Business Resource Group

Almost as many business owners undervalue as overvalue their company. If overvalued they can’t reach agreement with potential buyers. If undervalued they don’t even try to sell it, believing it’s not worth enough to fund their retirement or next venture. The business can lose value due to inattention which proves the owner right. The following applies to established companies. Valuing start-ups and Internet companies is different.

According to IRS Revenue Ruling 59-60: “The fair market value is the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.”

How often does this happen in the real world? Not very! I’ve never met a buyer who felt there was 100% disclosure. Sellers often have a compulsion to sell. (The three “D’s” of seller motivation are divorce, death and disability.) In reality, your business is worth what a qualified buyer will pay.

Common myths

The “rule of thumb” says my business is worth “X”. Rules of thumb are just that, and nothing more. They give an indication but do not substitute for a valuation. Use them for quick comparisons only. Here’s a big reason why, often a rule of thumb is an average. If one company sells for 2X revenue and another for 1X revenue, the rule may state companies in that industry sell for 1.5X revenue (a simple average). If you use this “rule,” you could tremendously short change yourself.

I’m going to sell my small, privately owned company for the same price to earnings (P-E) ratio as a large, publicly traded company sells for. Not valid for at least two reasons. Public company P-E ratios are based on after tax profit. Private companies are valued based on pre-tax profit (one reason being that small business owners have access to a wide variety of tax avoidance strategies). Second, there is a lot more risk in a small business versus a large, publicly traded firm.

Owner’s compensation is profit. Profit is what is left after allowing for fair market manager’s compensation. It’s a multiple of profit that buyers are willing to pay (and most buyers of small businesses want to earn at least 20-35% on their investment). If you earn $100,000 and it would cost $100,000 to replace you, then your business simply funds your job and you must grow the business to build profit and worth.

I deserve something for my sweat equity. There is no such thing as sweat equity. Sorry, but no sane person is going to overpay for a business just because you put in a lot of effort to get it where it is. Profit over a manager’s fair market salary is your payment for sweat equity.

My business is worth the assets plus a multiple of earnings. Businesses are valued on either their assets or on their earnings. Not both. Your business is not worth a multiple of earnings plus the essential assets of the business because this “method” values those assets twice. The assets are worth the greater of what they will earn or what they can be sold for. (Non-essential assets such as cash or accounts receivable can be valued separately and added to the firm’s value.)

There is a value to the cash I pocket (without reporting on my taxes). If you’re willing to cheat the IRS how much trust should a business buyer have in you? If you’re skimming you’ve already been paid for it by not paying taxes.

Points to ponder

Business valuations are part art and part science. The art comes from experience. Knowing what the information really means.
Profits are the driving force behind a high value (and selling price).
Most of what you’ve heard about what a company is worth isn’t true. That can hurt you if you have a strong company.

The price needs to cover the personal and business debt I owe. Back in the early 90’s a buyer client told me a seller informed him that he set the price by adding the business debt, personal debt and the price of a new RV. Stop laughing. I’m serious.

The potential of this business is great. In fact, you, as a new owner should do much better than I’ve done with my 20 years of experience. Therefore, I want you to pay me for the future profits I haven’t been able to generate.

The losses and my reduced salary over the last three years are a fluke. Just look at the profit eight years ago. (See the previous paragraph on potential.)

So what exactly influences the valuation and price of a small business? Recently Fidelity Mutual Funds ran radio commercials featuring investment guru Peter Lynch. One of the statements Lynch made was “Profits drive the market.” Profits also drive the price of a small business.