You are getting ready to sell your business so you must ask yourself some questions: When do you want to exit? Who is the most likely buyer? Is the business adequately prepared to sell? How does it compare to other like businesses? And of course, what’s it worth?
All business valuation relies on some prediction of the future. The most common valuation equation is quite simple:
Value = Expected Cash Flow / Risk Adjusted Expected Return
Yet there are various approaches and countless methods for calculating value. Business appraisers apply a complex variety of adjustments to financial statements, theoretical constructs, and historical data to divine the future. Others rely on applying a multiple of cash flow (EBITDA is often the cash flow proxy that is used). What is the best way to measure value?
Private equity firms often will bypass a valuation process and use their judgment to apply a multiple on adjusted EBITDA after scrubbing the financials and gaining a good understanding of the business. Likewise, buy-sell agreements often call for a specific formula or multiple. The advantage in this method is that it’s easy to understand and appears to be a cost-effective way to value a business.
Simplicity is a good thing, except when it conceals important information. For example, let’s say your Industry has businesses that have sold between 2-5x EBITDA. How can you understand where your company deserves to be within that range? Not knowing can be costly. Either in terms of not getting the deal done because you hold out for 5x EBITDA, or because you sold for 2.5x, when you should have received 4x. These value discrepancies can mean hundreds of thousands or millions of dollars. That’s not cost effective.
For this reason, a business valuation performed by an experienced professional makes good and common sense. A thorough and objective process should give you an understanding of value drivers in your business, provide you with comparisons of similar businesses, and help you examine risks from a buyer’s perspective. Ultimately, a business sale is a negotiation between the seller and the buyer’s perceptions.
A buyer seeks a reasonable return on their investment, without excess risk. Your task as a seller is to persuade buyers that the cash flow they see will adequately compensate them for the risk of the business. Without a clear understanding the various cash flow adjustments and factors that determine risk, and how that translates to market value, you enter the negotiation unprepared.
Jerry Matecun is based in Orange County, California. To contact Jerry for exit planning assistance and business valuation services, Email firstname.lastname@example.org or call (949) 287-8397.