Exit Planning Valuation

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David Hahn, CVA, ASA, MAFF, CM&AA, CCIM, MBA

Exit Planning Valuation

It is very important to know what the current value is of any business, especially a business where the owner is beginning or in the process of executing an exit plan. Understanding what the business is worth allows the business owner to determine if they will accomplish their financial goals upon the sale of the business. In addition, the business valuation process allows the owner to learn what they can do to increase the business value.

Eventually, every business owner will exit his or her business – whether voluntarily or otherwise. At that time, every owner wants to accomplish certain personal, business, financial, and estate planning goals. Most fail to do so. According to a number of surveys, efforts by business owners to exit their businesses have been, on average, less than satisfying. The majority of business owners regret the decision to sell their company because the sale did not accomplish their personal or business objectives. Most of these business owners cite the lack of knowledge or understanding of the available exit strategies.

Exit planning is the deliberate, adaptable, and customized process for assisting business owners with a successful strategy to exit from their company. It is designed to provide the owner with information regarding available exit strategies so that he or she can make an informed decision. A well-designed and implemented exit plan will help owners achieve the personal, business, and financial legacies they want to achieve upon their eventual exit from their business.

A properly prepared exit plan begins with an assessment of the goals and objectives (transfer motives) the business owner wants to obtain from exiting the business. The business owner’s transfer motive determines the appropriate transfer channel, which in turn determines the proper transfer method. A transfer method is the actual technique used to transfer a business interest.

There are many reasons for performing a valuation in the context of Business Exit Planning or selling your
business. The reasons for not doing so are few and weak!

Reasons for Business Valuation:

A benchmark against which to measure offers:
If you receive one or more offers for your business, how will you know whether those offers are good, excellent, or downright poor, unless you have performed some analysis and a valuation of your own? A valuation allows you to put any offers you may receive into the proper context.

Information to support your negotiations:
If an investor tells you that last year, there was a business in the same sector that sold for very low multiples, and that he or she thinks that this should be the basis for valuing your own business, what can you do? With a valuation, you might be able to answer that there was another business that sold this year at much higher multiples, and because this business is more comparable, this is the business that should provide the basis for valuation. Or you might provide 10 comparable Transactions, with the average and median multiples. Helps you resist attempts to reduce the price: The investor is almost sure, at some point during the negotiations, to raise certain aspects about your business in an effort to reduce the price. This could be anything from the loss of a contract to unfavorable currency fluctuations. Unless you have a business model, it will be very difficult, perhaps impossible, to quantify the potential loss in value. Similarly, it may be difficult to quantify whether other favorable developments may have occurred, developments which might more than offset the negatives.

Private businesses do not have a single "value" rather a private business can have a large number of different values at any point in time. This can cause confusion on the part of business owners and their advisors. After all, it’s the same business with the same products and services, same location, same personnel, etc., so how can the "value" be different?

The "value" of private business depends on the transfer method chosen because the standard (definition) of value differs. For example, if you want to gift an ownership interest to your heirs, the standard of value is "fair market value" as defined by the Internal Revenue Service. Alternatively, if you want to sell the shares to an outside investor, the standard of value is "investment value". The difference between these two "values" may be significant depending on the facts and circumstances surrounding the business.

Transfer methods correspond to specific value worlds. Each value world has an authority that governs the world. Authority refers to the agent or agencies with primary responsibility to develop, adopt, promulgate, and administer standards of practice within the private capital markets. Authorities set the rules and processes regarding business valuation, capital structure formation, and business interest transfer in the private markets. The authority decides whether the intentions or motives of the owner are acceptable for use in that world. Therefore, value is expressed only in terms consistent with the value world determined by the choice of the transfer method.

The securities of a private business do not have access to an active trading market. Either a valuation must be undertaken or a transaction must occur in order to determine the value of the securities of a private business for some purposes at some point in time.

The business owners and their advisors need to know the "value" of the business for different transfer methods in order to make an informed decision.

 

Exit Planning and Business Valuation
Eventually most small business owners will need to calculate the worth of their business - for the purpose of sale, loan application, estate planning, net worth calculation, etc. Also, valuation is critical when deciding to purchase a business.

There are numerous valuation techniques, ranging from simple "rule of thumb" methods to more complex ratios that include asset valuation and industry average valuations.

1. Rule of Thumb Valuation. This method usually involves a multiplier to determine the worth of a business, projected upon the cash flow and profitability. Often, the base for the multiplier is termed "Earnings Before Interest and Taxes," or EBIT. "Earnings," in this sense, translates to "profit," not "gross income." The EBIT is multiplied by 3, 4 or 5 to determine the valuation of the business.

Why 3 to 5 as the multiplier? Because it can be expected that a business would earn back an investment in 3 to 5 years. The 3-times multiplier represents a return of 33 percent per year, while the 5-times multiplier represents a return of 20 percent per year.

The valuation of a business with few tangible assets would be calculated by 3, whereas a business with substantial assets and other attractive features would be calculated by 5. In some instances, multipliers of less than 3 or more than 5 could be used.

Another way to determine the projected cash flow and profitability of a business is what is termed "Owner Benefit." This is the discretionary cash flow that would be expected from the business for one year.

Discretionary cash flow takes into account the fact that most small businesses calculate income in such a way that income taxes are minimized. Many companies operate at low net incomes (or even negative net incomes), while they may actually be highly profitable. Discretionary cash flow is the amount of money that would actually be available for paying for the business and generating profit.

Note: the valuation of a small business has many variables and is never an exact science. Some tangible assets clearly
increase the valuation (buildings, land, equipment, inventory), but the value of even these are often open to debate, based on appraised value, length of remaining life expectancy, importance to the operation of the business, etc. Other assets are highly subjective in value, including goodwill, customer base, location, length of time the company has been in business, barriers to entry (for new competitors), etc.

It's rare that the buyer and seller of a business come up with matching valuations. Compromise and negotiation begin with a comparison of valuations.

2. When businesses are asset-driven, such as retail stores, online or direct mail stores, manufacturing companies, wholesalers, etc., much of the valuation depends on accurately determining the value of these assets. Included in asset valuation are: Fair Market Value of Fixed Assets and Equipment, which is roughly how much it would cost to purchase comparable assets and equipment at current prices; and Inventory, usually at wholesale value. Asset valuation is normally added to Owner Benefit to determine the value of a business that is asset-driven.

3. Industry Average Valuation. This method uses valuations of comparable types and sizes of businesses that have sold within the last six to 12 months. At best, an industry average valuation produces a ballpark figure that can be a starting point for estimates of value. Variations that would affect industry average valuation include comparisons to the norm of: location, quality of assets, customer base, length of time in business, barriers to entry, goodwill, etc.

The approaches to valuation discussed in this article are introductory at best. When placing a value on your business, or on a business that you are considering purchasing, work closely with your accountant, business adviser, and business brokers to assure accuracy and practicality.




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