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Technical Methods of Business Valuation – An Overview

At some point in time, every business owner wonders: “How much is my business worth?” After all the effort you’ve expended to build your business, its nice to know that you’ve built a significant asset.

This article provides you with basic information about business valuation so you can: (i) understand the process and basic concepts; and (ii) be an educated consumer of business valuation services.

The most important things to know about business valuation are:

* It’s a combination of art and science;
* It’s not fixed (knowing how the valuation is done can help you increase the value of your business); and
* It’s an educated guess.

True business valuation (i.e., getting the “fair market value” of your business) truly occurs only when you sell a business at arms-length. Only then are all of the factors the effect valuation (including payment terms) known.

However, by using the following methods, you should arrive at a value range for your business.

The first step in any valuation is to analyze the business, its assets, history and market. Of course, a valuation is only as good as the information about the business. So, its critical to ensure all of your information is accurate and complete.

Central to this analysis is financial information. Accurate financial recording keeping is essential to establishing business value.

Yet, often financial information must be legitimately “recast” to reduce the effects of tax decisions and owner benefits, and to be able to compare the results against other similar businesses.

Basic Business Valuation Methods.

There are four basic business valuation methods:

Asset Based Valuation;
Market Based Valuation;
Earnings Based Valuation;
Cash-Flow Based Valuation.

Each method involves detailed analysis and calculations.

Asset Based Valuation

Generally, asset based valuation is used to determine the bottom end price (i.e., liquidation value) for an operating or “going concern” business. However, it is the preferred method for holding companies, such as a real estate holding company, where the company’s assets reflect its true value.

Liquidation Value. To determine the liquidation value, you first establish the current liquidation market prices for all business assets, except those that can’t be sold (e.g., special equipment, or other assets with no market). From that the outstanding liabilities (mortgages, etc.) are deducted, resulting in a business value if operations were ceased immediately.

Replacement Value. To determine the business assets replacement value, you establish the current market prices for the business assets.

Unfortunately, it is difficult to value the intangible assets (e.g., trademarks, goodwill, etc.) when using asset based valuation. As a result, asset based valuation is not usually an accurate estimate of business value.

Market Based Valuation

A Market Based Valuation analyzes the prices of other similar businesses to determine an approximate valuation for your business. Generally, the steps are:

Analyze the public markets to determine price-to-earnings (“P/E”) ratios for similar companies;
Determine the average or median P/E ratio of those companies; and
Multiply that P/E ratio by the net ordinary pre-tax earnings of your business.
Sounds straight forward. Unfortunately, there are several drawbacks.

First, public companies tend to be quite different than closely held businesses, including access to capital, layers of management, liquidity for owners, and many other things. Therefore, even if a P/E ratio for a similar public company is determined, that ratio will have to be modified to account for the differences between the companies. The extent of the modification is the “devil in the details.”

Second, the sale of a public company stock (from which the P/E ratio is determined) usually involves the sale of a minority interest in the company. The sale of a closely held company, on the other hand, usually involves the sale of a majority (controlling) interest. Controlling interest transfers are made at a premium to minority interest transfers. Therefore, an (upward) adjustment to the P/E ratio for transfer of a controlling interest is also necessary.

Third, the public market P/E ratio includes a discounted expectation of the future prospects of the company. For many reasons, public companies can grow at a higher rate than closely held companies and they’re not dependent on the buyer’s expertise. Thus, the portion of the P/E ratio applicable to future prospects should be reduced.

On average a dollar of earnings from a public company represented between twelve and twenty dollars of market price. For closely held companies, however the range is three to seven. Thus, the maximum P/E ratio that should be used to value a closely held business is generally seven.

Earnings Based Valuation

Closely related to the Market approach is the Earnings Based Valuation. Under the earnings based valuation, the business value is set by the following formula:

Valuation = Weighted Average of Normalized Earnings Before Taxes / Capitalization Rate

Weighted Average of Normalized Earnings Before Taxes.

To determine normalized earnings, you calculate a weighted average of earnings over a specific time period, usually five years.

Annual earnings reported on financial statements or tax returns are usually modified. First, deductions are taken from earnings for special events such as one-time extra-ordinary gains and credits given for extraordinary losses.

Second, if owners receive salary or benefits greater than they would receive outside the company, the excess payments are added back to company earnings. Conversely, if owners are not paid a salary or benefits at a market rate, the underpayment is deducted from earnings.

Once earnings are modified, they’re weighted based on the time received. The most recent earnings are heavily weighted, while earlier years’ earnings are discounted.

For example, the present year’s earnings may be weighted at 1.5 or 2 times, while the first year’s earnings may be weighted at.200. Sometimes a 5, 4, 3, 2, 1 approach is used, multiplying each year’s earnings by its factor, adding the totals and dividing by 15.

The weighting value depends on the stage of life of the company and the company’s growth over the time period. For a mature company, weighting will probably be consistent. For a start-up venture, earlier years will probably be discounted more heavily.

But there is no justification for heavily weighting nearer years merely because current financial performance is superb.

Capitalization Rate.

Weighting the earnings may be somewhat difficult, but the real trick with earnings based valuation is the capitalization rate.

Capitalization rate (or just “cap rate”) is the return on investment expected by the investor/buyer. In a way, it is a statement of the risk involved in your business compared with available investments.

For example, if “no-risk” investments (e.g., CD’s and government short term bonds) are generating annual returns of 4.5%, stock market blue chips 10-12%, and “small caps” 15-18%, then your small business capitalization rate will more than all of them.

Why? Because running a small business is much more risky than investing in a public company.

If your venture is heavily dependent on you, the industry is changing or your earnings fluctuating rapidly, the capitalization rate for your business could be as high as 50%.

However, for most closely held businesses, the correct “cap rate” is between 15% and 33%. Thus, as a rule of thumb, most closely held businesses are worth between 3 and 5 times the weighted average of the normalized earnings before taxes.

The obvious problems with the earnings based valuation are selecting the appropriate earnings weighting method and capitalization rate. These problems are, however, less severe than the problems with the other valuation methods.

Cash-Flow Based Valuation

The cash flow based valuation is similar in some aspects to the earnings based approach. Cash flow based valuation bases business value on the future cash coming from the business. That cash flow is discounted to a net present value at a specific discount rate to determine the value of the business.

The cash flow method is the least used method for valuation. First, it is difficult to estimate future cash flows from the business (although a good approximation can be made based on historical cash flows). Second, selecting the discount rate is more problematic than selecting a capitalization rate.

It is, however, useful for analyzing cash available for debt service after a purchase. If projects free cash flow for debt service and uses that as a method to approximate a portion of the business value. Therefore, cash flow is a good check for other methods.

Other Factors:

There are additional “soft” factors to be used in adjusting business value. After an approximate value is determined with other methods, that value can be increased or reduced based on soft factors, including:

* Overall “health” of the Business;
* The reason for selling;
* Cost of entry for new participants;
* Market -growing, steady or contracting;
* Competition – severe, moderate or limited;
* Legal Environment – not regulated to highly regulated; and
* Business Assets:

Facilities

Equipment

Employees

Intellectual Property

Goodwill and Market Image.

Conclusion:
Remember, a business valuation provides a range estimated based on an educated guess. To fully understand the valuation, you must review the methods used to arrive at the value and the information upon which it is based. And prior to acting on a valuation (as a buyer), you should thoroughly review the business for yourself.

Discover How to Write a Business Proposal Properly

The business world is a world unto itself. There is language and etiquette that exists strictly within the business world. To be successful in that world with your new business you will need to have a top-notch business proposal prepared.

Knowing how to write a business proposal is essential to get any new business onto its feet. Having a solidly thought out plan of action behind your business venture will help you know where you are headed. Having specific goals for your business as well as a plan for how to get there is really important. If you are not reaching for something, or if you have not thought about how to make those things happen then chances are you will never achieve those goals. Additionally, one thing that any business needs to get started is startup capital. Typically, this type of funding is something that you are going to look at getting from investors. Having a solid business plan that is realistic and well presented will show investors that you have a plan of attack, and that their money is in good hands.

The first step in writing a top quality business proposal is to solidify who your audience is. Spend some time deciding what type of investors you are interested in securing as well as what type of customers you are hoping to serve with your business. This information will help you to decipher exactly what details you need to address within your business proposal. The primary goal of this proposal is to answer the questions that your potential investors will have regarding how your business is going to operate.

Within your proposal, you will want to provide the details that they are looking for. Decide whether your potential investors are looking for a very detailed plan or if they would rather have simple bullet points issued. When in doubt it is best to make sure that your proposal is easy to read, so if you are giving a lot of information space it out on the page. Perhaps have one bullet point with the main goal or topic, and beneath that provide more specific details.

There is a lot of information to take into account in regards to starting a business, and it is your job to edit what you are going to put into your business proposal. Again, knowing your audience is really quite important so that you can tailor your information to them. For most investors they will want to know how you are going to achieve the day-to-day operations of your business. To clarify this you might want to take some time to outline the staff that you are going to need for your business. Within this outline, you will want to indicate some of the basic duties that those specific job titles would encompass.

Your investors will also be very interested in what is going to be happening with their money.  You want to take steps to assure them that their investment will be used properly.  Show your investors how their funds will help your business to operate properly, and to turn a profit. 

Speaking of a profit, you will want your business proposal to show investors how they are going to profit.  They will want to see what type of profits you are expecting your business to turn.  Typically the bigger the profits for your business, the bigger the profits for the investors.  To entice them to sink their hard earned money into your business proposition they will need to see that it will be a sensible investment that they can expect a return on.  

Additionally, you might want to spend a bit of time to outline the chain of command in your proposed business. Investors need to be sure that your business is a well-organized machine. Having a solid and clear chain of command will give some peace of mind to those investors that there are competent people in line to supervise the business. Additionally, this will show that there is a system of checks and balances in place to ensure that the business is being run properly, and therefore their money is being used properly.

Though business proposals may seem like a tricky thing to put together, the truth is that it is simply a plan for your proposed business. The trick to making it a successful proposition is to be clear and detailed, but remember to keep those details concise. Give the answers that the investors want without all of the complications, and chances are that your proposal will quickly gain their attention and faith.

Small Business Loan Update – Stimulus Bill Helps Bailout Businesses If They Cannot Pay Loans

As we continue to sift dutifully through the over 1,000 pages of the stimulus bill (American Recovery and Reinvestment Act of 2009), there is one provision that is not getting much attention, but could be very helpful to small businesses. If you are a small business and have received an SBA loan from your local banker, but are having trouble making payments, you can get a “stabilization loan”. That’s right; finally some bailout money goes into the hands of the small business owner, instead of going down the proverbial deep hole of the stock market or large banks. But don’t get too excited. It is limited to very specific instances and is not available for vast majority of business owners.

There are some news articles that boldly claim the SBA will now provide relief if you have an existing business loan and are having trouble making the payments. This is not a true statement and needs to be clarified. As seen in more detail in this article, this is wrong because it applies to troubled loans made in the future, not existing ones.

Here is how it works. Assume you were one of the lucky few that find a bank to make a SBA loan. You proceed on your merry way but run into tough economic times and find it hard to repay. Remember these are not conventional loans but loans from an SBA licensed lender that are guaranteed for default by the U.S. government through the SBA (depending upon the loan, between 50% and 90%). Under the new stimulus bill, the SBA might come to your rescue. You will be able to get a new loan which will pay-off the existing balance on extremely favorable terms, buying more time to revitalize your business and get back in the saddle. Sound too good to be true? Well, you be the judge. Here are some of the features:

1. Does not apply to SBA loans taken out before the stimulus bill. As to non-SBA loans, they can be before or after the bill’s enactment.

2. Does it apply to SBA guaranteed loans or non-SBA conventional loans as well? We don’t know for sure. This statute simply says it applies to a “small business concern that meets the eligibility standards and section 7(a) of the Small Business Act” (Section 506 (c) of the new Act). That contains pages and pages of requirements which could apply to both types of loans. Based on some of the preliminary reports from the SBA, it appears it applies to both SBA and non-SBA loans.

3. These monies are subject to availability in the funding of Congress. Some think the way we are going with our Federal bailout, we are going be out of money before the economy we are trying to save.

4. You don’t get these monies unless you are a viable business. Boy, you can drive a truck through that phrase. Our friends at the SBA will determine if you are “viable” (imagine how inferior you will be when you have to tell your friends your business was determined by the Federal government to be “non-viable” and on life support).

5. You have to be suffering “immediate financial hardship”. So much for holding out making payments because you’d rather use the money for other expansion needs. How many months you have to be delinquent, or how close your foot is to the banana peel of complete business failure, is anyone’s guess.

6. It is not certain, and commentators disagree, as to whether the Federal government through the SBA will make the loan from taxpayers’ dollars or by private SBA licensed banks. In my opinion it is the latter. It carries a 100% SBA guarantee and I would make no sense if the government itself was making the loan.

7. The loan cannot exceed $35,000. Presumably the new loan will be “taking out” or refinancing the entire balance on the old one. So if you had a $100,000 loan that you have been paying on time for several years but now have a balance of $35,000 and are in trouble, boy do we have a program for you. Or you might have a smaller $15,000 loan and after a short time need help. The law does not say you have to wait any particular period of time so I guess you could be in default after the first couple of months.

8. You can use it to make up no more than six months of monthly delinquencies.

9. The loan will be for a maximum term of five years.

10. The borrower will pay absolutely no interest for the duration of the loan. Interest can be charged, but it will be subsidized by the Federal government.

11. Here’s the great part. If you get one of these loans, you don’t have to make any payments for the first year.

12. There are absolutely no upfront fees allowed. Getting such a loan is 100% free (of course you have to pay principal and interest after the one year moratorium).

13. The SBA will decide whether or not collateral is required. In other words, if you have to put liens on your property or residence. My guess is they will lax as to this requirement.

14. You can get these loans until September 30, 2010.

15. Because this is emergency legislation, within 15 days after signing the bill, the SBA has to come up with regulations.

Here is a summary of the actual legislative language if you are having trouble getting to sleep:

SEC. 506. BUSINESS STABILIZATION PROGRAM. (a) IN GENERAL- Subject to the availability of appropriations, the Administrator of the Small Business Administration shall carry out a program to provide loans on a deferred basis to viable (as such term is determined pursuant to regulation by the Administrator of the Small Business Administration) small business concerns that have a qualifying small business loan and are experiencing immediate financial hardship.

(b) ELIGIBLE BORROWER- A small business concern as defined under section 3 of the Small Business Act (15 U.S.C. 632).

(c) QUALIFYING SMALL BUSINESS LOAN- A loan made to a small business concern that meets the eligibility standards in section 7(a) of the Small Business Act (15 U.S.C. 636(a)) but shall not include loans guarantees (or loan guarantee commitments made) by the Administrator prior to the date of enactment of this Act.

(d) LOAN SIZE- Loans guaranteed under this section may not exceed $35,000.

(e) PURPOSE- Loans guaranteed under this program shall be used to make periodic payment of principal and interest, either in full or in part, on an existing qualifying small business loan for a period of time not to exceed 6 months.

(f) LOAN TERMS- Loans made under this section shall:

(1) carry a 100 percent guaranty; and

(2) have interest fully subsidized for the period of repayment.

(g) REPAYMENT- Repayment for loans made under this section shall–

(1) be amortized over a period of time not to exceed 5 years; and

(2) not begin until 12 months after the final disbursement of funds is made.

(h) COLLATERAL- The Administrator of the Small Business Administration may accept any available collateral, including subordinated liens, to secure loans made under this section.

(i) FEES- The Administrator of the Small Business Administration is prohibited from charging any processing fees, origination fees, application fees, points, brokerage fees, bonus points, prepayment penalties, and other fees that could be charged to a loan applicant for loans under this section.

(j) SUNSET- The Administrator of the Small Business Administration shall not issue loan guarantees under this section after September 30, 2010.

(k) EMERGENCY RULEMAKING AUTHORITY- The Administrator of the Small Business Administration shall issue regulations under this section within 15 days after the date of enactment of this section. The notice requirements of section 553(b) of title 5, United States Code shall not apply to the promulgation of such regulations.

The real question is whether a private bank will loan under this program. Unfortunately, few will do so because the statute very clearly states that no fees whatsoever can be charged, and how can a bank make any money if they loan under those circumstances. Sure, they might make money in the secondary market, but that is dried up, so they basically are asked to make a loan out of the goodness of their heart. On a other hand, it carries a first ever 100% government guarantee so the bank’s know they will be receiving interest and will have no possibility of losing a single dime. Maybe this will work after all.

But there is something else that would be of interest to a bank. In a way, this is a form of Federal bailout going directly to small community banks. They have on their books loans that are in default and they could easily jump at the chance of being able to bail them out with this program. Especially if they had not been the recipients of the first TARP monies. Contrary to public sentiment, most of them did not receive any money. But again, this might not apply to that community bank. Since they typically package and sell their loans within three to six months, it probably wouldn’t even be in default at that point. It would be in the hands of the secondary market investor.

So is this good or bad for small businesses? Frankly, it’s good to see that some bailout money is working its way toward small businesses, but most of them would rather have a loan in the first place, as opposed help when in default. Unfortunately, this will have a limited application.

Wouldn’t it be better if we simply expanded our small business programs so more businesses could get loans? How about the SBA creating a secondary market for small business loans? I have a novel idea: for the moment forget about defaults, and concentrate on making business loans available to start-ups or existing businesses wanting to expand.

How about having a program that can pay off high interest credit card balances? There is hardly a business out there that has not been financing themselves lately through credit cards, simply because banks are not making loans. It is not unusual for people to have $50,000 plus on their credit cards, just to stay afloat. Talk about saving high interest. You can imagine how much cash flow this would give a small business.

We should applaud Congress for doing their best under short notice to come up with this plan. Sure this is a form of welcome bailout for small businesses, but I believe it misses the mark as to the majority of the 27 million business owners that are simply looking for a loan they can repay, as opposed to a handout.