The owner of a small business will face two difficult decisions when deciding to sell a business.
First, how to value the business? Second, how to obtain the maximum value?
Business owners have worked long and hard for many years to grow their businesses, and are justified in wanting to receive the best value when it’s time to sell.
Before getting into valuation, let’s spend a minute to clarify what is “small business.” There are currently over 3 million businesses with sales of less than $500,000 and less than four employees, representing 55% of the number of businesses in the U.S. The next level is sales from $500,000 to $1,000,000, and up to nine employees. There are approximately 1.2 million of these and they represent 21% of all businesses in the U.S.
The third level has sales from $1,000,000 to $2,500,000 and have 10 to 19 employees. There are approximately 690,000 of these, and they represent approximately 12% of all businesses in the U.S. These first three levels, are commonly referred to as “small business.” The fourth level of businesses have sales from $2,500,000 to $10,000,000, and are referred to as the Mergers & Acquisition market.
For this example, our focus will be on these businesses with less than $10,000,000 in sales, as this is the market where most of the sales activity occurs. The textbook definition of “fair market value” is the price at which property would change hands between a willing and able buyer and a willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell, and when both have reasonable knowledge of the relevant facts. A business appraisal can be prepared for the business by a professional business appraiser, if the owner is willing to pay the cost of the appraisal, usually between $4,000 and $15,000. However, businesses do not always sell for appraised value. The seller may be under a time constraint to sell, have health problems, or other issues that are value detractors and reduce the value of the business. On the other side, a strategic buyer may pay more than the “appraised value,” due to value considerations unknown to the seller or appraiser. So let’s examine what drives the sales price of businesses.
There are three main approaches to value used by industry professionals, whether business intermediaries, or appraisers, to value a business. These are the asset-based approach, the market-based approach, and the income approach.
Each of these approaches have several methods which must be used to arrive at a value, then the values derived from the method must be weighted to arrive at the most appropriate range of values of the specific business.
In the Asset-Based approach, the assets of the company are adjusted from book value to market value, using three methods. The values arrived at by utilizing these methods are then evaluated as to which is the most appropriate.
The Market-Based Approach used valuation ratios derived from actual sale transactions of “comparable” companies, which are then applied to the sales and discretionary earnings of the subject company. Discretionary earnings is a level of earnings defined by the industry that is applicable to transactions of companies in the small business and M&A market.
One of the issues to overcome in this approach is finding a comparable company in the same industry with approximate sales and discretionary earnings of the subject company.
The market approach is where the “rule of thumb” concept originated for values, where one applies some finite number to sales or earnings, deriving a magical value for all companies of a certain type. Rules of thumb have some value, but do not give weight to companies that perform significantly better than the industry standard.
The third approach to value is the Income Approach, where a capitalization rate or multiple is applied to a certain “level of earnings” to arrive at a value. This method factors size of company, business risk, and other factors into the valuation process, and is many times the most appropriate method utilized to value companies under $10,000,000 in sales price.
After the values are derived from the various methods, the analyst, be he a business intermediary or appraiser, must then select the most appropriate method for this particular business. For this reason, business valuation is considered to be more of an art than a science, and knowledge of the market plays a significant role, as the market will ultimately determine value for each specific business.