A buyer may use up to three approaches to determine the value of your business. One is to look at comparable businesses that have recently sold. Depending on the industry type, this information may or may not be easily obtained. Some industry groups form peer groups to measure performance. For example, some franchised restaurants share performance metrics with others in the peer group. The metrics are oftentimes based on cash flows, revenues or book value. In the Valuation profession, we refer to this as the Market Approach.
Another approach is to examine cash flows. Sufficient cash flows are what can make or break a company. Therefore, the buyer will ask, “Can I pay myself a reasonable wage and still make a bank payment? How many years will I need to finance the purchase with current cash flows?” Without sufficient cash flows, a buyer could face challenges in purchasing new equipment, researching a new product line, expanding service footprint or managing working capital, for example replacing worn out fixtures. In the Valuation profession, we refer to this as the Income Approach.
Finally, a buyer may simply look at the fair market value of inventory and equipment. He/she may not be willing to pay a premium for a business that could be started from scratch. For example, a company that does not have strong cash flows may only be worth the value of its fixed assets (fixtures, furniture, equipment, and working capital which is accounts receivable plus inventory less accounts payable). This is referred to as the Net Asset Approach.
Because value derived by both the Market and Income Approaches are based on cash flows, it important for business owners to omit any personal expenses from the business. Only expenses that are related to the business operations should be included in company financial statements. Moreover, any assets that are not related to operations (snowmobile, boats, airplanes, etc.) should be removed from the Company’s balance sheet.
If your exit strategy involves selling your company, you need to plan ahead. Having clean, profitable and strong financial statements for the last five years could raise fewer questions and lend to a smooth transition.
Please contact me with any questions when valuing a company that you are buying or selling.
Be sure to watch for the rest of the Business Valuation Strategic Planning articles in upcoming KT Addition Newsletters.