How To Value A Business: Advanced Concepts For Adding Value

Knowing how to value a business is critical to any owner wishing to sell. Particularly important is knowing about the key drivers that can add to value. Not because you should really consider doing your own valuation. There is much more value in having a knowledgeable, well known, and respected professional do that for you. Particularly if he has demonstrated expertise in your own industry.

Depends On Where You Stand.
The value of a business can depend somewhat on your perspective. Suppose that your business provides you with $250, 000 in yearly cash flow. Let's also suppose that you have consulted a directory that discusses value as a multiple of annual cash flow for various industries. From that manual you have determined that the appropriate multiple for your industry is 6,

This would firmly fix in your mind that the value of your business is $1.5 million. Now change roles. Look at the situation from a buyer's perspective. You are now a buyer. You have examined the same manual and seen the same multiple. But as a buyer are you as quick to believe that this business is worth $1.5 million? You may not be.

Your reluctance to believe it is likely based on the fact that you lack confidence in your ability to replicate the cash flow generated by the current owner. How much of that cash flow is dependent on unusual capabilities of the current owner? Or to his personality or charisma? After all who wants to pay full price for a personality driven business without having an identical personality?

Enduring Transferable Value.
How to value a business, and arrive at a number that most buyers will agree with depends on being able to successfully identify the business drivers that will lead to a successful transition of ownership. You need to identify the needed proven, effective systems and processes for critical business activities. If you don't have them, you have a choice. Either develop them, or realize that you will likely have to accept a lower valuation without them.

That sounded pretty discouraging didn't it. Let's examine this notion in greater detail. To start with, remember that the implicit assumption underlying the various industry multiples is that performance will continue at its current level, or perhaps improve. If you have implemented proven effective systems and processes recently, you may be able to successfully argue that a change in ownership and management will not reduce performance in any way.

You may also be able to argue that the multiple for your business should actually be higher than the industry norm. Your rationale in putting forward this argument would be that the industry norm is based on the assumption that performance will not be harmed by a management change. You would then point out that in reality, fewer businesses have these proven effective systems and processes than the prevailing multiples would suggest.

First Things First!
Activities related to attracting customers and creating revenue should head your list of proven effective systems and processes. And having more of these is much better than only having one. This will address most buyers' greatest concerns. The concern they will not be able to equal or better your revenue performance. Multiple methods for attracting customers and creating revenue will give buyers more confidence in the reliability of your valuation. And support your argument for a higher valuation.

Each business has its own critical valuation drivers besides customers and revenue. Analyze your own business critically. Determine which activities have the potential to cause you the most trouble. They are also likely to be the most costly when things don't work right. These activities are likely your critical drivers. So if you don't have effective systems for dealing with them, you need to develop and validate them.

Remember that the value of these systems and processes lies in the ability they have to prevent you from reinventing the wheel. When you have determined an effective way of handling a situation, you need to deal with it the same way every time it arises. Not waste time on a creative but unproven solution. A famous author in writing about the US Navy, likened it to a system created by a genius to be run by idiots. An excellent analogy, and something to strive for.

Conventional Wisdom
How to value a business is a question and subject that attracted and given rise to many experts. In some industries, there are rules of thumb such as some multiple of gross revenue, some type of asset value, and even the old real estate standard, comparables. Some experts resort to the most fundamental of methods. They derive forecasts of future earnings or cash flow, and then discount these using some appropriate discount factor.

The term fundamental was not meant in any derogatory way. Indeed, discounting future inflows is the method with the strongest underlying theoretical validity. The mathematics can be impeccable. But the weakness is that it assumes that the underlying forecast of future inflows is correct. And there is frequently no good basis for that assumption. Other than things will continue on trend. That may not be a very comforting assumption, particularly for a prospective buyer.
The other weakness lies in the selection of a discount rate. Particularly when the overall economy is in flux. However, unless lending rates get to be very high, choosing the wrong discount rate won't cause as much trouble as incorrectly forecasting future inflows.

The author, Martin Schultz is a leading authority in preparing a business for sale. He is the editor of the free information site http://www.selling-a-business-without-stress.com which provides actionable information about selling a business. His credentials include an MBA from a highly respected North American university, followed by over 30 years of business experience including evaluating and making acquisitions. Martin is now an author and business consultant in corporate finance and in selling owner operated businesses. Martin may be contacted by email at info@selling-a-business-without-stress.com. To download a free report on selling your business, go to http://www.selling-a-business-without-stress.com/support-files/freereport.pdf for immediate access.

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