Main Factors for Valuing of Company
Phase 1. Obtain accurate Audited and Certified copies of the latest Income and Expense Statements for the business.
This is a crucial part of valuing the business. You can’t properly evaluate the business operation until you can examine its lifeblood; the operating income and expenses. The best and only two sources recommended for this information is the business’s Federal Tax Return or an Audited Financial Statement from the latest full fiscal year, with the previous three years preferred.
We recommend three years worth of financial information because to a buyer, a financial track record is extremely important in building confidence that profits can be expected to continue. If only one year’s financial information is provided, the buyer won’t know whether that year was out of the ordinary and therefore, won’t know how to reasonably predict the future profitability of the business.
Some business sellers may artificially improve the operating performance of their business in the year before a sale to enhance its value. Of course, some efforts by the seller to improve performance of the business are fully legitimate and actually represent a clearer picture of the real operating characteristics of the business.
The best situation is if the financial records show an increasing profit picture for at least two additional reasons:
1. The seller may be able to justify a higher price for the business based on the projected next year’s higher profits rather than the current year’s.
2. The buyer will realize that the seller has other options than selling to him. The seller can keep the business and continue to pocket the profits or find a more amenable buyer. These facts should work in the seller’s favor in demanding a higher price for the business.
Expect to sign a Confidentiality Agreement
A Confidentiality Agreement is a very important document that’s signed by the buyer and delivered to the seller. This Agreement is intended to protect from unauthorized disclosure, the sensitive and private information that is provided by the seller to the buyer during negotiations. This confidentiality Agreement can be entered into before or after the Earnest Money Agreement are signed, but always before sensitive, private, and specific financial information about the business is provided to the potential buyer, such as IRS Income Tax Returns or audited financial statements.
There are other financial based documents that you should also carefully consider when evaluating the business. Using the capitalization of available cash flow approach lessens the analysis that you need to apply to this other information to arrive at a business valuation. However, you should certainly accomplish due diligence in satisfying yourself that the information presented to you is true
and current, and assess any impact that this information could have on the value of the business.
Due diligence is a commonly accepted term in the business purchase and sale field that refers to a process of investigation by the buyer into a business’s operating and financial performance and a rigorous verification of material facts affecting the business for sale.
Most of this other financial information can be analyzed after an Earnest Money Agreement has been entered into and can be evaluated on a contingency basis based on satisfactory verification of the presented information. Some of the documentation you should ask for and review as part of your due diligence are:
• Balance Sheet (list of assets, liabilities, and net worth)
• Accounts Receivable (I recommend that you don’t purchase this asset of the company because sometimes the accounts aren’t fully collectible)
• Inventory Listing (work in process and finished goods)
• Real Estate (a separate real estate appraisal based on present use rather than highest and best use should be used)
• Machinery and Equipment Lists (an independent appraisal of fair market value should be used)
• Accounts Payable (try to ensure that all accounts are current and that you don’t buy any debt)
• Accrued Liabilities (you may have to assume these as part of the business and the business valuation should be adjusted downward accordingly)
• Promissory Notes and Mortgages (buyers shouldn’t assume as part of the business purchase any notes and mortgages payable unless the terms are more favorable than they can otherwise get)
• Leases (carefully review the terms and conditions to determine future impacts on the business)
• Proof of the seller’s ownership and rights to assets
• “Key employee” contracts
• Significant sales contracts, warranties, and related documentation binding upon the business for sale
Phase 2: Analyze and reconstruct the Income and Expense Statements
This step is critical to properly value the operating business for sale and will require some investigation and business intuition on your part. Both the buyer and seller should carefully accomplish this step for the same reasons; identifying the real value in the business.
The reason we need to deal with this issue is because many businesses are operated in such a way as to maximize the direct benefit to the owner and to minimize the tax exposure to Taxation. Most of the ways this is done are fully legitimate, and some fall into a gray area.
We need to identify these “hidden value” areas and add them back to the overall operation of the business to give us a clearer picture of the actual benefits (money) that a new business owner can expect to realize from the business. Of course, the seller and the buyer will want to make the numbers
come out in their respective favor so there will necessarily be some give and take in this area during negotiations. These can refer to car usage, rentals, owners salaries
Examples Of Expenses
+ Owner’s wage below currently prevailing fair market wage
+ Planned increase in rent or any other increasing recurring costs
+ Increase in advertising and/or marketing costs to revitalize a sagging business
+ Increase in expenses to replace aging equipment
+ Any other planned expense increases
– Owner’s wage over the currently prevailing fair market wage
– Excess depreciation over what is actually needed to cover replacement costs (the IRS lets businesses deduct this but many times it’s not an actual expense)
– Excess amortization over the actual value decline of the asset
– Interest payments for debt that the buyer will not assume (the business debt costs will most likely be different and will be covered later under the valuation process)
– Excess advertising over what is actually needed
– Excess auto usage (personal use)
– Excess travel and entertainment (personal use)
– Salaries to be eliminated (unnecessary employees)
– Non-recurring expenses and those that should have been capitalized
– All other excessive expenses
– Donations that you don’t plan to continue
– Key person life insurance provided for the benefit of the owner
Phase 3: Unreported Income
Unreported Cash Sales. Some business sellers may try to get you to accept their claim that they had significant amounts of cash income that didn’t show up on their Tax Return and accordingly want you to include this income in your valuation of their business.
You should ignore these claims and deal only with the business’s reported income for the following reasons:
• Unreported cash sales constitute tax fraud, and you don’t want to make yourself party to the possible fraudulent actions of others.
• Unreported cash sales are difficult, if not impossible, to validate.
• You’ll never get any reputable financial institution to loan purchase funds to you on the basis of unsubstantiated income.
• If the seller cheats the IRS on the business’s income taxes, how can you be sure that you’re being dealt with honestly in regard to the entire collection of information about the business?
There are some businesses known in the business brokerage trade that have a certain notoriety for unreported cash sales; but that doesn’t necessarily mean that any particular one is guilty of this. In fact, the vast majority of quality businesses would never jeopardize their business reputation, not to mention taking the risk of criminal prosecution.
Phase 3: Determine the overall value of the business by adding in any non-capitalized assets
First, let’s define what I mean by non-capitalized assets. These are assets (also known as current assets) that are to be conveyed as part of the business purchase and are essentially the same as cash, i.e., they are easily converted to cash. Some examples are:
• Cash on hand (the buyer may be taking over the business checking account)
• Finished inventory (ready to be sold)
• Accounts receivable (money owed to the business)
The buyer must be very careful when buying finished inventory to make sure that it’s in good condition, readily salable, no outdated products, etc.
Buyers should carefully evaluate the finished inventory as close to the time of business sale closing as possible to verify its value and quantity. In fact, buyers may want to have an independent appraisal done of the business inventory.
During this valuation process and also during negotiations, it’s usual to use a rough approximation of the inventory value. This is okay because the actual selling price of the business will be adjusted up or down at the closing based on a detailed determination of the inventory value at that time. This holds true for any other assets such as checking accounts and accounts receivable that are to be purchased and will vary during the normal course of business operations that are ongoing during the business purchase process.
Buyers shouldn't probably include the accounts receivable as part of the purchase of the business. Some unscrupulous creditors upon learning that the business has been sold may not honor their debt to the business, and some accounts may already be uncollectible. In almost all cases, the seller should take responsibility for collecting the accounts receivable themselves to avoid any post-sale problems with the buyer.
Phase 4. Distribute the overall business valuation between the various assets
Now we can have a business valuation from which buyers and sellers can begin negotiations. We have an overall business value based on a capitalization of available cash flow and next need to structure that value among the tangible and intangible assets for the purposes of negotiations, and for structuring the asset sale of the business.
Some of the details that will have to be worked out in an actual business sale which will directly affect the business selling price and the cash required from a buyer include:
• Is there enough cash coming out of the business sale for the seller to pay off the liens, mortgages, and other business debts that the buyer isn’t assuming?
• Is there enough cash coming out of the business sale for the seller to pay the business broker’s commission?
• How will the fees for the various professional advisors be covered (lawyers, accountants, appraisers, etc.)?
• How will the fees for the various municipal filings, licenses, permits, etc. be paid?
• What is the income tax exposure of the seller, and is there enough cash and income from the Promissory Note to cover these expenses?
The Variables to Consider in the Business Valuation
Some of the variables that can be adjusted in the business valuation to affect the overall total valuation of the business. All of these variables would have a ripple effect on the company and many of the calculated numbers could change:
• The selected return on investment rate (ROI) could be changed.
• The selected expected income tax rate could be changed (and in some valuation approaches it is not used at all due to its situation-specific variability).
• The interest rate acceptable to the buyer as a return on the cash could be changed.
• The interest rate charged on the Promissory Note (whether seller financed or not) could be changed.
• The Promissory Note could be amortized over a longer or shorter period of time.
• The buyer could put more or less cash into the business purchase.
• The reconstruction of the Income and Expense Statement could be done differently (maybe the business really does need the services of the seller’s brother-in-law).
• The seller could take part of the purchase price as a consulting contract over a period of time, which might lessen the need for up front cash from the buyer. This could lower the overall cost of the business, while still providing income to the seller.
And finally, another good way to help evaluate the business that is being sold is to compare how it stacks up to other similar operating businesses. Search out compiled data for business that relates vital statistics about the business to such important operating data as sales, profits, number of employees, industry trends, number of businesses in your geographic area, etc. This data may give you a better feel about the business you’re evaluating and may influence your selection of a ROI that the business will support. Both buyers and sellers should seek out this information to use as part of the overall evaluation of the business opportunity, especially in helping you to determine positive or negative market trends.
Business ratio data includes:
• Current assets to current debt
• Net profits on net sales
• Net profits on tangible net worth
• Net profits on net working capital
• Net sales to tangible net worth
• Net sales to net working capital
• Collection period
• Net sales to inventory
• Fixed assets to tangible net worth
• Current debt to tangible net worth
• Total debt to tangible net worth
• Inventory to net working capital
• Current debt to inventory
• Funded debts to net working capital