The simple answer to this question is this: your business is worth what someone will pay for it. That said, the method by which a buyer values your company can involve complex financial modeling. Because buyers have different motivations and use a variety of valuation methods, we try to give you a few simple rules.

To begin, this is not personal. Granted, you and your family have put everything into your business, and now an outsider is trying to place a value on it. It is hard not to take it personally. Private equity investors, however, are seasoned and disciplined. The valuation of your company will be based almost exclusively on the financial health and potential of your company.

A Rough Estimate

If you want a general sense of your company’s value, determining your industries average multiple of EBITDA (Earnings before interest, taxes, depreciation, and amortization) is a good start.  For instance, if the average multiple in the logistics brokerage industry is 4X, then a logistics broker can assume his company is worth around 4X his EBITDA. Because there are hundreds of transactions a year, market average multiples can help you determine a rough value for your company. Most investment bankers and investors are happy to provide you data on common multiples in your industry to give you a general sense of the market.  Just remember that multiples vary and can be misleading.

Whether your multiple goes up or down has a lot to do with risk. Unlike venture capitalists, a private equity investor wants safer investments and is more concerned with losing his shirt than hitting a home run.  Whether an equity or strategic investor, the investor’s offer inevitably reflects the future value of present cash flow.

Once financial criteria are met, essentially the investor works backward–looking for a reason to say no. Some common red flags considered include:

• Seasonality – Does revenue show only in a certain time of year? What happens if Q4 doesn’t work out?
• Inconsistency– Does revenue bounce along or is it consistent month to month? Was this year a banner year or is this typical?
• Customer concentration – What happens if the top two or three customers go away? What percentage of my business is lost?
• Key man risk – If I buy this company and one or two key producers go away, will the customers still want me? Is there more than one person capable of running this company?
• True cost to own – What does it really cost to make this product? Are my cash flows going to be eaten by capital expenditures?
• Commoditized product – Are there so many providers, so little differentiation in competition, that prices are cheap and consistent?
• Welcome competition – What are the barriers to entry? Can anyone with $10,000 and a website get into the business and start stealing market share?
• Regulatory uncertainty – Am I relying on the whims of politicians to maintain revenue? What if the next president cares nothing about wind energy?
• Technological obsolescence – Is this industry being replaced by new technology? Will Facebook’s next announcement sink me?
• Value add uncertain – Is this an unnecessary product that will go first in a budget cut?
• Limited product line – What happens if my only product goes out of style or is copied by a competitor? What do I have to ensure the revenue keeps coming?

This is not an exhaustive list, but it provides an idea of the many items that can chip away or add to your value.

Valuation Methods

Once you have a rough estimate, the final valuation number is usually derived from a weighted average of suggested values.  The methods of valuation usually focus on one of three aspects: 1-Assets, 2-Earnings and 3-Comparable Sales.  Calculating a value utilizing alternative methods provides a good cross-reference while identifying the approach suggesting the highest value.  Remember that prospective buyers differ in their weightings of value based upon earnings, assets or comparable sales; so it is in everyone’s best interest to understand value from all perspectives.

1. Asset Methods

First revise the current balance sheet to better reflect today’s market value.  This information will also be important in supporting the buyer’s ability to obtain loans and/or take a “step-up” basis on assets for tax planning purposes.  If an asset sale is anticipated  (versus sale of stock) and your valuation is greater than 60% of assets then perhaps the assets are underutilized.

The following tangible assets should be reviewed:

• Accounts receivable – Are there adequate reserves for bad debts?
• Inventory – Are some items obsolete, over-valued, under-valued or no longer listed on the books?
• Land – Land is usually listed at cost and may have appreciated beyond book value.
• Buildings, machinery, furniture – Deduct any non-contributing (not used in the business) assets.  Oftentimes replacement value of certain assets is greater than the recorded book value.  Some valued assets may also be obsolete.
• Vehicles – Is the owner keeping the company car?
• Loans due from officer – Deduct this from company value as it will be paid at closing.

The intangible assets need to be reviewed as well:

• Going concern – What is the value of foregoing the start-up costs and corresponding risks associated with starting a new business?
• Patents, software or licenses – Is there a competitive advantage due to proprietary information? What is the value of anticipated license fees or royalties?
• Favorable leases – How much more would a buyer need to pay elsewhere?
• Trade secrets or formulas – If important to the business, what is the cost to replace?
• Customer and supplier lists – How proprietary and valuable is this information?
• Goodwill – Are there other reasons, such as reputation, that create value?

Knowing the value of tangible and intangible assets allows the following methods to be applied:

• Adjusted book value – This approach calculates the replacement cost of tangible assets less any debt.  Adjusted book value is normally the minimum an ongoing business should sell for because no value is considered for earnings capacity.
• Cost to create value – This figure is the total of adjusted net tangible assets plus intangible assets and start-up costs such as assemblage of personnel and assets.
• Liquidation value – If all else goes wrong how much cash would an asset sale raise?
• Multiples of value – Industry averages may indicate a ratio of assets to earnings which suggests a multiplier for estimating value.  Applying a multiple to assets is a worthy exercise but should not be the sole determinant of value.

2. Earnings Methods

Earnings are the best variable to utilize in valuing an ongoing business.  Machinery, management experience, and proprietary information quickly lose much of their value if they cannot generate earnings.

P/E Method

An industry average Price/Earnings multiple is applied to weighted, adjusted earnings.  
For example:  $5,000,000 pretax earnings x P/E (Price ÷ Annual Earnings) of 5 = $25,000,000

Note: Unlike publicly-held firms, a privately-held company’s “earnings” usually means pre-tax earnings.

Capitalization Rate

A capitalization rate must be determined for some valuation methods.  The capitalization rate is the buyer’s required rate of return.  Factors effecting this rate include the rate of return on risk-free T-bills, the nature of the business and history of earnings.     The capitalization rate (a build-up of various returns) is best explained in this example:

Return on risk-free investments   + 1%
(5-7 yr. Treasury Bills)

Plus return for business risk         +8%
(normal equity risk)

Plus return for specific risk     +12%
(varies per industry and business)

Minus business growth rate          -2%

Capitalization rate                      =19%

The capitalization rate is sometimes converted to a multiplier by dividing it into 100%.  (Example: 100% divided by a capitalization rate of 25% equals a multiplier of 4.)

Capitalization of Earnings

This is the most common method in valuing manufacturing companies.  A weighted average of pre-tax, adjusted earnings is multiplied by the cap rate to determine the valuation.

Ex: $5,000,000 pretax earnings X 5.6 (an 18% Cap Rate) = $28,000,000.

Capitalization of Excess Earning

Also called the I.R.S. Formula, this approach adds the calculated intangible asset value to the adjusted tangible assets value to obtain a total value.  The intangible assets value is calculated by taking excess earnings (earnings above a normal rate of return on tangible assets) and dividing by a cap rate which varies widely but normally ranges from 22 to 35%.

Discounted Future Earnings

This method is used by companies experiencing high growth rates and expecting significant jumps in earnings.  The value is obtained by discounting projected earnings to the present value and then adding back an income or asset residual.

There are other, less frequently used valuation approaches based upon future earnings and cash flow which we will not discuss here.

3. Market Comparable Methods

Comparing the price and terms of similar recent ownership transfers will provide valuable data for setting a valuation.  Most of the information available covers publicly-traded companies.   Significant adjustments must be taken when comparing publicly to privately-held companies. It’s more difficult but well worth the effort to gather information on recent sales of privately-held sales.  Most business appraisers have access to market data that includes comparable sale information to assist in the valuation process.

Privately-held companies often sell at a 20-40% discount compared to the values of publicly-held companies.  Discounts range from 40 to 70% for minority ownership transfers of privately-held companies.  The discounts occur due to a lack of marketability (no public market for shares), less access to financing, instability caused by the owner’s departure, less comparable sales information, and less predictable profits.

Upon completing and reviewing a variety of approaches to valuation the most relevant approaches are weighted and a final value is derived.