Small Business Methods of Valuation (Part 2)

The list of methods discussed is not comprehensive of all methods available or in practice. But they are simple and can be used for most small business sales and valuations. View these methods as a starting point of where to begin an analysis or negotiation. I discuss transaction structure in the next installment (Part 3). That has a meaningful impact on what fair value to negotiate, including the risk, timing, and up/downside of future payments.

Liquidation is a floor value. Some assets can be valued quite simply. A trucking and delivery company might have a few semis, a half dozen box and “bread” trucks, and a warehouse. By looking at some “blue book” values and contacting a local commercial real estate broker, determining an approximate liquidation value is easy. The sum from these sources is market value. Some assets will be tough to get a full and specific price for in a sale – the smaller the item, the less likely. Office supplies, hand tools in a machine shop, older computers – they could be negligible, or a conservative catch-all figure could be applied. In the case of small business liquidation and liquidation valuation method, little, if any, credit is given to intangibles – it is the value of the hard assets.

Discounts to book value. Book value refers to the amount listed in the financial statements. The difference to the liquidation calculation method is that we are expanding the list of accounts to include in the valuation, including items such as accounts receivable and liabilities. In the event of a small business sale, it is common for asset and liability categories to be revalued or discounted. Cash will be at 100%. Accounts receivable might not get credit for anything past 60 days – the buyer will not pay one-hundred cents on the dollar for a collection that is unlikely. Inventory could be at less than the purchase cost - and in the case of retail or perishable goods - could be heavily discounted. After all, if it were highly desired, it wouldn't be on the shelves. It is common for small businesses to accumulate too much inventory and supplies - either through not carefully tracking inventory or hoping that it will eventually become useful again. On the liabilities side of the balance sheet, it is possible to negotiate or settle payables or debts for less than the book value - but it can also be challenging to do so. Excess inventory is how some small businesses can find themselves "upside down" from a working capital perspective.

Without going into too much detail on asset versus stock sale transactions – some assessments on the worth of accounts receivable or payables or debts may be set aside in the negotiation/transaction, and the seller is entitled to all of those new proceeds or responsible for satisfying those obligations.

Replacement Cost. The replacement cost of hard assets and startup expenses is straightforward. The difference between replacement cost and book value is most straightforward to understand when considering a longstanding business with a valuable building. The building might have a low book value - it has been depreciated for tens of years deducting from the book value every year, while the building maintained its value or even appreciated with worth.

Aside from real estate – few hard assets (e.g., computers, machinery, inventory) will appreciate. Some assets may have a book value of zero – so there will be a recapture of realized value beyond the book value to a seller so it could be subject to gains taxes. In other words, the sale of these hard assets is a discounted repayment of capital with minimal gain.

Developing a capital budget of new or used equipment, inventory, and supplies requires thoughtfulness and research. However, replacing or developing IP and intangible assets can be much more difficult. Let’s consider a vertical software company. It specializes in software for industrial and specialty construction parts and materials. This software is critical for the customers. It manages inventory, project management, accounting, and delivery schedules. Developing an asset like software is difficult. It takes time. New kinks, customizations, reliability issues come up in the development process. What should have been $1 million in salary and employee hours for a minimum product becomes $2 million. Understanding replacement cost is pretty different and a more challenging exercise than buying a handful of used trucks. Nonetheless, in the acquisition of a software business – that is a consideration and method to value the IP product. Use conservative estimates.

Multiples/Comparables. Investors and business owners can easily understand an annual return - earning 10% is earning $100k on a $1 million investment. Remember from part 1 regarding adjustments, do not consider an owner-operators fair salary as earnings. A multiple is an inverse, paying 10x earnings would be a $1 million investment. The comparables method identifies similar businesses (e.g. same industry and size) or transactions and divides the purchase price by a financial metric such as earnings, pre-tax earnings, EBITDA, or cash flow. My preferred metrics for a small business multiple valuation are cash flow and pre-tax earnings. These multiples can be used as a range, an average, or a center point and adjustments are added/subtracted based on what is more attractive or negative about the business in question versus the best comparable. The multiple of the comparables is then multiplied by the financial metric of the business in question to estimate a value. The amount of debt and interest expense needs to be considered for a strong comparable in the small business valuation market.

Payback Period. Payback period is also easy to understand. If you invest $1 million in a business that pays out $100k per year, that is a 10-year payback period, the same as the multiple when comparing the same financial metric. Payback period is typically calculated without discounting future payments, which is a criticism of the technique, especially for payments received many years in the future. If future cash flows are equal, the payback period and the cash flow multiple are equal. However, if using projections with variable cash flows, the payback period sums the future cash flows and finds the point in time when the investment outlay (purchase price) has been recouped. For example, a business is purchased for $1 million, and at the end of year one, cash flow is $400k, and year two is 600k, then the payback period would be two years. Had cash flow stayed flat, $400k, the payback period would be 2.5 years. Using estimates for future years results includes uncertainties but may be appropriate if expectations differ drastically from current results. Given the higher risk in small business, entrepreneurial mindset, and desire for control, a payback period that is higher than five years is often too long for an acquiror in an owner-operator business.

Discounted Cash Flows and Cost of Capital. Another method that is commonly used and will require projections and a spreadsheet or financial calculator is a discounted cash flow analysis or DCF. This method requires various assumptions and will take longer to complete. After projecting out a series of annual cash flows, each flow is discounted back by an appropriate rate of return and taking into account compounding. Summing the discounted flows together gives an estimate of value.

If this is a new concept, this table should make it easier to follow.

The discount factor is 1+the required rate of return ^ year. So, year 2 is 115%*115%, and so on. The discounted cash flow is the cash flow divided by the discount factor.

The cash flow annual growth rate was about 6.5% and was generating $100k more in annual cash flow. If the business were available for purchase at 5x or $1,750, that would be a good deal if the projections were achievable – in fact resulting in a return of 24%, significantly above the required return of 15%. The payback period was just a bit shorter (4.5 years) versus the multiple of 5, accounting for the growth in cash flows.

I haven’t discussed the 15% discount rate or cost of capital yet. If this table had too many numbers or was challenging to understand – here is the key. The annual cash flow yield must be equal to or higher than the desired return. The desired rate of return is also the cost of capital, which can sound strange, but the entrepreneur needs to recognize they should charge the business for their investment. Discount rates can be derived using complicated formulas. Some methods include market volatility. However, many small business owners see no correlation between the stock market’s gyrations and the perceived risk in their business. I agree – and prefer to think of it as a buildup or layers of risk methods. A safe treasury or corporate bond return + risk of owning equity (versus debt) + industry risk + execution risk which should also consider the size, age, and recent performance of the business. Another method would be to demand a return that is more attractive than any other investment alternatives. Many small business owners are focused on growth and stability. Instead of withdrawing the majority of the available income and cash flow, they will seek to minimize taxes and leave money in the business for growth – the full amount of the earnings (whether distributed or not) should be used to measure the return – and if it is meeting the cost of capital.

There is no single formula to value every business appropriately. Instead, look at the simple methods described here and establish a high and a low and see if there is any clustering. If there is an asking price, back into various calculations such as payback period or estimate the value of the intangibles after liquidating the tangible assets. Once an estimate or range of value is set – or the asking price is fair, put the amount into context by making decisions and finding agreement on the succession plan or transaction structure, which I'll cover in Part 3.