How business valuation works: What business owners and buyers need to know
Buyers and sellers need to know the same thing: how much is a business really worth? Buyers need to ensure they don’t pay more than what the business generates for them in the future. Sellers must try to earn a high enough return to fund their next phase of life. However, finding the Fair Market Value (FMV) is a complex process. It’s both an art and a science – based on facts but predicting the future. It uses formulas, but the variables are open to interpretation.
Both a buyer and a seller may have quite different views on FMV of a business, even if they have worked on it with qualified third parties. To better understand how this happens, we’ll walk through factors that determine a business’s value, how to value a business, common mistakes both buyers and sellers make in the process, as well as how commercial bankers can help you with financial projections, market trends and connecting you with trusted partners in business transfer.
What determines a business’s value?
Business value is primarily based on sustainable future cash flow. Figuring out what that cash flow will be is the goal. You can’t just look at what the business earned in the past because there are many other factors that can influence a business transfer, such as:
-
Profitability and margins
-
Projected growth
-
Customer concentration
-
Management strength
-
Industry outlook
-
Balance-sheet condition
-
Tangible and intangible assets
-
Debt
After thoroughly reviewing and considering each area, the business value is then usually expressed as a multiple of its EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization). Generally, the higher the quality, predictability and growth of potential earnings, the higher the multiple – and therefore FMV – will be.
A tale of two valuations
In a family-owned business, one brother decided to buy out another brother. They hired an accounting firm that suggested a sale value of three-to-five times EBITDA. The buying brother thought that value was too low and decided to pay his brother at eight times EBITDA. Two years later, he then sold the company for 13 times EBITDA.
In this example, the business value changed dramatically in a relatively short time not because of any major changes at the company, but because the buyer was making a strategic acquisition and needed the specific business assets for growth.
How to value a business you own
Prepare to sell your business two to three years before it actually happens. FMV fluctuates: to get the best value for your business at the time of sale, take the time to find gaps that affect it. Work with banking advisors, accountants, and lawyers to address financial statement clarifications, tax planning, and corporate structure.
Avoid these common mistakes that sellers make:
-
Late exit planning – if you wait until you’re ready to walk away you risk getting a lower price or paying more in taxes due to lack of planning
-
Owner dependence – if you are too entwined in the business it can hurt the value of what someone is willing to pay because the business may deteriorate without you
-
Overvaluing – if you focus on historical earnings and cash flow and discount other valuation drivers you will likely think your business is worth more than you realistically can get
Learn more about selling property with your business: Strategies to consider when planning a business transfer.
How buyers assess value before making an offer
Buyers have two big questions to ask themselves: What is it worth for me, and what could go wrong? To answer those questions, buyers will dig into the same valuation factors as sellers, but with more due diligence since they are taking on responsibility of the business. Margins, customer concentration, key contracts, working capital requirements, employees, management, suppliers, etc. will all be reviewed carefully and thoroughly.
Avoid these common mistakes that buyers make:
-
Underestimating the importance of culture – a good culture fit is essential with the employees and managers who will be running your company
-
Miscalculating transition risk – don’t minimize the cost and impact that changing ownership will have, especially if the current owner is involved in day-to-day operations
-
Not enough due diligence – get the right advisors to help you review the transaction step-by-step to really understand what you’re buying
How banks often value businesses
While buyers are looking for a good future return on investment and sellers are looking for the highest price, banks are looking to determine whether the business can support the debt required to buy it. Even if a buyer and seller both agree on the FMV of a business, a bank may not provide financing on that full purchase price if they don’t agree that the business will generate enough sustainable cash flow to pay the debt. Banks also consider whether the purchase includes mostly goodwill or tangible assets – a stronger asset base may support greater financing.
Documents a bank will often ask you for when valuing a business may include:
-
Financial statements
-
Asset verification
-
Business valuation report
-
Quality of Earnings (QoE) or accounting due diligence report
-
Tax planning or tax due diligence documentation
-
Management succession plan
-
Financial projections and cash flow forecasts
National Bank has a specialized mergers and acquisitions team to guide you through this critical stage, along with our knowledgeable commercial banking team. Our experts provide practical, advice-driven support and can connect you with legal and accounting firms experienced in business transfer. Talk to you advisor or make an appointment today.