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How to Sell Your Business - A Series (Part IX)

Phase IX: Valuation Concepts Continued:

Last week, we addressed valuing assets and cash flow independently. We will now look at some valuation methods that combine them together. One commonly used method is the excess earnings method.

In this method, The fair market value of the company’s assets is identified. Let’s assume they are valued at $500K. We then look at the cost of capital, let’s assume 10%. Then the cost to carry these assets per year is $50K. Any annual cash flow in excess of this $50K is considered excess and is capitalized as we have previously discussed using a risk adjusted capitalization rate.

Another popular model commonly used for identifying value in a growth scenario is the Net Present Value (NPV) method or Discounted Cash Flow (DCF) method. This method includes 5 distinct steps.

1) Identifying the true current level of profit
2) Developing growth plans
3) Projecting growth plans for 5 years (or more)
4) Calculating the investment required to achieve that growth and the profits that will be generated by the larger entity over those 5 years
5) Discounting these figures to the present using a discount rate which reflects the degree of risk and expected inflation.

This is an optimistic and often abused method of looking at a business. The growth rates are always estimates and the discount rate is subjective. However, given sound assumptions, it can be a good indicator of the value an acquisition will bring a buyer. In a growth scenario, it will often support a higher price point than is apparent at today's sales and profit levels.

A few more comments on value and price. Business owners often ask how buyers value potential? In reality, potential is usually the reason someone buys a business. How they pay for it in real terms is usually in one of two ways...

1) Through variable pricing (earn outs, etc.). If the business performs at a level above historical levels as this "potential" is unleashed by the new buyer, there may be additional payments or royalties paid to the seller at some time in the future.

2) More commonly (especially in smaller businesses) it is not valued. That is to say, the price paid is derived from the historical sales and profit levels. Buyers typically do not value potential simply because it is the buyer who will be taking the risk, putting in the effort, and funding the investment required to achieve the potential. If there truly is potential in the company, the one best way to get paid for it is to hang in there long enough to uncover the potential (this may take additional investment) or at least begin to tap into it and set a clear and defined path to achieving the potential that indicates it is real and you uncovered it.

Next time we will address some of the "tests" buyers will perform (along with their advisors) to confirm that they are buying the business for the right price and with a clear understanding of the major risks involved.

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If you have missed previous parts of the series and would like a copy, please contact Matt Coyne at 610-408-0554(ext 102) or at MCoyne@VRBrandywine.com.
Very Best Regards,
Matt Coyne, CBI