Business Valuation Fundamentals for Financial Advisors

You don’t have to be the ‘valuator’… just a reliable resource

by David Fein

Part three in a 3-part series

For advisors, business owners represent a special breed of clientele with their own unique financial needs. Being able to have conversations with business owners about the value of their business, how that value is derived, and how operational and strategic decisions ultimately affect value gives you a competitive edge and solidifies your reputation as the trusted advisor who understands their unique needs.

Financial Advisors do not need to become “valuators”, but instead, should strive to be a professional resource who, not only understands valuation basics, but also one who can educate and make intelligent recommendations and referrals – positioning you as an invaluable resource to business owners.

You need to be able to help a business owner determine a reasonable value for their business so you can incorporate that value into their planning process. In fact, how can you prepare an accurate and comprehensive financial, retirement or estate plan for a business owner if you don’t have a realistic value for their business?

What is Business Value?

In the simplest terms, “value” is an educated opinion of what someone will probably pay for something. In the case of a business, “value” is what a seller will probably receive as consideration for transferring the rights of the business to the buyer. However, in the world of business valuation, there is more than one definition of “value” and it’s important to know which definition of value should be used in different situations. Here are three common definitions of value called “Standards of Value”:

Fair Market Value – This is the most commonly used and recognized valuation definition for formal valuations.
Fair Value – This definition is subject to state law or legal precedent that may be used in shareholder disputes or divorce asset allocation.

Brokers’ Opinion of Value or Most Probable Selling Price – This is when a business broker determines the value of a business and is not considered a formal valuation.

Formal Verses Informal Valuation

Formal (certified) valuations have a specific place in the business world. Formal valuations are required in situations like divorce, issuing stock options, death of a business owner, gifts of private company stock, and various other IRS actions. A formal valuation typically costs between $5,000 and $18,000, can take weeks to complete, and requires extensive data gathering from the business owner and the accountant. A formal valuation is needed if your client needs a definitive value performed by an accredited valuator. If your client needs a formal valuation, you can refer them to www.NACVA.com, the nation’s largest association of certified valuation professionals.

Informal (ballpark) valuations are more prevalent in the day-to-day business world. This is because there are many circumstances that do not need a 100% verifiable expert-backed value. These values are used for decision making like the following:

• Financial, estate, and retirement planning
• Planning a tax and/or exit strategy
• Selling or buying a business
• Determining the correct amount of life insurance and/or buy-sell insurance
• Analyzing strategic business decisions

If your client needs an informal valuation, you can (and probably should!) subscribe to one of the several online business valuation tools available for Financial Advisors – or you can refer them to someone who routinely provides informal valuations. Either way, you’re providing a value-added service and “heads up” that many Advisors would pass by.

The Valuation Formula

The formula for all business valuations is Value = Future Cash flow / Risk to Achieve Future Cash flow. Cash flow is something all business owners understand. However, risk is very much overlooked and misunderstood. Which is why it is a common misconception amongst business owners that the value of their business is determined largely by revenue and cash flow. The truth is that business value is much more than simply the revenue and cash flow (i.e., “the financials”), it’s actually related to the overall ability of the business to produce revenue and free cash flow in the future. Businesses with the same sales and cash flow sell for significantly different amounts.

Business Valuation Approaches

There are three main approaches to business valuation: the income, market, and asset approaches. Choosing which approach is best depends on the type of business being valued, and many times, multiple approaches are used to come to a final opinion of value. Every approach has advantages and disadvantages.

Income Approach
This is the preferred approach used for business valuation. It is based on calculating what the future cash flow to the owner of the business is worth today, also called the “present value”, or the “discounted cash flow”. The advantage is that the predicted cash flow and the risk to achieve that cash flow are related directly to the current operational state of the business and, therefore, directly values the business. The disadvantage is that both the cash flow and risk are simply predictions of the future – and of course predicting the future is challenging.

Market Approach
The market approach is the most common approach in valuation. The best evidence of the value of a business is the market, or what other similar businesses have sold for (think of the MLS® system for residential real estate). The market approach looks at what similar businesses have sold for and then uses multiples (to adjust for size) to determine the value of a business. The advantage of the market approach is that it relates the current value of a business to what buyers have previously paid for a similar business. The disadvantage is that it is difficult to find a directly comparable business. Usually, businesses are compared as to product/service, size, and geography. However, it is very difficult to compare the competitive advantages of one business to another business even if both sell the same product, are the same size, and operate in the same geographic area.

There are several databases that contain business sales data including ValuSource Market Comps®, Bizcomps and DealStats. This data is collected from business brokers that have completed a transaction and reported the sale to the aforementioned services.

Asset Approach
The asset approach looks at the value of the business in terms of the market value of its assets only. To accurately determine the value of the assets an appraiser may need to be hired. For most service-based businesses, the assets (furniture, fixtures, and equipment) are small, but other types of businesses like a manufacturing company may have substantial assets. Note that the value of real estate and buildings is usually excluded from the value of the operating entity. The advantage of the asset approach is that it will establish the lowest value of a business. The disadvantage of this method is that it does not really establish the highest and best use value of the assets in the business.

The Business Valuation Roadmap

One important thing you can do as an Advisor is help business owners understand the business valuation “roadmap”, meaning the range of what businesses sell for. This means providing them the range of values (ballpark figures) based on their specific business situation. Business owners need to understand what businesses like theirs actually sell for because they tend to substantially overestimate their own business value. It is a difficult conversation to tell a business owner that their sweat equity did not increase their company’s value as much as they expected, but as an Advisor, having accurate and substantiated data in hand helps with focusing the conversation on fact vs. opinion surrounding this charged topic.

Based on data from businesses that have sold, here are some general guidelines on business value ranges:

• 2 to 6 Times Earnings (companies with under $2 million in sales) – in this type of transaction, the buyer is actually just purchasing a “job” (i.e., everything the owner takes out of the business in terms of salary, bonus, perks, etc.) and the selling price is normally between 2 and 6 times earnings.
• Rule of 5 (normally companies with over $2 million in sales) – 66% of businesses sell for 5 times EBITDA (Earnings before interest, taxes, depreciation, and amortization). This scenario typically occurs when a company (rather than an individual) is a strategic buyer, the CEO/owner is typically replaced and there is usually at least a 5-year pay back to the previous owner.
• Rule of 10 –A large strategic buyer (company) with operational/financial synergies, the purchase will allow the buyer to eliminate at least 20% of the acquired company’s overhead. Here the average price is 10 times EBITDA.

The Valuation Roadmap Data Story

When you look at business sale data, it tells a compelling story of what businesses sell for and how much more a better performing business is worth to a potential buyer. A “better performing” business means a business with similar revenue and cash flow is selling for more (or even, much more) than its peers. Business owners understand that businesses with more revenue and cash flow will sell for more, however, what they do not understand is that the range of what businesses sell for with the same revenue and cash flow is very large! This means there are two fundamental things a business owner can do to improve value: first is to improve revenue and cash flow; second is to improve “business performance”. One example of “business performance” is recurring revenue – a business with a higher percentage of recurring revenue will typically sell for more than a business with a smaller percentage of recurring revenue.

Performance, Risk and Business Value

Let’s look at Price to Earnings (P/E) ratios of 6,185 restaurants that have previously sold in the US. In the table below, the Percentile number is the Price to Earnings ratio at the 10th, 50th and 90th percentile.

This data tells us that restaurants at the 90th percentile sell for 5 times more than restaurants at the 10th percentile – WOW! This has nothing to do with the higher performing restaurants having more revenue or cash flow, instead the difference is purely based on having better performance which is unrelated to revenue and cash flow. From the valuation perspective, better performing businesses have less risk than poorer performing businesses.

Conclusion
Without becoming a “valuation professional” you can obtain new clients and significantly help your existing business clients, by helping them understand the value of their business and the roadmap to improving that value. You can take the next step by helping them to understand the importance of this information.

For a FREE demo and 15-day Trial of the Online Business Valuation platform, please contact kstockton@valusource.com or call 719-799-6014.