Valuing a Business on its “Potential”: Part 2

Last week’s post about valuing a business based on its potential – Part 1 – raised a couple of questions – and one of two issues I discussed need some clarification.

You may remember that I discussed three types of situations in which a seller might want to be paid for the business’s potential:

1. What the seller thinks is possible by making some changes to the business
2. What the seller thinks is possible due to changes in the market
3. What the seller has done that will cause the business to increase in value – without much effort from the buyer.

Early in that post I stated that when we hear an owner tell us they want to be paid for what the business has the potential to do, we have to educate the owner that expecting to get paid for how the business might perform in the future is usually an unrealistic expectation. But not always.

For example, in the first instance listed above, the seller wants to be paid for something he expects the buyer to do. This, of course, is unrealistic on its face and, as I explained last week, we dispense with this claim in short order. But in the other two instances, the seller may have a legitimate claim to some of the future potential value of the business.

Changes to the Market

Our course, “Learn How to Value and Successfully Sell Businesses”, contains two modules – 15 lectures – on valuing a business. One of the examples used in the course – and one that I used last week to explain how to consider a business’s “potential” – is a convenience store that was located across the road from a 30 acre parcel that was just approved for a 400-unit apartment development. I suggested that such a market development would be expected to have a positive impact – possibly a significant one – on the value of the convenience store; and probably as soon as ground was broken given all the workers that one would expect to be involved in the construction of such a project.

I received several questions about how to develop financial scenarios that would allow brokers – and sellers – to arrive at a justifiable value. Let’s take a look at some of these questions.

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One that popped up fairly often relates to how we estimate future revenue. We use two approaches in a situation such as the convenience store. They might be appropriate for any general retailer or any business open to the public that depends to some extent on visual exposure.

Projections based on traffic counts. We request traffic count information from the highway department and the local government. Additionally, in most jurisdictions, prior to issuing permits for such a construction project, officials will project future traffic counts. If the current or most recent traffic count is 70,000 vehicles per day and the projected future count is 100,000 vehicles per day, we know that traffic will increase by roughly 43% over the construction and lease-up period. But we also know that this increase will be gradual so, when we build our projected P&L spread sheet, we might project revenue increases of 12% year one, 10% year year two and so on until at year five, revenue is up 43% over the period.

Properly allocating expenses will result in projected Discretionary Earnings for each of the next five years. Perform a Discounted Cash Flow Analysis and you have the estimated present value of that future cash flow – the estimated current value of the business.

Projections based on population growth and demographics. I can’t stress how important associations are to us. They have a seemingly bottomless well of useful information on the industries they represent.

In this case, we go to the American Petroleum and Convenience Store Association (APCA)  and National Association of Convenience Stores (NACS). Both can tell us what we can expect this 400-unit project will do to the sales at our clients c-store.

Granted, those associations are US-focused but there are associations in every country where there is private business. And if you can’t get the answers you want, contact the U.S. Chamber of Commerce which has an office in nearly every major – and many minor – city in the world.

Another question is related to how we calculate future DE.

When we build our projected P&L spread sheet, we know that certain fixed costs – such as rent, electricity, insurance and such are unlikely to change very much. This means that a greater percentage of the additional sales is likely to fall to the bottom line, increasing the Discretionary Earnings as a percentage of sales – and also increasing Discretionary Earnings, on a percentage basis, more than sales were increased. Again, performing a discounted cash flow analysis will give you the current value of the projected future cash flows – the current estimated value of the business.

A third  question category relates to negotiation with the buyer.

If the parties can’t agree on the value you and your client have arrived at even though you feel it is realistic and that your assumptions justify it, the acquisition agreement can be structured so that the seller accepts the buyer’s number to get the deal closed but that if the actual revenue over the next 3-5 years is greater than the buyer estimates, the buyer agrees to pay the seller more.

Structuring a transaction like this is not for the squeamish – and certainly not for novice business brokers. But if you’re trying to close a gap between the buyer and seller, there are many ways to do so. Some are outlined in the course and discussed in our weekly course coaching call.

And finally, a little clarity related to timing.

You’ve got to be able to justify your numbers and one way to do that is to calculate the impact of the market change only from the point that the change occurs and, if the impact is expected to be gradual, your projections must be applied gradually. (See the first paragraph under “how we estimate future revenue“, above.)

Changes the Seller Has Made

From last week’s post: If the seller has caused something to happen and the buyer will have to do little or nothing to benefit from what the seller has done, the seller is entitled to be paid for his or her work in doing the “thing”.

The example I used was a client of ours; a wholesaler of sporting goods that had just signed a supply agreement with Walmart to stock 17 additional stores to add to the 10 they were already stocking.

In this instance, arriving at a reasonable estimate of additional revenue was fairly easy.

One way was to average the sales of the existing 10 stores and apply that average to the additional 17. More accurately, find out from Walmart the population demographics of the existing stores, as well as of the additional stores, and make your estimates based on the relative differences.

In this example, you might even be able to get from Walmart the “sales-per-foot” figures for the existing stores. Of course, our client’s products represented a very small percentage of each store’s sales but we applied that percentage to the “sales-per-foot” figures of the new stores to arrive at an estimate of the revenue we expected from the new stores.

Again, the buyer may not agree with your conclusions but if you have a legitimate buyer – one that has the cash or the financing in place – it would not be unrealistic to structure the deal so that the seller receives payment for the current value of the business at closing but also receives the value of the additional future cash flows as actual revenues are determined over the next several years.

In any of these instances, when valuing a business, it will be nearly impossible to predict the current value of the business’s “potential” but in every instance you should be able to get reasonably close.

Sometimes the parties, each willing to take a bit of a gamble, will agree to a number and the transaction will close with no future obligations to confirm revenues or project earnings on an annual basis. If that happens, great!

But more likely is that the parties will not be in agreement. This means that the transaction must be structured so that the seller has to wait until the “potential” value is realized before receiving payment for that value.

The Bottom Line

When valuing a business, a professional business broker must remember that there are certainly instances in which the seller can rightfully claim he or she is entitled to the potential value that results from something the seller made happen or even something that happened in the market place – even if that value has not yet been realized. But what business brokers are more likely to hear is a buyer saying that they believe their business is worth X amount more than our valuations suggest because, “if the buyer did this or did that…”

If the buyer has to do it, the seller can’t get paid for it. Period.

Valuing a business based on its potential requires a little more work than valuing a business based on its history but in some cases, the seller is genuinely entitled to the value of that potential.

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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