How Might a Buyer Consider Valuing My Company?
Welcome to the first in a series of articles aimed at aiding you in using Business Valuation as a strategicplanning tool.
A buyer may use up to three approaches to determine the value of the business. One is to look at comparablebusinesses that have recently sold. Depending on the industry type, this information may or may not beeasily obtained. Some industry groups form peer groups to measure performance. For example, somefranchised restaurants share performance metrics with others in the peer group. The metrics are oftentimesbased on cash flows, revenues or book value. In the Valuation profession, we refer to this as the MarketApproach.
Another approach is to examine cash flows. Sufficient cash flows are what can make or break a company.Therefore, the buyer will ask, “Can I pay myself a reasonable wage and still make a bank payment? Howmany ye
ars will I need to finance the purchase with current cash flows?” Without sufficient cash flows, abuyer could face challenges in purchasing new equipment, researching a new product line, expanding servicefootprint or managing working capital. In the Valuation profession, we refer to this as the Income Approach.
Finally, a buyer may simply look at the fair market value of inventory and equipment. He/she may not bewilling to pay a premium for a business that could be started from scratch. For example, a company that doesnot have strong cash flows may only be worth the value of its fixed assets (fixtures, furniture, equipment,and working capital which is accounts receivable plus inventory less accounts payable). This is referred to asthe Net Asset Approach.
Because value derived by both the Market and Income Approaches are based on cash flows, it important forbusiness owners to omit any personal expenses from the business. Only expenses that are related to thebusiness operations should be included in company financial statements. Moreover, any assets that are notrelated to operations (snowmobile, boats, airplanes, etc.) should be removed from the Company’s balancesheet.
If your exit strategy involves selling your company, you need to plan ahead. Having clean, profitable andstrong financial statements for the last five years could raise fewer questions and lend to a smooth transition.
Please contact me with any questions when valuing a company that you are buying or selling.