The Real Value of Your Business

The current economic climate has created the perfect storm for business acquisitions. Some owners, intent on riding out the recession, have accumulated overwhelming debt that is literally sucking any positive cash-flow out of the business. Other owners have lost their zeal to compete in this marketplace. Now is the very best time for businesses with idle cash resources to make their move.

As a potential acquisition candidate or an entity intent on growing through business acquisitions, the components of business valuation become paramount to striking a good deal. Certainly there are numerous valuation practitioners that can help to value your assets and negotiate on your behalf. As any of these professionals will attest, the acquisition process starts two to three years ahead of the actual liquidation event. It is at this point where fortunes are made or lost.

The Three Valuation Components

Arguably, the value of any business is in the eyes of the beholder. Owners who have listed their entities for sale always believe that various intangibles should increase the monetary value of their business — the proverbial “goodwill.” Acquirers take a more pragmatic view when looking at the saleable value of a business’ tangible assets. Beyond the haggling that invariably becomes the part of any acquisition, there are three components that effectively control real business value: revenue, profit and debt.

Most business owners mistakenly believe that gross revenue is the primary basis for valuation. These owners work diligently to grow the top-line of their businesses only to find that of the three valuation elements, revenue is of least importance. Surprisingly, it is profitability that leads the valuation calculation giving credence to the business practice that smaller and more profitable businesses are far more valuable than larger, less profitable enterprises.

Debt is the wild card that can sink a business valuation. For many businesses that have incurred higher levels of debt during this recession, the acquisition outcome may be less than favorable. Not only do debt-servicing costs erode business profits — any remaining debt on a business balance sheet is automatically subtracted from a valuation calculation.

For one recent contractor who was selling his business, this realization had a painful downside. His business that he thought was worth over $1 million was, after being valued, going to cost him $200,000 to sell. Debt had swallowed his firm.

Buying the Future

Many owners attempt to value their businesses based on the current financial statement information. There is a presumption that any business being acquired will cease to have any value after the sale is consummated. This philosophy is completely counter to the rationale for any acquisition.

For the prudent buyer, it is the future value of the combined entities that is of greatest interest and, quite frankly, the reason for the acquisition. For an acquirer, the equation 1+1=3 is upper most in their analysis.

Since future value is the basis for an acquisition, then valuations should include the presumed value of the acquired business into the future. For most businesses, this future time frame will encompass three to five years. Pro forma growth information associated with revenues, profits and reinvestments in the business are all incorporated into the valuation calculation. For most sellers, this is where the real value is found.

However, do not presume that a buyer will blithely accept your future growth expectations – particularly if there is no history of ever achieving these lofty rates. This is why planned acquisitions start two to three years prior to the liquidation event. It is at this point where a business needs to build a plausible case for any future scenario. If you want to presume 27 percent profitability subsequent to the acquisition, the seller’s case is best supported by achieving such levels over the last two years of actual operations.

Mistakes to Avoid

Firm’s that use acquisitions as a means to grow their empires are well-schooled in the art of negotiation leaving first-time sellers at a distinct disadvantage. As one seasoned business executive put it: “We belong to associations as a way to identify potential acquisition candidates. For us, it is our hunting ground.”

Here are some of the tactics that should be avoided by first-time sellers:

Don’t stop running your business. Many business owners get stars in their eyes when approached about an acquisition. They change their focus from building corporate value to working long-hours on due diligence requirements. In a very real way, they focus on the sale, not the business at hand. Seasoned acquisition professionals seek to extend the duration of the acquisition knowing that the longer the process, the less value the firm will have at the liquidation date. And, if the deal never happens, the business has a long road back to success.

Don’t get fixated on a number. When asked, every business owner has a “magical” number that they believe their business is worth. Invariably, it is far more than the actual value — once valuations are calculated. The goal is to work two aspects of any deal — the initial buy out and the subsequent earn out over future years.

Valuations are the starting point for negotiations. Valuations are not the end-all. No deal has ever been consummated based solely on the arithmetic outcomes from valuation models. Instead these values serve as a guide for negotiating a good deal between buyer and seller.

Finally, know when to walk away. The acquisition process is expensive in terms of time and money for both buyer and seller. Today with the depressed business market, there are many individuals looking to buy businesses “on the cheap.” For the seller, you need to weed these individuals out early in the process so time is not wasted on a worthless effort. To do this, ask for an opening bid. If the amount is ludicrous, stop the process. Don’t waste time on these “bottom-feeders.”

Business acquisitions are at an all-time high. Businesses with idle cash are using the depressed market to build their empires — usually with entities that have succumbed to high debt levels. For both buyer and seller the anatomy of any deal starts with understanding the real basis for business valuation. Understanding that revenue, profit and debt form the foundation of the calculation and future value drives overall acquisition price sets the stage for both parties to negotiate from strong positions. Now, as a business owner, what is the real value of your business?

Brad Dawson is an internationally-recognized business strategist and growth-oriented financial management consultant. He is a frequent speaker at business events and serves as a contributing writer to several international management and leadership publications. He can be reached at BLDawson@LTVdynamics.com.