Business Valuation - In Theory and Practice

Reason For Having a Business Valuation and How to Prepare

Usually, the reasons a business valuation would be required would be to a.) bring in a new outside partner or investor, b.) establish the value of a company for management to buy in, c.) for succession purposes, d.) for banking purposes, or e.) if the owner is looking to sell the business and wants to establish a target price.

We believe being prepared for your business valuation and having it be a proactive process rather than a reactive process is critical to maximizing value. That is: if you are an owner who knows that 3 to 5 years from now you would like to slow down and maybe exit the day to day operations of your business, then don’t wait until then to start as this approach is surely to generate a lower value.

Preparations for Valuation

Preparing for a business valuation has quantitative, administrative, and qualitative elements to it. Quantitatively, the business is likely to be valued based on two or three metrics being a multiple of EBITDA, a multiple of assets, and perhaps a multiple of cash flow. The potential purchaser may conduct a more comprehensive valuation perhaps using a discounted cash flow method to generate a target price, but ultimately it most always comes back to measuring this value against multiples of EBITDA, assets, and/or EBIT to determine its reasonability. Qualitatively and administratively, there is a number of things that you should to prepare but namely include having your company fully organized to facilitate the due diligence and give the potential purchaser the assurance that your business is not a "one generation" business but rather a scalable business that could be easy to integrate.

Top 10 Things to Do

So what should you do to prepare for a business valuation and generate the best value possible? Here are the top 10 that we recommend you want to do as a minimum:

  1. Clean up the organizational structure of the company - if you have subsidiaries or companies that are silent, then wind them up
  2. Get the company’s minute books, bylaws, and other corporate documents updated and in order
  3. Develop your organizational structure early so that you have a proper succession plan in place. At a minimum, you want to start grooming your successor now. If you don’t have this person in your company, then go and hire him or her. Purchasers want to acquire commercial goodwill rather than personal goodwill. The simplest way to define the difference between these two is if you can leave for six months and not have your company encounter serious difficulties, then you have commercial goodwill. Alternatively, you have personal goodwill and purchasers are reluctant to buy it.
  4. In line with the previous point, you wan to develop some decent biographies on your key management team. This doesn’t mean you write a full 2 pages on each manager, just make sure you have a well crafted paragraph that speaks to the strengths of your key people. Relevant experience is more important than education.
  5. Collect all significant customer and supplier contracts in place. If you have any customer contracts that specify a certain term and set pricing, then make sure you have them available. Purchasers look for certainty in the revenue stream as well as the ability to raise rates post acquisition. When you are promoting your company, you want to make sure you point out the ability to raise the revenue line by potentially increasing price.
  6. If you don’ already have one, invest in a designated accountant (i.e. a CPA) to act as a full time controller. Notice we use the word "invest". Most small businesses don’t consider this expenditure important, and end up having a family member do the books or their external accountant review the books once a year when a tax return needs to be filed. This is not the way to go if you are looking to max out the value of your business upon sale. A good controller would add credibility to your team and can do a whole subset of things to clean up your business which are discussed in the following points.
  7. Scrub the last few years of historical performance to make sure that any expenses of a capital nature are identified to put on the balance sheet rather than reduce your EBITDA.
  8. Get all balance sheet accounts cleaned up particularly those affecting working capital and capital assets. A purchaser is likely to require you deliver a certain level of working capital as part of the purchase price but will likely not take receivables over 90 days or old inventory, so get this cleaned up first. Also, a solid continuity schedule of capital assets is a big plus, as purchasers will want to reconcile the purchase price or enterprise value of the business against the tangible net assets to calculate goodwill paid. Therefore, having a good paper trail to the capital assets acquire is very important.
  9. Ensure your accounting and information system can deliver accurate and reliable information. What this means is don’t do "cash accounting" once every three months or every year. It means making sure a proper set of financial statements can be produced that is in accordance with U.S. generally accepted accounting principles or international financial reporting standards. This is where a good controller is valuable. Not only can they provide you with more timely information that you can use to run the company, but they can also professionalize the reporting and put in place the processes to deliver this reporting on a more timely basis. This would show a purchaser that the information upon which they will be making their decisions is reliable.
  10. If you have any hard assets i.e. property or equipment that will be included in the business valuation, then get a full or desktop appraisal. We usually recommend you only include the assets required to generate the business income be included in the transaction. Other assets such as real estate should be excluded and leased back to the company after it has been bought therefore creating a nice passive income stream for you. Regardless of how the transaction is structured though, you need to know right from the go what the fair market value of the assets is, as this would be the price floor in your head. Of course you want to get goodwill for your business, but what that goodwill is will be determined by the value of the assets. You are better off knowing that yourself than letting the purchaser conduct their appraisal and telling you.

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Written by Divestopedia Team
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Divestopedia is a resource for entrepreneurs who want to sell their business for the best price and terms. Whether you are thinking of selling, have started a sales process, or are post-deal, we aim to arm you with the knowledge required to maximize value and limit your downside risk. Full Bio