Highlights from the October 20, 2021 webinar featuring Kelly L. Carrier-Goncz, ASA, CBA, CPA/ABV, CFP, HBK Principal and National Director, HBK Manufacturing Solutions
A question we are often asked by our business clients: What’s my business worth? The answer has changed dramatically over the years. Valuation has become a science.
Profile of business owner:
- A business generally accounts for 60-90 percent of the business owner’s personal net worth.
- Most owners don’t understand what drives the value of their business and often overstate the value of their business.
- The transition out of their business is one of the most important financial events of their lives.
Planning for business owners includes identifying what an ideal exit would look like and how that would fit into their needs. Following is a framework to use as you consider the value of your business and how to lever it upward to achieve your goals for you and your family.
The process evaluators use to value a business and buyers use to determine a price:
Step 1: Understand the business and the industry value drivers
Step 2: Analyze financials
Step 3. Adjust the financials
Step 4. Apply valuation methods
Step 5. Reconcile value indications into a single value
Steps 1 and 2 are where most of the time in a valuation process is spent.
Step 1: Provides the backdrop for the financial statements
- end market or markets
- management quality and depth (how much relies on the owner?) and availability of skilled labor
Step 2: Typically five years of financial statements are applied and trends are examined to determine what is behind the numbers. Analysis addresses:
- top-line revenues
- gross profit margins including trends and the explanation of what driving them
- overhead (SG&A) and how that will impact overall profit
- EBITDA (earnings before interest, taxes, depreciation, and amortization): a gross cash-flow number before nuances with debt, tax profile, and bonus or straight-line depreciation
• Buyer will pay close attention to the balance sheet:
-working capital management: how you are managing receivables, how quickly you turn inventory, payables
-fixed asset management: comparison to industry norms, discussion of whether you have excess assets, analysis of capital expenditures, and impact of repairs
Step 3: Adjust the financial statements: to project what the business will do going forward-profits on the financial statement need to be normalized:
- owner’s compensation: usually discretionary; buyer will make adjustment based on what it will take to replace the owner
- rent: can also be arbitrarily; adjust to simulate a market-based lease payment
- non-recurring items: Anything in a past P&L that abnormally changed profits; e.g., a theft
- discretionary items: things unnecessary to maintaining profits; e.g., country club dues
- non-operating items: e.g., life insurance gains or losses, a sale of assets
- adjustments to balance sheet to determine the fair market value of the assets invested, net of liabilities:
- inventory (if value distorted)
- fixed assets: restate value to fair market value
- PPP loans: eliminate forgiven loans from liabilities
Step 4. Valuation methods:
- asset approach: Determines value by adjusting a company’s balance sheet from GAAP to fair market value, factoring in off-balance sheet items.
- market approach: Value is computed applying a multiple to revenue, EBITDA, seller’s discretionary earnings, or net income; based on comparable publicly traded companies or industry M&A multiples.
- income approach: Value is based on future returns converted to present value: Key inputs are cash flow and required rate of return, Required rate of return is what is required to attract an investment in the company and Relevant inputs include mix of debt and equity capital, interest rate on debt, cost of equity.
• Under the income approach, if you are a stable company, you can reduce your returns to one number and capitalize that number via a mathematical formula, dividing cash flow by cap rate. If you aren’t stable, would employ the discounted cash flow method and forecast out four to five years of revenue, margin, and cash flow.
Step 5. Reconcile value indications into a single value
- Different methods could generate different values.
- Value is reconciled among different approaches: typically asset value is floor value; market and income approaches support whether the business has any value over and above asset value, such as intangible value driven by profits superior to profits on only underlying assets.
• Typically do not get add-on value for the assets when you apply the multiple to EBIDTA. The resulting value encapsulates all the assets required to support the profits of the business.
- Multiple includes the value of receivables and inventory.
- Seller retains cash, debt and any other non-essential asset.
- Real estate is a negotiated item.
• What kind of buyers do you want to attract (particularly if your providing seller financing)?
- Business expertise
- Sufficient capital to outlast downturns
- Geographically near customers
- Pass due diligence of factors, including financial, legal, environmental, HR
• Value Drivers:
- Increase EBITDA and cash flow by growing revenue, reducing overhead, maximizing profit margins, and managing A/R, inventory and payables
- Reduce risk by diversifying markets, building a strong management team, protecting your competitive position, and systematizing your business
- Reliance on owner for ongoing operations and profitability
- Availability of skilled workforce and sufficient skilled and knowledgeable supervisors/managers