How Privately Owned Businesses Are Valued by Buyers and Lendors

In your taking the time to read this, the last thing I want to do is waste your time or mislead you, so I’m going to give you the disclaimer right up front --- there is no one single formula that applies to all types, sizes and businesses in all areas across the US. So, after that initial disappointment, read on and you will start to have an understanding of the many different, very subjective issues that are involved in valuing a privately owned business.

In the vast majority of cases, a Buyer will come to a decision as to the value of a business they are interested in buying based upon six primary issues: {a} the business’ demonstrated and historic earning power, {b} what the buyer believes that they can generate in the way of future earnings with their efforts, talent, drive, capital, etc., {c} the value of the assets, minus any liabilities that are assumed, that come with the business as part of the purchase price, {d} the tax benefits, or lack thereof, that are part of the structuring of the business, {e} the type and nature of financing that is available, and {f} the buyer’s perception of the risks involved in the particular business, its industry and the anticipated economic environment.

While some of the above are simply mathematical computations, the others are highly subjective issues that vary from one buyer to another. Thus, the first understanding of business valuation is to be aware that it is not a single number to designate value but, more appropriately, it will be expressed as a range of value. Why a range? Simply because different buyers view the above 6 factors quite differently and therefore come to very different assessments of value.

Other than a buyer’s evaluation of the degree of the risk involved, a buyer’s perception of future earnings will drive their Return on Investment (ROI) calculation. Simply stated, all buyers tend to have minimum ROI expectations, and those expectations vary from buyer to buyer. The ROI calculation is made by determining the business’ recast stabilized earnings (typically expressed as EBITDA --- Earnings Before Interest, Taxes, Depreciation and Amortization), which is after a reasonable rate of Owner Compensation. EBITDA is then computed as a percentage of the total Purchase Price to determine the projected ROI for someone acquiring the business at that purchase price, regardless of whether they pay cash or finance the purchase.

In the preceding paragraph I refer to the word ‘recast’, and it simply means that few privately owned businesses operate in such a manner as to maximize their earnings (and taxes) on their tax returns. Therefore, a vital and necessary step in the valuation process is to recast the tax return numbers so as to eliminate the influence of owner discretionary and non-cash items.

The degree of risk, high or low, that is anticipated in a given business will be reflected by the buyer demanding either a higher ROI or a willingness to accept a lower ROI. Thus, as a buyer’s ROI expectation goes up, the purchase price goes down and vice versa. To further add to the variability of value conclusions is the fact that different buyers will assess risk differently, and an issue that might really concern one buyer might be of little concern to another. An extension of this axiom is that the same earning power in two businesses that are in two different industries will have very different market values, just as two ‘identical businesses’ located in different parts of the US can sell for significantly different prices as there are regional differences in both supply and demand.

The reality of ‘the range of value’ in valuing privately owned businesses underscores the critical importance of effectively and confidentially marketing a business. By logic and reason, a minimal marketing effort, or simply waiting for an unsolicited buyer, does little to assure your business being exposed to enough different buyers to come across those who will consider paying the upper end of your range of value.

While I know that you have heard of people who sold their businesses at ‘x’ times revenue or ‘y’ times earnings or some other shortcut abbreviation of valuation, please don’t make the mistake of assuming that the same shortcut formula applies to your business. Whether a business sells at 3 times revenue, 1 times revenue or 50% of annual revenue, those numbers are an incidental and meaningless relationship as, most assuredly, that is not how the buyer determined a price that they were willing to pay. To prove the point, two businesses with identical revenues but with very different levels of profitability will obviously have different market values.

Another key aspect of selling a business is to make certain that you get paid for it, as agreed. ‘Seller provided financing’ is a very high risk approach, and thus getting either cashed out or substantially cashed out is invariably in your best interests. The fact of the matter is that, unless the value of your business is a very low dollar amount, few buyers will have all the cash necessary for the purchase and will need to have an outside lender involved. While it will vary by the value and type of your business, you will find that conventional bank loans are ‘collateral based’ --- they will only lend a small percentage of the purchase price of a given business --- and are therefore are not an attractive resource.

If your business has a market value of less than about $2.5 million, you will find that SBA guaranteed financing can provide your buyer with a high percentage of the funds needed to get you either completely of very nearly fully cashed out. Above that value range, the SBA is not meaningful source; however, the nature of the buyers tends to change so that they tend to have access to greater funds, etc. You should also be aware that out of all of the SBA ‘preferred lenders’, only a small percentage are highly responsive to and effective in expediently approving, processing and closing transactions.

So much for lender background. Let’s look at how lenders approach the issue of valuation of a business. Non-SBA lenders will generally loan about 60% to 80% of the liquidation value of the assets or collateral provided to secure the loan. On the other hand, SBA guaranteed lenders are ‘cash flow lenders’ who look at the last two years for which tax returns have been filed and recast the reported earnings, from which they deduct a reasonable owner salary and determine the ‘available pre-tax cash flow’. This dollar amount is then compared to the annual debt service necessary to amortize the loan (generally over 10 years), and a reasonable ratio between the two is required. In practical experience over a number of years, the SBA valuations tend to be higher than most buyers will agree to pay for a given business.

Hopefully the foregoing will have been of assistance in understanding that in valuing a privately owned business ‘one size does not fit all’ and that the process is highly subjective and best approached by an honest and experienced individual who is actively involved in the sale of privately owned businesses.