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Marc L. Goldberg and Jim Dannhauser  |  SCORE certified mentorsQuestion: I am considering exiting my business. How do I determine its true value?Answe

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Marc L. Goldberg and Jim Dannhauser  |  SCORE certified mentors

Question: I am considering exiting my business. How do I determine its true value?

Answer: For many small-business owners, the business is the largest of the owner’s assets, one that is expected to provide them financial capacity for retirement. So, an understanding of the value of a business is of critical importance. But determining the value of a business is not a simple formula, especially for small businesses. 

There are multiple factors to consider. It is not enough to rely upon an owner’s own estimates, which are often inaccurate. And having your accountant perform the valuation is also unreliable, unless the accountant is experienced in business valuation. This exercise is not a “rule of thumb” or a figure agreed to with a handshake, but a thoughtfully and professionally crafted activity. It is executed by an appraiser experienced in valuing businesses. 

Having an accurate business valuation eliminates conflict in the selling price and helps owners evaluate their retirement financials. A business owner needs to use a Certified Valuation Analyst, or other credentialed professional, to prepare the valuation as a first step in the exiting process.

Business valuation: Often, there is a disconnect between what the business owner thinks, relative to the value of the business, and what someone will be likely to offer. Why do business owners want a valuation of their enterprise? To have another measure of the business’s health or success. To know if the business has value in the marketplace, or is even salable. It is important as a first step in preparation for the business’s sale – and to know if there is sufficient value in the business to fund the owner’s retirement.

There are multiple reasons for having a valuation conducted. When there are multiple owners, a valuation will enable the owners to properly fund the buy-sell agreements. Most businesses with revenue over $1 million have multiple owners. And most of those multiple owners sign a buy-sell agreement detailing what share of the selling price each shareholder will receive. Having a valuation is the starting point in establishing a selling price for the business. It is needed to estimate the nest egg that will be generated by the future sale. The valuation will also help fund the tax burden of the future sale.

There are three basic approaches to determining the value of a business, according to Tom Gledhill of XitPro Systems. 

Market approach: Businesses have an infinite number of moving parts, so the common denominator is comparable sales of other businesses in the same sector. But since small businesses have few metrics, and data may not generally be available, it is very hard use this approach, which is geared more toward public and large companies.

Income approach: This most common approach for small business valuation is based on company revenue and earnings. According to Gledhill, the most common method is to employ a multiple of seller discretionary earnings, where the SDE is defined as the net operating income, plus adjustments, plus the owner’s salary. Valuation is a multiple of that amount, with the multiple varying depending upon industry sector, local market conditions, prevailing interest rates, and other factors. 

Asset approach: When most of the value of a company is in the assets of the business, this approach is used most often. It includes machinery, equipment, furniture and fixtures. This approach is most often used when the business is no longer a going concern. It becomes very clear, very quickly, that a good business valuation is not a simple analysis, and is best done by an experienced professional to achieve a reliable result.

The multiple that will be used to estimate a business’s value will be affected by many factors, including the industry in which it operates, growth trends of the segment, size of the operation, and environmental factors affecting economic sensitivity.

Of course, the company itself will be critical – its history, its brand and the values the brand represents, and the reputation the enterprise has in the industry. Understanding the products and services offered by the seller includes taking a look at the acceptance of the brand by its customer and potential customer base, the competition and their competitive advantages, profit margin trends and customer service reputation. The demand for the products/services should also be included in the evaluation to address growth, decline or stagnation. 

Another important element in valuation is the competition: how many competitors there are, their size, where they are located and what is known about them. In addition, an estimation of the intensity of competition needs to be assessed. Is every aspect intensely competitive, or is brand loyalty a major factor in an ongoing business? 

The management team is another element that drives value. Who are they? What is their experience? Do they have contracts? What kind of ongoing training does the company offer to keep key employees engaged with the latest trends? What about longevity – is there high turnover? What kinds of employee incentives are in place? As part of a valuation, the business’s systems and procedures are subject to analysis as well.

In the end, even if a valuation is done, the market determines the purchase price of a business, which is worth only what someone is willing to pay for it. Still, a comprehensive, professionally prepared valuation is a critical first step in preparing a business for sale, as it will establish an estimate of the price that can be expected to be achieved and help owners to plan effectively.

Contributed by Marc L. Goldberg, certified mentor, and Jim Dannhauser, certified mentor, SCORE Cape Cod & the Islands. Sources: Simple Steps for Exiting Your Business, SCORE Association/MassMutual. For FREE and confidential mentoring in creating your succession plan, contact SCORE at www.capecod.score.org or capecodscore@verizon.net or 508-775-4884. Download the free e-book “Tips from SCORE, Vol. II” at www.amazon.com/dp/B08QPR7G35.

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