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Five Key Factors When Valuing a Privately Held Business

4/22/2015

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To identify the best buyer and maximize purchase price, the business owner and the business broker should both be able to articulate the value drivers for the company. Clearly articulating these points can help a potential investor see the value of your business.

Below are 5 key value drivers that must be discussed as early as possible in the process so that all parties are on the same page:

1. Customers

One of the most important value drivers to discuss is your customer. An understanding of how a business makes money and who its customers are is essential for any potential buyer and deal negotiation. Too often, I see write-ups or pitch books of a business that do not explain how the business makes money. You must be able to answer that question; you have to succinctly be able to tell someone how the company makes money.

You also have to be able to speak to how you acquire customers. What is the profile and size of your customer base? How do you engage with them? Having a more organized CRM and legitimate salesforce, while not necessary for a successful deal, can help demonstrate to an interested buyer that you are working with regular, sustainable customers.

Last, but not least, you also have to be able to speak to how you lose customers. If your customers are able to abandon your business overnight with little to no switching costs, it will be a red flag for many buyers. If you have customers that can leave next week without pain and heartburn, that’s not a good thing. While it is not an insurmountable challenge, the deeper entrenched your business is in the customer’s life and business, the better.

2. Industry & End Markets

In addition to your customers, it is imperative to be able to comment on the size of addressable market. There is no need for detailed reports, but you must have a sense of the number of potential customers and trends in that space. Is your industry growing or shrinking? Is there heavy regulation? These types of extra-company factors can make realizing a successful investment difficult for most business buyers.

3. Suppliers

We already discussed the addressable market and your customers, but now it is time to consider your suppliers. The two questions you need to address are:

Are their any supplier concentrations? If your business is being influenced by your supplier because of their consolidation or control of the market, that is not a deal killer, but it is something that must be disclosed to the potential buyer as soon as possible. It is important to understand the costs and risks of switching suppliers.

Can a supplier go straight to your customer? If that is the case, it makes investors very nervous. Most sophisticated investors want to see a fundamental, tangible reason why your business exists. If you are relying on opportunistic inefficiencies, there is a great deal of risk that your business will be squeezed out by larger competitors or those with vertical integration capabilities. You need to demonstrate that your firm will be around for a long time because it is addressing a clear need.

4. Competition

As the interested investor gets the lay of the land, he will also need to know about the level and type of competition surrounding your company. You will need to effectively be able to address the presence of any competitors and how you differ from them. What are the variables? Price? Service? Location?

if there is no competition, then you still need to explain why the customer is buying from you. Are they buying from your firm because of the salesperson? Or because of the right price? It may sound like a silly question, but it is fundamental to why a company exists. The more and better you can answer the question, the more value you can demonstrate in your business.

5. Management & Financials

Only after understanding the full ecosystem in which you company exists will the investor begin to look into the company itself. Understanding the key stakeholders and management of the business is absolutely crucial to a successful deal.

Many potential buyers will spend a great deal of their time getting to know the sellers and making sure there is a fit.  The transition of a business from seller to buyer is very critical and the two parties must be able to work closely together and have a level of trust between the two parties.  Without developing a level of trust the deal could fall apart quickly.

When it comes to financials, the numbers will be what they will be. At this stage of the process, the investor is probably most interested in seeing how organized your business is. The numbers need to be reliable. We don’t want to be in a situation where we’ve made a deal, then did some diligence only to discover that we were misled. In those situations we have to break the deal, which is disappointing for everyone involved. The more confident we feel in your ability to track numbers, the more confident we will feel about the deal. However, don’t worry about too many add-backs or no CFO — just be systematic with the process.

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How to Value Your Business

4/8/2015

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There are three main ways to value a privately held business.  This week we will be discussing the most popular approach, which is Seller’s Discretionary Earnings, oftentimes referred to as Cash Flow.

Seller’s Discretionary Earnings

In this method, the Business Appraiser creates a cash flow worksheet derived from historical income statements or preferably tax returns. The Appraiser analysis the financials and add backs interest, owner’s compensation, any non cash related expenses as well as “non essential business expenses” to the bottom line. 

Interest is added back to the bottom line if the debt will not be passed on to the buyer.  This applies to asset purchases, but not stock purchases.  The owner’s compensation is added back to the bottom line since this is a benefit the new owner will acquire if they are hands on.  For a passive buyer they will discount the owner’s compensation based on the market price for hiring an employee to handle the seller’s duties. 

Two common non cash expenses are depreciation and amortization.  Even though no cash is involved these are legitimate expenses a business owner may use.  Adding back the non essential business expenses requires a conversation with the business owner.  These are typically expenses used to minimize taxes and are not required to run the business effectively or efficiently. A common example is travel expenses for a business such as a restaurant that does not offer delivery or catering.  The owner expenses trips where they discuss business, but we all know a trip to Las Vegas or New York isn’t typically required to operate a restaurant in the Florida Panhandle.

A completed cash flow worksheet with the add backs shows a potential buyer what they can expect as their true future cash flow keeping everything constant.  Of course business is never constant so a buyer will consider other items such as stability of cash flow, time value of money, and current market conditions when creating their projected owner’s benefits.  However, for the purpose of this article we will project a constant cash flow for the buyer.

Once everything is complete the appraiser will apply an industry standard multiple to the seller’s discretionary earnings and adjust it based on their analysis of the business as well as current market conditions.  Lastly, the cost of current hand’s on inventory is added to the valuation to calculate the final appraised value.  


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    Jeremy Hovater

    President, Sunset Business Advisors

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