Business Valuation Basics: 9 Critical Concepts to Understand

Executive Summary

There are nine critical valuation concepts you should understand before valuing your business:

Fair Market Value vs. Strategic Value

Most business appraisals use fair market value (FMV) as the standard of value. Strategic value is the value of a business to a specific buyer. It can represent a value in excess of FMV to a specific buyer of a business, usually a strategic buyer. The primary downside to strategic value is that you cannot measure strategic value until you know who the buyer is because every buyer is able to extract a different amount of value from the transaction. Should you use FMV or strategic value to appraise your business?

Small Market vs. Middle Market

The methods used to value a small business (less than $5 million in revenue) are different from those used to value a middle-market business (more than $5 million in revenue). Which method is right for your business?

Business Valuation is a Range Concept

The range of possible values for a business is wider than for other investments such as real estate.

The M&A Market is Inefficient

Some markets, such as the real estate market, have a ready supply of highly comparable transactions. The market for businesses, on the other hand, is fragmented, and it’s difficult to obtain relevant comparable transactions.

Buyers Don’t Always Follow Valuations

Buyers don’t always follow valuations. An appraiser is making an educated guess as to what a hypothetical buyer might pay for your business.

Terms Affect the Value

In most transactions, some portion of the purchase price is contingent. It follows that the terms of the sale — such as the amount of the down payment, the repayment period, and the interest rate — can all affect how much a buyer will be willing to pay.

Your Personal Needs Affect Value

Poor health or financial pressures may force you to sell. If, for these or other understandable reasons, you need to sell quickly, you will probably have to accept less than the optimal sale price.

Comparable Sales are Rarely Comparable

The ideal way to value your business is to determine what similar businesses have sold for. In the business world, there may have been few, if any, recent sales of businesses similar to yours.

You Won’t Know What Your Business is Worth Until You Sell It

No pricing formula, expert estimate, or clairvoyant can accurately provide a sales figure that is exactly “right.” You will not know how much it is really worth until the day a buyer writes you a check.

Now let’s do a deep dive into each of these concepts.

Concept #1: Fair Market Value vs. Strategic Value

Fair Market Value

Most business appraisals use fair market value (FMV) as the standard of value.

The real-world understanding of “fair market value” is as follows:

The highest price a business might reasonably be expected to bring if sold by using the normal methods and in the ordinary course of business in a market not exposed to any undue stresses and composed of willing buyers and sellers dealing at arm’s length and under no compulsion to buy or sell, and both having reasonable knowledge of relevant facts.

EXPLICIT in the definition of fair market value is the following:

• Amount (Price): The prevailing standard in business transactions is the highest price, whereas in real estate transactions, the standard is the “most probable price.”
• Willing: The definition implies that the parties are willing and able, have sufficient motivation, and are acting in their best interests.
• Compulsion: FMV assumes the parties are “under no compulsion” to make a deal and that they are dealing with one another at arm’s length, not influenced by special motivations.
• Knowledge: Fair market value assumes the parties are well-informed and possess reasonable knowledge of the industry, marketplace, and the opportunities and weaknesses of the subject business.

Strategic Value

Strategic value, also called investment value, is the value of a business to a specific buyer. It can represent a value in excess of FMV to a specific buyer of a business, usually a strategic buyer. The primary downside to strategic value is that you cannot measure strategic value until you know who the buyer is because every buyer is able to extract a different amount of value from the transaction.

For middle-market companies, a valuation will only serve to establish a “floor” or a minimum price (fair market value) at which the company may sell. It’s possible that your business may sell for more (strategic value) if it’s purchased by a strategic buyer.

We can’t quantify the synergies until we identify the buyer, and many times we can never quantify the synergies, as most buyers hold these in confidence throughout the process to maintain their negotiating leverage. For middle-market businesses, the purpose of our valuation is only to establish a minimum floor price (fair market value), and then we can only determine the true value (strategic value) in the actual marketplace by establishing a competitive auction process among buyers.

Concept #2: Small Market vs. Middle Market

The methods used to value a small business (less than $5 million in revenue) are different from those used to value a middle-market business (more than $5 million in revenue).

Multiples

Mid-market companies with annual revenues between $5 million and $100 million commonly sell for four to seven times their EBITDA. However, companies with less than $5 million in annual revenue typically sell for a multiple of two or three. This is because a smaller business is riskier. The business may not have a diversified customer base or produce enough cash flow to withstand a downturn in its market. Small businesses are more vulnerable to failure than middle-market businesses, so they sell at lower multiples.

ROI vs. Multiples

The riskier your business is, the higher the rate of return your buyer will require to compensate for the risk, and the lower your multiple will be.

It’s a simple formula: if your business is larger and less risky, an investor might decide they need only a 20% return (5.0 multiple) to justify the risk. If your business is smaller, a 40% return (2.5 multiple) may be required.

Middle-Market Businesses are Easier to Sell

You will receive more for your business if you are seen as a mid-market company and not an owner-operated small business. There is another good reason to grow beyond that $5 million mark (if you can): less competition for buyers.

There are approximately 300,000 mid-market companies in the United States with annual revenues ranging from $5 million to $1 billion. But there are more than 10 times as many owner-operated small businesses with revenues of less than $5 million.

Concept #3: Business Valuation is a Range Concept

A Valuation is Based on a Professional’s Opinion

When obtaining a business valuation, you are simply paying for a professional’s opinion. This opinion is a subjective opinion from an independent professional and is always subject to change. This represents the professional’s opinion as to what a hypothetical person or company is likely to pay for your business.

Valuation is Essentially Mind Reading

In reality, the appraiser is attempting to predict how a diverse audience with different preferences, views, and perspectives will behave. Doing this is inherently difficult because the range of possible values for a business is wider than for other investments, such as real estate.

Identifying Value Drivers

Nonetheless, an appraiser’s opinion is valuable and can be a realistic starting point for planning your exit. One of the most important roles an appraiser will play is identifying the factors that will most heavily influence the value of your business. Knowing what these factors are will allow you to maximize its value.

Concept #4: The M&A Market is Inefficient

Lack of Comparable Transactions

Some markets, such as the real estate market, have a ready supply of highly comparable transactions. The market for businesses, on the other hand, is fragmented, and it’s difficult to obtain relevant comparable transactions.

Values Change Based on Markets

Because the marketplace for the sale of small- and mid-sized businesses is inefficient, values vary wildly. Current market conditions can, therefore, greatly affect the final selling price of your business.

Concept #5: Buyers Don’t Always Follow Valuations

Buyers don’t always follow valuations. An appraiser is making an educated guess as to what a hypothetical buyer might pay for your business. That task is difficult, especially if there are potential buyers for your business who are unsophisticated.

It is inherently difficult to predict how unsophisticated people behave, whereas it’s easier to predict how sophisticated people will act. Sophisticated investors tend to enlist professionals who share the same training and education and often share uniform perspectives regarding what makes an intelligent investment. Their behavior and perspectives fall along a more narrow band than those of unsophisticated buyers.

That’s why estimating the value of a small- to mid-sized business is difficult — you are conjecturing how a diverse group of investors will think and behave. This is an inherently onerous task, regardless of one’s expertise and knowledge.

Concept #6: Terms Affect The Value

Buyers don’t always follow valuations. An appraiser is making an educated guess as to what a hypothetical buyer might pay for your business.

In most transactions, some portion of the purchase price is contingent. It follows that the terms of the sale — such as the amount of the down payment, the repayment period, and the interest rate — can all affect how much a buyer will be willing to pay.

An installment sale may affect your sale price calculation in another important way:

You may want to charge a higher interest rate if you will be paid over a longer period of time rather than a shorter period of time, since during the repayment period you will be exposed to more risk.

Lower Taxes

Keep in mind that selling on an installment plan can benefit you because it often puts you into a lower income tax bracket than would apply if you received the entire sale proceeds in one lump sum.

Minimum Cash Down

Regardless of the terms, you should walk away from any deal in which the cash you will receive at closing does not meet the minimum you are willing to accept for the business.

Concept #7: Your Personal Needs Affect Value

Poor health or financial pressures may force you to sell. If, for these or other understandable reasons, you need to sell quickly, you will probably have to accept less than the optimal sale price. Similarly, if you are unable or unwilling to work for the buyer, even for a short time after the closing, that fact may diminish the value of the business in the buyer’s eyes. Many buyers prefer to have the seller stay on board during the entire transition period.

Concept #8: Comparable Sales are Rarely Comparable

The ideal way to value your business is to determine what similar businesses have sold for. Unlike residential real estate transactions — where it’s not difficult to find recent sales of homes more-or-less like yours — in the business world, there may have been few, if any, recent sales of businesses similar to yours.

All Businesses are Unique

Additionally, businesses tend to be unique. Even if you are able to find a somewhat similar sale in your field or area, the business will not be the same as yours in terms of location, sales volume, number of employees, or a host of other important factors.

Availability of Accurate Information

Even in the unlikely event that you can find the recent sale of a company that closely resembles yours, you may not be able to access accurate numbers on the business and the transaction. Unlike sales of real estate, which often leave a public paper trail, reliable business sales numbers can be hard to come by, especially because rumor and exaggeration often obscure the facts.

Beware of Incomplete Information

Watch out for incomplete sales information, such as hearsay. Attend any business event with people in your field, and you are sure to hear that so-and-so sold his business for such and such dollars.

For example, at a Kiwanis lunch, you may learn that Emma received $10 million for her business. Even assuming this number has some truth to it (and it may not), you may not be told other important details. For example, the reports of the sale price may not mention that Emma agreed to work for the buyer for three years, which was included in the purchase price, or that the price included the real estate, or that Emma received only 15% of the purchase price upfront with the rest to be paid over five years, or that 80% of the price was based on an earnout.

Concept #9: You Won’t Know What Your Business is Worth Until You Sell It

A key task in selling any business is deciding how much it’s worth. Price your business too high, and you will scare off potential buyers. Price it too low, and you will leave money on the table.

No Valuation is Exact

If you expect precision in pricing your business, you will be disappointed. No pricing formula, expert estimate, or clairvoyant can accurately provide a sales figure that is exactly “right.” So, while you need to price your business sensibly, you will not know how much it is really worth until the day a buyer writes you a check.

Start High and Be Prepared to Negotiate

If you have a healthy business, you will probably pick an initial asking price toward the top of your range and then, if necessary, be prepared to back off a bit in negotiating the final price. You will also need to take into account the general economic climate, as well as trends in your industry, whether positive or negative. And, of course, if you have to sell quickly, you may be required to settle for less than you might receive otherwise.