted to perform in the hands of the new buyer. In the above model, the company may have been growing at a 25% rate for the past few years, but there is no guarantee that growth rate is sustainable. Current business owners and managers may be confident the business will continue to show that level of growth or do even better, but buyers may still be skeptical.
Poor quality financials, an unpredictable sales history, fluctuating profit margins, or a product line that lacks diversity can all decrease a business’s value. They all impact the buyer’s return on investment (ROI) expectations. Here are some factors buyers take into account.
- Cash flow – Smaller businesses are typically valued based on the owner’s salary and benefits along with earnings before interest, taxes, depreciation, and amortization. They often sell for between two and four times the cash flow. Larger businesses typically hire an employee to take the owner’s place at a reduced salary. They often sell for three to six the times cash flow.
- Revenue – If two companies have the same cash flow, but one consistently shows higher revenue, that company will have the higher valuation.
- Financing access – A business’s ability to obtain financing capital affects what it’s worth.
- Competition – If competition is tight, growth can be limited. When a business serves a niche market or is larger and more established than its competitors, its value improves.
- Intangibles – Geographic location, a number of growth facilities can support, and proprietary products are all intangible assets of value to buyers. Some buyers may not recognize the value of intangibles.
Because future projections are uncertain, buyers and sellers often have a different view on what is an appropriate discount. Established companies with a long track record of consistent growth can show data to support a set predictability discount. New companies may not have been around long enough to make a solid prediction.
Analyzing Customer Base
When businesses have a diverse customer base, buyers know losing one won’t significantly affect profit. However, sometimes businesses receive a large percentage of their business from one client. In that situation, the buyer is often concerned about what will happen if that customer takes their business elsewhere.
If one customer provides more than 10% of a business’s revenue, it affects business valuation negatively. Even if there are long-term contracts that indicate the relationship with the client should continue, buyers know losing them will hurt revenue. It helps if the seller can provide data or other information to support the probability the customer will continue.
Forecasting Profitability for New Companies
When new companies have a hot product or service, they may attract interested buyers very quickly. Valuation is difficult to establish when a company hasn’t been around long enough to show profitability. In the example of technology companies, businesses experience exponential growth in a matter of months, expanding so fast it’s almost impossible to predict future financials.
In this situation, the buyer and the seller must work together until they agree on future profit margins and growth rates. Often, perceived values are far apart, making it difficult to set a price.
When companies are in their infancy, they might not have revenue at all. There’s no data to place on a spreadsheet or use to calculate growth. Despite no cash flow to chart, their intellectual property (IP) may still have very real value to interested buyers.
Brightside Technologies was still in the development stage of creating improved liquid crystal displays for TVs. Dolby Laboratories bought the company for $28 million before the technology was completed, based on the projection of future revenue from the company’s patents.
Companies hoping to establish value before there is revenue can benefit by finding someone with experience and current market knowledge. Startups with services or products in high demand may still be able to defend high projected growth rates. Valuations might take into account the business’s location, the strength of its management staff, and current market trends.
When unestablished revenue, fluctuating market conditions, or a lack of consistent data make it hard to agree on a fair value, buyers and sellers often look at comparable businesses to come to an agreement.
Professional analysts use comparables regularly at stock brokerage firms. Each analyst pulls data from individual companies and compares that data to the performance of others like it. Tech companies, for example, use price to earnings (P/E) ratios and price to sales (PSR) to communicate value.
When buyers calculate value, they factor in the cost of illiquidity. This basically accounts for what happens in the case of buyer’s remorse. If they buy the company and immediately sell it, some assets can be quickly turned back into cash, but others cannot.
Most of the time, a private company is worth 30% less than a public company because of the discount for illiquidity. Since a private company’s shares can’t be immediately resold on the public market, those shares are illiquid.
Valuing Companies Based on Type
The type of company affects its revenue and growth rate. Software-as-a-service companies may be young ,with no established revenue, but they may still be valued at a high sales range price for P/E, like three to four. Most of the time, cost for producing and delivering product is low, and a diversified customer base makes it reasonable that they will show recurring revenue and continued growth.
Established companies that show low but steady growth might be valued at a price to earnings ratio of four or five. While they won’t show massive growth over the next few years like a SaaS company might, they also don’t have the unpredictability that comes with buying an unproven product.
Companies like web design firms, human resource providers, and management consultants have a low PSR of 0.5 and a P/E as low as two or three. They are limited by the rate at which their employees can produce, so they are unable to grow as fast as companies that don’t depend on human productivity.
The type of company, therefore, affects its cash flow. For instance, a business with a high fixed assets base that demands large amounts of working capital has less cash available because more of the profits have to be reinvested to keep the business making money. That business will have a lower value.
Manufacturing facilities may list equipment among their assets, but if that equipment requires regular replacement, the capital investments cut into cash flow. In contrast, businesses with a low fixed assets base, or low requirements for working capital, may be valued higher.
Considering Other Factors
During negotiations, buyers and sellers hammer out the details that affect long-term profitability. Here are a few factors that can make all the difference.
- Assets – It’s important to specify what exactly is part of the sale. Are accounts receivable and current inventory part of the transferrable assets, or will the buyer just receive the customer list? What equipment is included? State-of-the-art equipment is a plus, but equipment that is obsolete is a liability. Businesses don’t just have to plan for its replacement, asset depreciation affects how much a lender will finance if they need capital.
- Exit strategy – For business owners, an exit strategy can enhance their business value. It typically takes several months to a year or longer to complete a business sale. The more complex the owner’s exit strategy, the longer the deal may take, extending the time before the buyer can expect to start making a profit. Some common exit strategies involve an initial public offering, corporate divestiture, or a management buyout where the current management team purchases the company.
- Deal structure – How the business is going to be paid for affects its value. A business selling for all cash often has a lower value than one that offers seller financing. How much financing the seller is willing to provide impacts what the business costs in the long run. Often, buyers prefer asset sales while sellers prefer stock sales. Both scenarios will have to be agreed upon during negotiation.
Each industry and company type has key performance indicators (KPIs) that help determine its value. For example, e-commerce companies might compute the company’s asking price based on the number of unique monthly visitors to their website. Valuation models can be developed based on metrics that are specific to each entity.
Establishing an Accurate Value
With so many factors involved, small businesses and middle market companies might struggle to find a number that accurately reflects what their company is worth. A formal valuation can help establish a fair value and streamline exit transactions. It also provides owners with these benefits:
- Provides specific analysis of company assets – Business owners know what they paid for their equipment and how long they can expect it to last, but it’s hard to communicate that feeling in numbers. A business valuation lets potential buyers know important data like what they might have to reinvest and what it will cost to insure current assets.
- Supplies market experience – Just like a realtor knows what properties are selling for in their area, a business valuation puts businesses in touch with professionals who have experience pricing and selling others with similar qualities. That experience can be even more valuable when it comes to negotiations, planning exit strategies, and accessing potential investors.
- Finds accurate valuation – Responsible business valuation providers use multiple valuation models. The income approach, the asset-based approach, and the market approach are examples of ways to determine a business’s true value.
- Helps during mergers and acquisitions – When an accurate value is established, business owners don’t feel pressure if a larger company offers a low number during an attempt to merge.
- Aids in securing financing – When the buyer approaches their lender to obtain financing for business purchase, a solid business valuation means data lenders feel secure in providing funds.
Whether owners decide to sell their business or not, a business valuation is helpful in measuring growth and finding room for improvement.