Selling a Business – Part II – The Value of the Valuation

Posted by Carl Doerksen on February 8, 2012 at 10:00 AM

A few weeks ago we started a series of articles about the process of selling a business. This is the second in the series and deals with the next step. As you’ll recall, the first step when selling a business is simply deciding that now is the time to sell.

importance of a business valuation when selling a businessMany of you are confronted on a daily basis with the fact that the volatility of our economy and pending geopolitical issues are making the risks associated with owning your own business greater than ever. Because of this, we are meeting more and more business owners who have decided that now is the time to begin some serious exit planning. If you find yourself in this situation, our series of articles on selling your company should be very helpful (you also may want to attend one of Generational Equity’s workshops about how and when to exit your business for the most profit. To learn more about them, click here).

After you have decided to sell your business, the vital next step is determining what your company is worth in today’s market. The “value” of your business valuation cannot be overstated. If you approach the market with no idea what your company is worth, how will you know which offers you should accept?

The evaluation of your company is an important step in positioning your company to be “buyer ready.” If you would like to learn more about how to develop a buyer ready business, please click here and you will be able to download our whitepaper on the topic.

Accurate Recasting – The Foundation of the Valuation

Because of the critical nature of this step, deciding to have a third party do an evaluation of your firm is well worth the investment. Of course you can do this on your own if you are well versed in the practice of “recasting.” If you have not heard of this term or if you are not sure what it entails, I would highly recommend that you hire a professional firm do this for you.

Recasting is the accepted accounting principle of removing or adjusting items on your financial statements that are unrelated to the ongoing business. Many of you have worked hard over the years with your accountants to under-report your earnings for tax purposes, which is perfectly legal and acceptable. But it understates the true value of your company.

Keep in mind one key principle: Professional buyers are buying your future, not your past. But the only way to accurately highlight your future profitability is by recasting your historical financials and then project out three to five years using the new recast baseline as your starting point.

Items removed or adjusted via recasting can be superfluous, excessive, or discretionary expenses and nonrecurring revenues and expenses. The recasting process can be quite time-consuming and tedious. The person providing the service will ask you lots of questions and will dig deeply into your historical financials to find as many legitimate recastable items as possible.

Again, buyers are buying your future and will base their offers on what they see in your financials. So if they are not recast accurately, your documentation could understate your profitability, impacting what buyers will pay for your company.

For example, let’s assume a buyer is looking at two similar companies in the same industry. Both are generating the same level of revenue, and Company A is showing $500,000 in EBITDA (earnings before interest, taxes, depreciation and amortization) on its latest fiscal year income statement. However, Company B, again doing the same level of revenue, was wise enough to have its financials recast and it is showing EBITDA of $750,000. Which of these companies do you think will receive a better offer? Assuming that there are no extraneous issues affecting Company B, it will most likely generate better offers than Company A. So you can see how vital recasting is in protecting you from offers that are too low.

Questions, Questions and More Questions

experienced m & a advisory firm doing business valuationBut recasting is just one part of the evaluation process. In a sense, a good evaluation of your company is very similar to the due diligence that buyers will ultimately conduct on your company. Although due diligence will involve much more intense scrutiny of your company, any reputable firm that has done evaluations for years will ask you a series of questions and will delve deeply into your business. The goal in this evaluation process is to expose not only your company’s strengths, but also any perceived weaknesses that could affect buyers and their future offers.

For example, some of the following questions could be asked of you during the evaluation: 

  • Do you have any patents?
  • Does your company have an established brand in your market?
  • Who are your long-term customers? Do you have contracts with them?
  • How many suppliers of your raw materials do you have?
  • Who are your key employees? Why are they key?
  • Do you have a solid middle-management team in place?
  • What is your employee turnover ratio?
  • Union vs. non-union employee base? If union, when does the current contract expire?
  • Do you have a backlog of orders?

This is just a short list of questions you may be asked by any experienced firm evaluating your company. Business owners often become frustrated with this process because it requires quite a bit of your time and can be laborious. However, if you work closely with your advisors during the evaluation, you will probably be amazed at what you will learn about your company. You will also be surprised at how you can improve your operations and enhance your value to buyers by implementing some very simple steps along the way.

How to Determine the Value

As I mentioned earlier, it is possible to produce an evaluation of your firm on your own. If you have an accountant that is experienced with recasting (many are not), and if you have the time to spend not only asking yourself these hard questions but also objectively documenting them, you could produce your own evaluation document. However, having done the recasting, the question now becomes how do you determine the value of your company? This is where it becomes critical to have the services of an experienced M&A advisory firm.

You may be aware of standard “multiples” for your industry, and sometimes these can be quite accurate. But again, professional buyers are buying the future. This means that they will project your recast earnings into the future and then will “discount” them back into today’s dollars using a discount rate that matches their internal rate of return for comparable investments like yours (the “discount rate” is based on a variety of factors including risk, stability of the investment, believability of the projected revenue growth, etc.). This is where it really gets complicated.

Ultimately, a number of methods need to be examined to accurately value your company. In addition to the discounted cash flow analysis, other methods that can be used are industry comparables, rule of thumb multiples, asset-based valuations, preceding transactions, etc. Each method has its strengths and can be used alone or in conjunction with other methods depending on your business. Unfortunately, time and space does not allow me to delve deeply into all of the valuation methods used. Suffice to say, this topic could be several future articles alone.

The Bottom Line

The bottom line is this: The valuation of your company sets the benchmark for where you will expect offers. If it is not done accurately, you could be undervaluing your company, placing your expectations too low. Conversely, you could also over-value your firm and end up with expectations that are way too high.

These are things you can avoid if you obtain the services of an experienced M&A advisory firm at the outset of this process. Be sure to contact firms that will not only value your company but will also stand behind their valuation and represent you in the market. This really is key. Lots of firms will value you, but if they are unable to represent you in the market, how legitimate is that valuation?

Once you have developed a buyer ready business and have decided to sell, make sure that the valuation is done accurately. Don’t skimp on this step and try to save money by hiring a firm with less experience. The old adage is true: You get what you pay for.

Generational Equity has been valuing and selling businesses for years. Our team of financial analysts and evaluation managers is second to none in our industry in terms of experience and skill. Their abilities are matched by our deal-making teams that have proven over the years that they can effectively close deals. If you are interested in talking with us about your company and its valuation options, please click here to contact us. 

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No matter who you ultimately use to value your company, be sure to work closely with them during the process and ensure that every possible recast is identified and documented. In the end, when the deal closes and you achieve your financial dreams, all the hard work during the evaluation phase will have been worth it.

Carl Doerksen is the Director of Corporate Development at Generational Equity.

© 2012 Generational Equity, LLC All Rights Reserved

Topics: documenting your business, selling a business, exiting your business, selling your business, valuation

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