buying an existing business and how to create a valuation

Valuation of a business when buying or selling

First Financial Acquisitions, SBA Loan 1 Comment

If you are preparing to sell your business, despite all the valuations and figures that you try to create, it can be hard to come up with a final asking price. You will have looked at a number of financial statements over time, what the company is expected to earn in the coming months, how earnings and cash flow would be affected by a new owner, and more. Furthermore, all equipment, inventory, and other assets will all have to be individually valued. However, it is still hard to bring all of this information into one simple asking price.

Firstly, if you haven’t already, you should always looks to hire a business appraiser as they will be able to help with what you need. Appraisers will have the experience and the know-how to value everything correctly which will help when it comes to the final valuation.

Asset-Based

By working out the exact sum of the parts that are easily saleable, you would have worked out the minimum at which you should sell your business. However, these methods aren’t always accurate as goodwill or intangible assets can sometimes make up the majority of the business. If this is the case, the business will be severely undervalued. Here are the two main methods:

Liquidation Value

This method is not often used as going out of business would be an easier option due to the amount of costs involved in selling a business. Liquidation value refers to the amount left over after a business has been sold and all debts have been cleared; since the costs would be extremely high (attorney fees, broker’s commission, etc.), this is often rejected if a bid of this type comes in.

Book Value

A better method to use is the ‘book value’ amount as shown on your balance sheet but it does have to be adjusted slightly as this document looks back at prices and depreciates assets without reflecting true value. When recasting your financials, you should find a new book value at which the business should be valued (minimum).

Historical Earnings

These types of valuation are preferred by many as they take goodwill into account; if it can be justified by your earnings, the price will be higher than if it were just down to assets. Buyers tend to be more careful with this type of valuation as they prefer to look forward rather than at past accounts but it still gives a good indication of what the business has to offer and the growth it can experience in the coming months and years.

When valuing a business, one or both of the following techniques are typically used (all taking into account earnings in the past and hoping that this will translate into the future):

Earnings and Cash Flow

This is one of the most used methods of valuation and it is relatively easy to work out. The first step is to work out a figure that represents annual earnings over the years gone by, this can be one of two figures.

  • EBIT – Earnings before interest and tax

  • EBITD – Earnings before interest, tax and depreciation

Once this has been achieved, a capitalization rate is calculated by using the return rate the buyer wants to earn. If the investor want to achieve a 20% return rate, this will then become the capitalization rate. The first figure will be divided by the capitalization rate to find the final valuation. The capitalization rate helps to compare with other opportunities that are on the market for the same amount of risk.

For example: if the buyer wanted a 20% return with the EBIT at $100,000, the calculation would be 100,000 / 0.20. This would set the valuation at $500,000. Some people, however, prefer to use cash flow as we will see in the next section.

Debt-Paying Ability

Again, this is a commonly used method. As most potential buyers would have to take out a loan to complete the purchase, they need to know that they will be able to pay this loan off through the earnings of their new company. Furthermore, they want this time-frame to be relatively short; normally a maximum of five years.

When selling a company, the price needs to look attractive to potential buyers whilst also having the potential to pay the loan off quickly as this will eliminate as much risk as possible. To find this figure, start by working out the historical free cash flow. This is calculated by taking the business’ net income (after tax and remembering to factor in a salary for the owner) and subtracting working capital increases and capital improvements. It is important to note that depreciation is also normally added back on here. Existing loans and their interest are not included in the valuation as a potential buyer wants to know how the company would look and operate with no debt.

Once you have this figure, the annual free cash flow, you multiply it by the amount of time the loan will last for (in years). If the buyer wants it to run for five, multiply it by five, and so on. From this new figure, remove the down payment. Now you have an amount that the new owner will see and be able to evaluate and compare to other options on the market. If the figure allows them to achieve the target return on investment, you will be in a good position to sell your business.

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