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LOOKING FOR: Food and beverage manufacturers. EBITDA: $3-$15 million. Location: U.S.-based in**@Wo**********************.com
24 June 2024: Business Valuation: What Drives the Number?
One of the biggest surprises that I’ve had over the past 20+ years of advising business owners is how few of them have any idea what their business is worth. They inevitably have a good idea of the value of their house, their car, their boat, their investment accounts, their IRA and most of their other assets, but for some reason the value of what is usually their largest asset – by far – is a mystery to them; and they seem remarkably sanguine about it.
And knowing the valuation of the business you own is very often important for operations, not just for when it’s being sold; and even when being sold, a surprisingly small number of business owners even seem curious as to their business’ value.
And that’s because many business owners “need” of “want” X for their business.
Business owners are notorious for having a wildly optimistic opinion of what their business is worth – and that opinion is usually based on little more than the WAG theory of valuation; the Wild Ass Guess.
We often meet with business owners who tell us what they want for their business – but are generally completely unable to justify their number. But justifying what a seller wants is critical for establishing a basis for negotiation with a buyer and without having a realistic price expectation – i.e., knowing approximately what the business is worth and understanding that the business is unlikely to sell for much more than that – is usually the determining factor as to how soon, or even “if”, the business will be sold.
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As many of you know, aside from valuing and brokering businesses, we provide training and consulting for business brokers, real estate agents, business owners and business buyers covering all aspects of selling and buying a business. One of the most important aspects is, not surprisingly, knowing how to determine a business’ value. In fact, this aspect comprises 40% of our Flagship Course. And it’s the most discussed topic during our weekly Office Hours and Pro Sessions in The Brokers Roundtable℠.
When I speak to business groups – or simply find myself at a small party or dinner – it’s not unusual that I get a question about valuing businesses. And though almost every owner has a theory of how valuation is determined, no one in all these years has been able to articulate any reasonable approach to business valuation.
During Office Hours last week, there was some discussion about issues that arise when valuing businesses. So, we’ve decided to try to help clarify certain valuation aspects in the hope of giving business owners, brokers, buyers, Realtors and others a better understanding of the some of the intricacies of business valuation. This post, as well as the next couple, will discuss several important aspects of valuing a business.
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Courses! Courses! Courses!
Many of you have asked if our Flagship Course, “Learn How to Value and SUCCESSFULLY Sell Businesses“, could be made available on a module-by-module basis. Instead of enrolling in the complete course, could you enroll only in the module(s) you wanted? We’re happy to report that this is now possible.
We’ve broken our Flagship into six separate modules (or module groups) to give you all the flexibility you need to learn only what you want to learn – and we’ve moved them all over to the new Brokers Academy in The Brokers Roundtable℠ . The Flagship is still available but the modules are now available individually.
You don’t need to be a Member of The Brokers Roundtable℠ to access any of these courses but if you are, you’ll receive a 20% discount on any course you enroll in. If you’re not yet a member of The Brokers Roundtable℠, you can learn more – and get access to all the talent and resources – here.
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Buyers
That’s right; we start with buyers – or at least “likely” buyers.
In general, there are two types of business buyers: financial and strategic. (Well, three, actually but for the purposes of this discuss, we’ll keep it at two.) The most basic explanation of the difference between the two is that financial buyers are most interested in a business’ discretionary earnings while a strategic buyer is concerned with how the acquisition of a business will help the buyer’s other business(es) or interests.
Essentially, financial buyers want to know the answer to the most basic of financial questions: “How much money will this business put in my pocket every year?”
When we’re talking to a financial buyer, we point out that neither the taxable income shown on the business’ tax returns nor the bottom line shown on the profit and loss statements are likely to be the correct answer to that question. But by analyzing those tax returns and recasting those profit and loss statements, we can show a buyer what that number actually is then begin our calculations to determine its value. It also allows us to show a buyer how it addresses the three financial requirements that make a business sell-able.
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Our course, “Learn How to Value and SUCCESSFULLY Sell Businesses“, teaches you how to accurately value and successfully sell businesses.
Strategic buyers, on the other hand, usually have different goals and need different questions answered. And though we don’t always get asked these questions, we know that they all relate to how the acquisition of a particular business will enhance the performance, or support some specific goal, of the buyer’s existing business or plan.
For example, a buyer may be an existing business that wants to expand it’s geographic footprint. The buyer believes acquiring an existing business in the desired geographic region would accomplish this better and more quickly that establishing a new outpost and competing with the existing businesses already operating there.
Another strategic reason for acquiring a business would be to acquire a technology or patent. Still another is to acquire a license or certification that would allow the acquiring company to enter a new field or produce a product or provide a service that, without such license or certification, would not be possible.
When we’re talking to strategic buyers, we try to determine what their motivation is – what’s driving their search – to see if we can shape our marketing efforts to show that the business we’re representing can fill the buyer’s needs.
An Example of the Difference
Over the past 18 months or so, we’ve seen solid demand for certain types of what one institutional buyer referred to as “dirty hands” businesses; businesses in “the trades”, such as plumbing, electrical and HVAC contractors.
If we have a client that wants to sell his HVAC contracting business, we consider whether the business is likely to appeal to a financial buyer or a strategic one (and certainly sometimes the business will appeal to both). The value of the business to the financial buyer is easy to establish. We determine what the discretionary earnings are, apply the appropriate metrics and, voila!, we have the business’ likely value.
However, if we’re dealing with a strategic buyer, though we still go through the complete valuation drill (so that we and our client know what the business is likely to fetch at minimum), we focus as best we can on determining how much value the acquisition will add to the acquiror’s existing business.
If our client’s HVAC business has revenue of $2.5 million, depending in the results of our financial analysis, it might be valued at $1.1 million. For a financial buyer, that’s our target. But if our client’s business has an exclusive license to use a proprietary testing device that makes diagnosing or repairing HVAC problems easier, we might consider that a competitor – a strategic buyer – will pay more for the business than its discretionary earnings are worth simply because the acquisition of the license will enhance the performance of the acquiring company.
The Bottom Line
Valuing a business has many moving parts. Identifying the type of buyer the business is likely to attract is but one of them.
Though we always start with determining the probable market value of the discretionary earnings, the second phase of the process is to describe the buyer; create an avatar, if you will. Strategic buyers see value in something other than the financial aspects of the target business. This often adds value to the target. We adjust accordingly.
Over the next couple of weeks, our posts will be focused on different aspects of valuing a business. If you’d like to get more knowledgeable about the detailed steps of valuing businesses, visit The Brokers Roundtable℠ to see some course options or simply join The Brokers Roundtable℠ and start interacting with the people who do this for a living.
I’d like to hear from you. What topics would you like me to cover? How can we tailor these posts to be more useful to you and your business. Let me know in the comments box, below, or email me at jo*@Wo*******************.com.
If you have any questions or comments on this topic – or any topic related to business – I’d like to hear from you. Put them in the comments box below. Start the conversation and I’ll get back to you with answers or my own comments. If I get enough on one topic, I’ll address them in a future post or podcast.
I’ll be back with you again next Monday. In the meantime, I hope you have a safe and profitable week.
Joe
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NOTE TO READERS: Our “Searching For…” feature has been moved to our online community, The Brokers Roundtable℠. It will appear there exclusively from now on.
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The author is the founder, in 2001, of Worldwide Business Brokers and holds a certification from the International Business Brokers Association (IBBA) as a Certified Business Intermediary (CBI) of which there are fewer than 600 in the world. He can be reached at jo*@Wo*******************.com