May 12th 2008 06:58 pm

Serious Selling Your Business part 4

ASSET VALUE

For most companies the asset value should represent the lowest amount below which the owner might just as well liquidate. There are only two differences between asset value and liquidation value. In calculating asset value you don’t have the costs of liquidation and you can be more generous in appraising certain assets than you might be if you had to liquidate.

INDUSTRY STANDARD VALUE

It’s common in many industries to have a valuation method. Travel agencies are generally valued at ten times annual commission. Manufacturers’ reps, on the other hand, are generally only worth one year’s commission. Magazines use a certain number of dollars per subscriber. Manufacturers might expect to get between two and ten times annual earnings.

In some industries it would be very hard to get more than this standard valuation because everyone has used the rule for so long. This would be especially true if there are always several similar companies on the market at any given time.

On the other hand, some of these approaches are almost useless in assessing value. For most very small businesses, the real value is whatever the market will bear. The use of any type of industry standard, however, may help the seller convince the buyer that the offering is reasonable.

ENTERPRISE VALUE

Business BlogThe most logical and reasonable approach for both seller and buyer is to determine the enterprise value. Other than the esoteric aspects of ownership such as control, ego, and the like, the real value of the company to its owner is how much revenue and how much wealth it will produce. (And the seller can point out to the buyer that there would be certain costs to him if he were to attempt to build this enterprise from scratch. The buyer wouldn’t want to pay much over what he could do it for himself )

Revenue and wealth must always be weighed against risk. The seller must realize enough cash from the sale to produce the same amount of revenue adjusted for risk. (For example, a gift shop owner may be receiving $100,000 per year from his business, but admittedly incurring a certain amount of risk as well—a certain amount of sleepless nights. If he were receiving $75,000 a year from certificates of deposit or 1-bills after the sale, the $25,000 difference would represent the amount the owner would be paying for the lower risk—the deeper sleep—associated with both the income and the principle in the CD’s versus the gift shop.)

How does one arrive at enterprise value? A common method is to use five years of income plus ending liquidation value, discounted to present value.

Begin by taking at least five years of previous income statements. If possible, recast these in the way the expenses would look if the company were a) managed by an employee, rather than at the wage you pay yourself, and b) fully capitalized. (There would be no interest expense.) You may also want to review some of the privilege-ofownership expenses. For instance, would a totally profit-oriented company take the same trips, stay at the same hotels, and eat at the same restaurants? After these elements have been adjusted, there must also be an adjustment in taxation to account for the greater earnings.

Using this historic information, project the likely after-tax earnings for the next five years. Next, you’ll want to calculate the liquidation value at the end of five years. This is the minimum amount that the new owner could realize from the sale of the business after taking the projected income for five years. You might use the current liquidation value. If you believe you can prove that the liquidation value would be higher at the end of the five-year period, back up such an assertion with solid arguments. You may find it easier to use the current liquidation value.

Determine the interest rate you’d need to offer someone to lend you enough money to run your enterprise at maximum efficiency, plus pay you back your initial investment and all loans you’ve made to the business. You can be relatively certain that it will be more than a few points above the best rate currently available for AAA bonds. Depending on how solid the buyer believes your enterprise is, you may end up with an interest rate between three andten points over prime.

Whatever number you determine to be reasonable, you’ll use this rate to discount each year’s earnings and the liquidation amount to present value. This discounting is necessary because a buyer is not going to pay you, say, $100,000 today in the hopes of getting that $100,000 at the end of the year. (He could just stick that money in the bank and make more money.) He’ll only be willing to pay whatever amount that, invested for that period, would give him the$100,000 later.

A graphic representation might look like this. We’ll use 20 percent as the risk based return on investment. (The amount one could earn by investing in a high yield growth stock, for example.) For instance, in the first year you project your business will earn $80,000. If I were to lend out $66,667 at 20 percent interest, it would yield $80,000 at the end of the year. I would have to loan $65,972 for two years to get $95,000 back at maturity, and so on. The table below shows what the seller would have to pay, the “discounted” value, as an equivalent (with 20 percent interest figured in) to the projected earnings, including, $241,127, which (with 20 percent interest figured in) equals the amount the company’s assets would bring, “liquidation value,” after five years. The yearly discounted earnings added to the discounted liquidation value equals the enterprise value of $556,862.

In setting the price for your business, use any one of the above approaches, use them in combination, or use all of them. You may want to show the enterprise value method to a buyer who’s already in the industry and will be using your company to expand, since he’ll be able to realize the full enterprise value almost immediately and with a higher degree of certainty. You might find that the industry standard theory is the only one you can use for a savvy outside investor, since he’ll recognize that there are plenty of opportunities to be had using that standard, and since he won’t be limited to looking only within a specific industry.

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