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Chapter 7

Valuation:What Is It Really Worth?

WE ARE ALWAYS SURPRISED by how little business owners understand about the value of their enterprise. The vast majority, or approximately 70 percent, of business owners’ net worth is captured within their operating business. Over time and wishing for the best, owners begin to believe their firm is one of a kind and should not be valued like other firms of its ilk. Friends, associates, and industry colleagues all assure the owner that he or she is sitting on a gold mine. This feedback, almost by osmosis, begins to set value expectations for the owner that are not in context with the marketplace.

In a first meeting with owners as we learn more about the business, the owners subconsciously are pitching us the value of their enterprise. We always listen respectfully, and the eight-hundredpound gorilla in the room keeps putting on weight as the conversation rolls towards the dreaded question, “What is my business worth?”

In short, the inevitable and regrettable answer is, “Not as much as you think.” We often avoid this explosive question and answer because if a quick snapshot of worth is given and not well received, the conversation of selling most likely will be terminated. Even getting a seller this far into a conversation is one in a hundred of sales approaches to business owners. There is no reason to have the mission aborted before you can explain professionally what has to be done to give a reasonable opinion of value.

Net-net: final after-tax money that a seller receives from the sale of company after all costs are paid.

It is a delicate balance to find the right time in discussions with a potential seller to broach this key subject. As the methodologies for valuation are eventually discussed, we, as intermediaries and investors, must begin to discuss not only the overall sales price associated with the sale of their business but also what is the net-net to the seller after all expenses including taxes are paid off. This number is almost always met with dismay, and the owners will bark out, “Well, for that price, I am better off continuing to run the business than selling and getting that @#%&^%!!” And oftentimes this assessment is true, and on and on they go. But as in Moby Dick, the harpoon is lodged in the whale’s back, and the Nantucket sleigh ride begins! For someday for a variety of reasons—ill health, no successor, a divorce, or a myriad of other reasons—the business will be put on the block.

Goodwill: intangible assets of a company (for example, a brand name, customer list, patents, etc.)

There are four traditional ways a small to mid-size business is evaluated. In seeking a valuation, we try to use at least two and hopefully three of these methodologies and have them all come to the same valuation, give or take 10 percent swing in value.

 Records of comparable sales

 Discounted cash-flow model

 Multiples of revenue/earnings (EBITDA)

 Asset value plus goodwill

COMPARABLE SALES

This is really the best barometer for judging business worth. In many industries, like-sales make it relatively easy to compare the value of companies if there are many similar businesses in the same field. This would, in particular, be true for Main Street America as retail, competitive sales organizations, service companies, distributers, and small manufacturing firms litter small-town America’s landscape. These companies, especially on a franchise basis, have multitudes of similar companies that have been going through their life cycle and have been sold. It is oftentimes difficult to find out the actual terms of the sale (especially from the seller), but with detective work and persistence, a matrix can usually be assembled to bracket in a sales value. Many evaluators gravitate to Internet research and to sales of “like” but large public companies. Though this information is easier to find, it is most times irrelevant to compare a public entity with a small privately held company.

DISCOUNTED CASH-FLOW MODEL (DCF)

This is a method used by many to determine the present value of a business by rolling out forward-looking projections and discounting them back to a present value. The discounted cash-flow methodology most often favors the seller in gaining a higher valuation. The seller can take the often lackluster, current performance numbers and forecast three to five years in the future, which many times shows (not surprisingly) a sudden performance jump in the business. Many assumptions are tied to this usually heightened valuation, which is mostly an academic exercise in growth. Most DCF exercises do not show downward or non-significant growth. As a tool to buy or evaluate a small business, most experts will concede that DCF is not a true indicator of value. The fortunes of a small business can swing dramatically with an infusion of cash, the loss or gain of a big client, or the departure of a key executive thus heightening or cratering a valuation. This methodology is obviously liked by accountants, CPAs, and CFOs as they enjoy a spreadsheets and the manipulation of numbers. Although it has its drawbacks, DCF is one of the two most used methodologies as it does not require outside data but only the creative mind of the business owner.

MULTIPLE OF REVENUES/EARNINGS

These are two methodologies that can be intertwined in smaller business evaluations. Multiples of revenues methodology is often used when evaluating a small business, oftentimes in the software, technology, or even service sector. Many evaluators in seeking a quick handle on a valuation immediately try to pinpoint what industry or sector a company is in. The evaluators then try to quickly plug a valuation number in that virtually ignores the company’s balance sheet and/or performance.

Defining what sector the company is in is as important as the company’s performance. As an example, an SaaS (software as a service) company is pegged between 2X and 3X revenue for a company under ten million dollars in sales. Thus a company doing $3M in sales that is struggling but with sound technology could be valued at $7.5M ($3M sales x 2.5), despite having a break-even or negative cash flow. If a firm is showing steady growth at $3M and has upward mobility, it could be valued at $9M, or 3X revenue. Then, of course, the discussion leads to how much cash down and how much has to be kept in the deal.

Multiples of revenues for sales valuations are used in evaluating service businesses or Main Street America businesses as well. Law firms, accounting practices, insurance agencies, as well as a host of other traditional service organizations, are evaluated with the multiples of revenue models. As an example, the firms listed above could be said to be valued at 1X revenue. Thus a CPA firm doing $3M in revenue would be perceived to have a value of $3M ($3M x 1). Looking at traditional retail operations, they all have a revenue multiple attached to them. Dry cleaners, food markets, check-cashing outlets, frame stores, etc. have a prescribed value. But to owners of such businesses, these preset notions of valuation are often vigorously protested for a wide range of reasons and circumstances. For a quick snapshot, however, this methodology does have a purpose—you have to start somewhere!

EBIT: earnings before interest and taxes; an indication of a company’s financial performance, or cash-flow bottom line.

Multiples of EBITDA (earnings before interest, taxes, depreciation, and amortization) valuation is the most widely methodology. As a cornerstone of the method for valuing mergers and acquisitions and seen universally as a true measuring tool, EBITDA multiplies are used on virtually any company that has revenues and earnings. But as a stand-alone tool, it is not a true indicator of value if the firm in question is doing under one million dollars in revenues. The key part of the term really is EBIT (earnings before interest, taxes), which is a good definition of cash flow, net profit, or earnings of the company. Depreciation and amortization (the DA of EBITDA) are measuring tools that add to a company’s bottom line or value on paper but are not truly cash flow numbers. Depreciation is used to add back dollars to the bottom-line value of a company that has a serious amount of equipment, trucks, etc. that have been depreciated over time. Amortization is used as an add-back also but does not truly assist in reaching smaller firms’ true enterprise value. Non-cash additions of depreciation and amortization in an EBITDA calculation can overvalue a business.

add-back: expenses added back to the bottom line of a company’s financial statement or EBITDA; usually one-time expenses, such as owners’ compensation.

BUSINESS REFERENCE GUIDE

For over 20 years, BRG [Business Reference Guide] has been the essential guide to pricing businesses, providing business transaction professionals with up-to-date rules of thumb and pricing information for 700+ types of businesses.

Most pricing entries contain:

 Rules of Thumb based on both sales and earnings (SDE)

 Pricing Tips from Industry Experts

 Benchmark information that provides comparison data

 Industry Resources such as Associations and Publications with Web sites

 General Information providing industry data, surveys, and comments

 Fascinating facts about many different businesses and industries1

EBITDA valuation is the constant matrix initially used to ascribe a value to a company. An EBITDA multiple can range from 3 to 10. The size of the company also greatly impacts the multiple. The larger the firm, the higher the multiple as the increased bottom line and scale of operation increase the value. The smaller a company, the lower the EBITDA multiple usually is. A firm, for instance, with a $1M EBITDA could have a 4X valuation, and a similar company with a $5M EBITDA could have a multiple of 6. The increased size can make the same type of company worth virtually 30-50 percent more. This can makes sense, as the larger firm will have a bigger industry footprint and larger platform to grow quickly from. It usually would have a bigger presence in the marketplace, have the capability to grow faster and obtain growth capital, and have other sought-after attributes.

In summary, a company’s EBITDA dollar value times its industry EBITDA multiple gives the company’s valuation.

Vertical: short for “vertical market”; a specific industry or sector.

Each separate vertical, or industry, has an EBITDA multiple. Within these industries, there are submarkets and sectors that have even a more refined EBITDA multiple. Most discussions involve the multiple for the company. Here is a snapshot of industry multiples for companies with $2-5M in EBITDA.