Business Valuation Tips: 4 Tips Before Valuing Your Business

by Jacob Orosz (President of Morgan & Westfield)

Executive Summary

If you needed an operation, would you seek out a general practitioner or a surgeon who’s successfully done the procedure a thousand times? Yes, the GP might have a broad understanding of your medical issue and what it would take to get you on the mend, but when it comes to actually fixing what ails you — whether it’s a hernia operation or a heart transplant — it’s always best to use someone who’s been there before. Preferably, many times before.

The same principle applies to getting your business valued and appraised. There are various types of appraisals, but when it comes to selling businesses, we highly recommend that you use someone who’s got a successful track record of actually getting businesses sold. Preferably, lots of them. Here’s what we suggest:

Tip #1: Use Methods Buyers Use in the Real-World

When valuing your business for purposes of a sale, it makes sense to use valuation methods that are used in the real world by the types of buyers most likely to buy your business. Otherwise, your appraisal will be of little use to you.

Tip #2: Hire Someone Who has Real-World Experience Selling Companies

If you are planning the sale of your business, you should obtain a valuation from someone who has real-world experience buying and selling businesses. Regardless of how much appraisal experience they have, they should also have real-world experience selling businesses, such as a business broker, M&A intermediary, or investment banker.

Tip #3: Understand What’s Behind the Numbers

As a business owner, you should understand what’s behind the numbers. Ask yourself these questions:

• What multiple is used to value your business and why?
• What could you do to increase its value?
• What is the possible range of values for your company?

Tip #4: Do What Works in the Real World

We have found that what works best is a combination of an abbreviated spreadsheet calculation of value with a written exit plan and an in-depth conversation to educate the owner on our findings.

Read on for a complete understanding of these tips.

Tip #1: Use Methods Buyers Use in the Real-World

Why do business appraisers use methods for appraising a business for legal purposes that aren’t relevant in the M&A world?

There are three primary reasons:

• Specific methods that are irrelevant in the real world are legally mandated when preparing an appraisal for legal purposes.
• Most appraisers use third-party software that has been designed for preparing an appraisal for legal purposes. It’s difficult and time-consuming to customize the reports produced by this software.
• Most of a business appraiser’s clients are business owners who need an appraisal for legal purposes. As a result, it’s inefficient for most appraisers to value a business for purposes of a sale since most of the reports they prepare are for legal purposes, and a valuation for an owner looking to sell requires different valuation methods and, preferably, a different report style.

When valuing your business for purposes of a sale, it makes sense to use valuation methods that are used in the real world by the types of buyers most likely to buy your business. Otherwise, your appraisal will be of little use to you.

Tip #2: Hire Someone Who has Real-World Experience Selling Companies

If you need an appraisal for legal purposes, you should hire a business appraiser to appraise your business.

If you are planning the sale of your business, you should obtain a valuation from someone who has real-world experience buying and selling businesses. Regardless of how much appraisal experience they have, they should also have real-world experience selling businesses, such as a business broker, M&A intermediary, or investment banker.

Buyers in the real world generally use one method of valuing a business — a multiple of earnings.

Unfortunately, many business appraisals prepared for legal purposes use methods that would never be used by a buyer in the real world. If you are planning to sell your company, you need someone who has real-world experience with selling companies to real-world buyers. Access to the databases alone isn’t sufficient, even if they contain data on actual transactions.

Does this mean that business appraisers don’t provide any value to those considering the sale of their business?

No, not at all. Experienced business appraisers have access to expensive databases, tools, and resources, and there is value in much of this. But if you are obtaining a valuation solely for purposes of planning the sale of your company, then you will be far better served if you retain an expert who has real-world experience buying and selling businesses (e.g., a business broker or M&A intermediary).

This expert will be familiar with not only what methods buyers may use to value your business, they will also consider the salability of your business and any changes you can make to your business to improve its value.

Valuing a business is much more than simply arriving at a number. The art of valuation also includes anticipating how a buyer will behave.

Who better to perform this task than an expert who has real-world experience working directly with the people whose behavior they are trying to anticipate?

Here is a real-life example of how the information may be used — or not. This example is when I worked for another brokerage firm. (I sold third-party appraisals to clients, which I no longer recommend, by the way.)

One time, I sold an appraisal to an owner of a small manufacturing company. We prepared the documents and other information to send to the third-party appraisal firm. We received the report back about two weeks later. The report looked beautiful and official — it was hard-bound in leather with a gold stamp on the cover. The numbers inside were precise and exact. I drove to the client’s office to deliver the report. The client opened it, flipped to the back of the report to look at the “final number,” and then closed the book. That was it — he didn’t bother to look at the rest of the report. He didn’t ask another question regarding the contents of the report.

That time I almost became an appraiser.

Eventually, I stopped selling these third-party appraisals. Few clients actually read them, and even if they did, I wasn’t qualified to answer their questions. Then, I picked up a couple of dozen books on business valuation so I could gain the knowledge to explain the reports to clients. My understanding progressed, I gained experience, and I even began preparing some appraisals myself. At one point, I was narrowing down my choice of which appraisal certification to obtain.

That’s when I caught myself.

After a couple of years of learning the craft, I realized that so little of the knowledge I acquired had any relevance in the real world of buying and selling businesses.

I paid for and learned a half-dozen pieces of appraisal software. Every time I explored a new program, I became frustrated because the majority of what was in the software was useless for our clients’ purposes — namely, selling their business.

Tip #3: Understand What’s Behind the Numbers

As a business owner, you should understand what’s behind the numbers. Ask yourself these questions:

• What multiple is used to value your business and why?
• What could you do to increase its value?
• What is the possible range of values for your company?

We have seen appraisals in which the value was $5,434,918. Don’t be fooled by exact numbers. A more realistic range might be $4.2 million to $6.0 million, depending on several factors.

For example, at Morgan & Westfield, we often perform an assessment for clients, and during the process, we may discover that our client’s business has three groups of potential buyers. The values for each group of buyers may be substantially different.

If the business is sold to an insider, an upper cap on the value might be $3.5 million. If the business is sold to a private individual, it may be worth $3.6 million to $3.8 million. On the other hand, if the business were sold to a competitor, it could be worth as little as $1.8 million or as much as $4 million, depending on who the competitor is.

Attempting to capture these ranges and nuances in a report is time-consuming.

Businesses are complex, and it’s difficult to boil down a multitude of interdependent factors to a fixed formula, then squeeze it into an efficiently produced report. I know. I’ve tried dozens of times, and I have never found a piece of software that can consistently give clients what they want.

But, it’s important to convey this knowledge to the owner of the business. Just don’t expect your standard business appraisal software to be able to do this.

Tip #4: Do What Works in the Real World

At Morgan & Westfield, we have found that what works best is a combination of an abbreviated spreadsheet calculation of value combined with a written exit plan and an in-depth conversation to educate the owner on our findings. Here is a summary of our process for valuing a business:

• We prepare a spreadsheet, which contains adjusted income statements (P&Ls) and a range of multiples applied to the company’s earnings.
• We then prepare an exit plan, which addresses all of the qualitative factors that may affect the value of the business, such as potential buyers, deal-killers, value enhancements, deal structure, and so on.
• We then set up an in-depth conversation with the owner, which is the most interesting part of the process. In hundreds of conversations, no two have been even remotely alike. Every business has its own unique set of issues. By not limiting ourselves to the fixed format of a software program, we are free to focus on the key issues that can impact the sale of a business or its value, whether these issues are qualitative or quantitative. Many times, there are several issues at play that are interdependent, and we thoroughly explore each issue independently before tying them together into a cohesive strategy. This is a process of exploration for both the business owner and ourselves.

As our understanding of the business grows, we develop a fuller appreciation of the business and can develop a more appropriate strategy to both value and sell the business. This process is too difficult to reduce to a set of formulas with most business appraisal software.

Conclusion

If you need an appraisal for legal purposes, by all means, hire a business appraiser. If you plan to sell your company, stick with someone who has real-world experience. A business broker or M&A advisor can help you value your business using methods buyers use in the real world and explain what’s behind the numbers.