Thursday, December 15, 2011

Business Sales Multiples

First we need to figure out what multiples we are talking about and what we are using them for. There are multiples of gross sales, seller’s discretionary earnings (SDE), earnings before interest and taxes (EBIT), earnings before interest, taxes, depreciation and amortization (EBITDA). Multiples are also used as general rules of thumb. For this article I will concentrate on the methods used for the purpose of the sale or purchase of a business.

Multiples of gross sales are the least accurate as they do not account for the quality and profitability of a business as they tend to be averages for classes of businesses. Some business owners know how to run a business and make excellent profits while others barely survive. These multiples are generally used for business categories that have large numbers of the same type of businesses, such as franchises.

Multiples determine the relative value of the business’s cash flow, but they do not measure the business asset value. I use a multiple to determine only the cash flow portion of the business. An asset bases analysis is a separate part of the appraisal.

For a sale of a business we need to know the SDE and the EBITDA In other words, the net income plus the seller’s discretionary earnings, interest, taxes, depreciation and amortization are necessary. This number should represent the amount of money a new buyer would expect to have available after purchasing the business. Interest and taxes will depend on how the business is financed and run. Depreciation and amortization are tax credits and the money remains in the business.

Differences in businesses will require use of different multiple values. Manufacturing businesses will have a middle of the road value while construction companies will have a multiple of about half and some high demand businesses may be double. Size matters, as larger businesses will have larger multiples.

Changes in economic conditions don’t change the basic multiples I use for appraisals. As economic conditions grow or deteriorate the gross sales and adjusted net profit of a business will go up or down thus increasing or decreasing the businesses value. I also use certain economic changes to adjust the net profit based on such things as growth or decline in sales over prior years, businesses having customers that represent a large percentage of their business and other cash flow influences. I very rarely find reason to adjust the multiples I use for an appraisal and I have been doing this for over 20 plus years.

Monday, October 10, 2011

Importance of a Business Appraisal

Would you buy or sell a house or commercial property without first having an appraisal? Most buyers and sellers of small businesses don’t bother determining a business’s true market value. Buyers are reluctant to spend money on an appraisal and sellers usually pick an arbitrary price or one higher than the business is actually worth. It is the selling broker’s responsibility to get the highest possible price for his client. Yes, the broker has a responsibility to be honest and fair to the buyer, but his primary responsibility is to his client. This leaves the buyer hanging out there with little sense of the business’ true value. He may bring in his accountant or other advisors but these people who are probably very good in their profession may not have the years of experience and skills necessary to determine the true market value of the business. Buying or selling a business is probably the largest financial transaction a buyer or seller will ever make in his life. It may involve his life’s savings, new debt or his entire retirement prospects. There are many situations where a buyer has paid too much for a business and can’t make it work. The buyer looses his investment, a bank may loose on its loan, and the seller will loose money he has lent to the buyer and possibly get a worthless business back. Doesn’t it seem important to confirm that the business you are buying or selling is a wise, or at least not a foolish sale or purchase? A Business Appraisal should be a mandatory process for any business sale or purchase. It definitely will increase the chance of success and protect the buyer’s and seller’s hard earned assets.

Friday, June 10, 2011

A Guide to Business Appraisals

There are a number of standard appraisal methods used to value a business that include, Asset approach, Income approach, Market approach (Comps), Capitalization of Earnings and Discounted Future Earnings. Each one of these methods individually does not always represent the true value of a business. We have seen appraisals where the derived value of these five different approaches varied by 500%.

Also used are Rule of Thumb values based on multiples of adjusted profits or percentages of gross sales. The rule of thumb methods only work when there are many similar businesses having the same operating expenses and assets. This doesn’t always happen and when you use the method on more unique businesses it just doesn’t work.

Using Comps tends to give the average value of the compared businesses and not the value of the business being appraised.

Capitalization of Earnings and Discounted Future Earnings are less often used and tend to end up with values that also tend to give the average value of the type of business.

After working with the standard methods for some time and evaluating what creates value in a business we learned that combining the Asset, Income and adding market influences into a single method gave an accurate market value. Having been involved with our own Business Brokerage for over twenty years we were also able to look at the businesses we sold and adjust and refine the combined method to reflect a True Market Value Appraisal.

The next step was to find a way to keep the through detailed analysis of the business being appraised and present it in a simplified easy to read manner. By looking at the components of a business that created value and categorizing them into Income, Assets and Market related we were able to create an Excel program to present the appraisal. The program was designed to be flexible so that it can be changed to meet different types of businesses and the many different purposes for business appraisals. This system may look simple but the complexities of doing an appraisal are still applied. There are many things that we still consider that are not listed in every report. When they are needed we add them into the Excel program.

Appraisal Requirements

For an appraisal system to work it must address the following:
1. the profitability of the business
2. the tangible assets of the business
3. the presence of intangible assets
4. the value derived should represent the market value
5. have flexibility to allow for the terms of a sale.
6. simplicity - Usable and understandable.

The first step was to determine what components in a business have value. These are some of them:
1. a functioning business with modest growth
2. skilled employees
3. working equipment
4. adequate usable inventory
5. a quality product or service
6. a profit
7. collectable receivables
8. a broad customer base with no very large customer
9. some new product development capabilities
10. a good reputation (name) in the market place
11. a clean, adequately sized work area
12. a financially sound operation with a good accounting system
13. the business located correctly for its market place
14. a good base of suppliers

After building this list it has to be divided to fall into a profit/asset based appraisal system. They are categorized as follows:
1. Profit based items.
a. business profit
b. a functioning business
c. business size - gross sales
d. intangible assets
1. skilled employees
2. a quality product or service
3. a broad customer base - customer list
4. new product development capabilities
5. a good reputation - business name
6. good financial management

2. Asset based items:
a. inventory
b. equipment
c. receivables
d. contracts
e. patents
f. trademarks
g. real estate

By Robert A. Klein, President and owner of Business Appraisals, providing business appraisals on all types of businesses. Former President and owner of Business Search, Irvine, California, a Merger & Acquisition firm specializing in the sale of manufacturing, distribution and related businesses, with programs for both buyers and sellers.