 |
What's Your Company Worth?
Posted by B2B on: 2006-06-09 09:13:36
William Cate
What's Your Company Worth? By William Cate
Any company is worth what a willing buyer will pay a willing seller. Usually one party to the sale's transaction is making a bad deal. More often than not, it's the seller that makes the bad deal.
The value of your company is important in two respects. If you want to sell your company, you need to know its rough value. Otherwise, you will probably make a bad deal when you sell. If you want to raise equity capital to build your company, the value of your company often determines the amount of equity that you must sell to raise the needed business capital.
For most businesses there are two formulas for estimating the value of the business. Both approaches are subjective. The appraisal formula estimate can be the basis for getting the buyer and seller to then determine what the buyer will pay the seller for the business. And, what the seller will accept for their business.
Discounted Cashflow
The formula will either be based upon owner equity (the amount of money the owner has invested in their company). Or, it will be based upon the business' revenues. Using owner equity strongly favors the buyer. Using one year's gross income strongly favors the seller.
If you use the owner equity approach, the business' value is based upon the amount of money the owner has invested in the company, since its inception. This sum is adjusted upward by annual inflation. Among the problems with this formula is the usual source of the inflation rate data is the U.S. Department of Labor's Consumer Price Index (CPI). The CPI is always well below the real inflation rate, because the Government benefits from acknowledging the lowest possible inflation rate.
If you use the one year gross revenue approach, it becomes a subjective effort to decide upon the value of the business. The norm is somewhere between 80% and 120% of the annual revenue. The value is then a function of the time it will take to recover the risk capital, adjusted by the inflation rate.
Profitability
Your business pays you a salary and gives you an annual profit. Assuming that your salary is within industry norms, the profit can be used to estimate the value of your business. The question is how much cash would it take to generate an annual profit equal to your profit?
This gets us to the subjective question. How much risk is there of your business failing? The greater the risk, the higher the reward in the form of interest payments. Your business risk of failure is higher than that of a bank failing to repay depositors. Bank deposits are insured by the taxpayers. Fortunately, your bank can easily tell you what the risk factor is with your business. Ask your bank for a loan. Whatever the interest rate being asked by the bank is the risk factor for your business.
Let's assume that your bank wants 8% simple interest, to loan your business money. Further, we'll assume your pretax profit was $100,000. To estimate the value of your business, you need only divided 8 into 100 and get 12.5 as your factor. You then multiply your pretax profit of $100,000 by 12.5 to get your business valuation of $1,250,000.
Keep in mind that the buyer's intend is to use your pretax profit to pay you for your business. Most buyers have a plan to increase your pretax profit to allow them to benefit from their hard work in meeting their repayment obligations to you. But, they are always starting with the premise that they can pay you
for your business from your present pretax profits. Business
Appraisers
Given the subjective nature of business valuations, an industry-knowledgeable, unbiased appraiser seems to be the solution. This is especially true for industries where the standard appraisal formulas fail to reflect fair market value, like industrial chemical manufacturer.
The problem is that most business appraisers are also business consultants. If you're selling, you aren't a potential future client for the appraiser. The buyer is a potential client and if the business appraiser can help the buyer acquire your business at a low price, the buyer is far more likely to use the business consultant in the future.
The seller shouldn't hire a business appraiser. If the buyer wants to pay for the service, you should cooperate with the appraiser. If the appraised value of your business is more than 5% below your profitability calculation, don't accept the appraisal as a starting point to discuss the sale price of your business.
The Two Minute Appraisal
Here are three simple formulas that I use to find a rough value for most businesses. 1. The business lacks revenues. It's worth the equity investment in the business less debt. The long term debt being all debt not being paid by the seller from the proceeds of the sale. 2. The business has revenues, but it is unprofitable. It's worth its annual gross revenues less its long-term debt. That is debt that is due in more than 90 days and won't be paid by the seller from the proceeds of the sale. It's assumed that revenues, up to the date of the sale, will be used to pay the short-term debt. 3. The business is profitable. It's worth its pretax profit factored by its risk factor less its long-term debt that won't be paid from the proceeds of the sale of the business.
The Sellers Alternative
Buyers acquire a business expecting to pay for it from its pretax profits. This fact gives the seller an option to the sale of their business. Hire a competent business manager. I'll concede that finding a competent business manager isn't easy. However, a competent business manager can allow the seller to eat their cake and have it to.
Instead of selling your business, you pay the competent business manager your salary and you live on your pretax profit. You agree to equally share any increase in the company's pretax profit with your business manager.
I'm aware of scores of business owners who have adopted my advice. The business is often better run and more profitable under the direction of the business manager than the owner, who is now a passive investor.
The reason that this option makes sense is that you will get your income until the day you die. The track record of business managers is often better than that of business buyers when it comes to avoiding bankruptcy. You will share in any increase in the pretax profit. And, as the passive investor, you can always drop by between vacations and see what is actually happening. If you are the creditor from a business sale and the buyer is getting into trouble, you won't be welcome back at the old watering hole.
Sellers should think passive investor rather than business seller. It makes sense for most business people.
About the author:
He is the Managing Director of Beowulf Investments [http://home.earthlink.net/~beowulfinvestments/]. He's the Executive Director of the Global Village Investment Club [http://home.earthlink.net/~beowulfinvestments/globalvillageinves
tmentclubwelcome/] He's a Venture Capital & Equity Finance Consultant [http://home.earthlink.net/~beowulfinvestments/williamcateventure
capitalampequityfinanceconsultant/]
Post new Comment
This site does not allow anonymous comments. Registered members can login to participate. Registration is free and takes only a few seconds