Can you look at my financials and give me a quick opinion of value? I don’t need a formal appraisal or valuation. I just want a quick number. Given your obvious expertise, I’m hoping you can look at my business and give me a ballpark number of what it’s worth. Is this possible?
A valuation is based on both qualitative and quantitative factors. You cannot look at a profit and loss (P&L) statement — a quantitative factor — and assess the value of a company in a few minutes. Determining the range of potential values for a company takes time to do properly because there are dozens of factors that must be taken into consideration.
Understanding the value of a company requires examining how the company compares to others in its industry. It’s important to understand both the growth prospects of a business and its risk factors. One overlooked factor — a new competitor, for instance, or steadily increasing revenue — can impact the value of a company up or down by 50% or more.
Earlier in my career, I used to offer free opinions of value. However, I soon realized I was doing a disservice to business owners. You get what you pay for, which in these instances was nothing more than wild guesses, not unlike throwing a dart at a dartboard — I hit or came close to the bullseye about half of the time and completely missed the board the other half of the time.
Why? Since I wasn’t being compensated for my time, I couldn’t take the time to thoroughly learn the businesses and their industries. There are many factors to be considered and many questions that need to be asked when valuing a company.
An owner tells me they have a manufacturing business generating $1,000,000 in EBITDA. Sounds simple enough — most manufacturing businesses sell at a 5.0 multiple, so it must be worth about $5 million, right?
In the preceding example, there are many factors to consider.
What if the top three customers generate 70% of the revenue? What if revenue has declined 5% per year over the previous three years? What if revenue is growing 20% per year? What if revenue is growing 30% or 40% per year? What if gross margins are decreasing? What if revenue has increased because credit policies have recently been loosened? What if the business is highly dependent on the owner and there is no management team? What if key employees are not willing to stay? What if the industry is in decline? What if a well-backed competitor recently entered the industry? What if the owner wants all cash? What if revenue is inconsistent? What if EBITDA is inconsistent? What if there is deferred maintenance? And so on.
Lots of questions, and we’ve got answers. For insight into how we approach business valuations, read on.
Our Process for Valuing a Business
With every company we value, we must take hundreds of factors into consideration. Only then can we objectively opine on the value of a company. At best, we can usually ballpark the value within 30% to 50% at the outset with limited information. But you have to keep in mind that the 30% to 50% potential range is in one direction — this equates to a total range of value from 60% to 100%.
Once we dig deeper into a company, we can usually narrow the range to 10% to 20%.
30% to 50% range of value (with no knowledge of your business): If your company is worth $5 million, we may estimate the potential range to be between $2.5 million and $7.5 million. Without knowledge of your business, we cannot tell you where in this range your business is likely to fall.
10% to 20% range of value (with knowledge of your business): If your company is worth $5 million, we may estimate the potential range to be between $4 million and $6 million. But, in this case, with detailed knowledge of your business, we can tell you where in the range your business is likely to fall, the specific factors that will impact the value, and exactly what you can do to influence the value.
The most important value we provide to owners is not necessarily a number — it’s the understanding behind the numbers. Why is a company worth what it is? What can be done to improve its value?
Here’s the process we use at Morgan & Westfield to arrive at an opinion of value for a small to mid-sized company:
- We first request financial statements during our initial assessment of a business. This normally includes the following:
- Three to five years of profit & loss (P&L) statements
- Three to five years of balance sheets. We use these to assess the quality of the accounting records.
- Current accounts receivable and payable aging schedules
- List of monthly revenue for the previous three to five years
- We send the owner a detailed five- to 10-page questionnaire. We have designed this questionnaire to uncover the factors that may positively or adversely affect the value of the company. Upon receiving the completed questionnaire, we discuss this with the client for 30-45 minutes.
- We help the owner normalize or adjust their financial statements. Once they send us a list of adjustments, we review them with the owner and verify them for accuracy. We often must educate the owner regarding which adjustments are allowable and which are not.
- Once we receive the financial statements, we “spread” the numbers, putting them into our internal spreadsheet for analysis. We look for increases or decreases in expenses, or other anomalies in the numbers, and research the stories behind the numbers. This process, including the analysis, takes a minimum of several hours. Doing this helps us spot trends in the business that may impact the value of the company. We also prepare a comparative P&L that allows us to analyze the normalized P&Ls from year to year. We then discuss a couple of dozen questions regarding the financial statements. This helps us understand the company, its operations, and its unique competitive advantages.
- We then research the industry, including comparable transactions, industry rules of thumb, and other valuable industry information.
- Finally, we put the finishing touches on our financial model and send it to the owner. There is normally at least an hour spent discussing the spreadsheet with the client, including covering the multiples and the factors that affect the value of the company.
Altogether, this process takes at least ten hours to do properly. Once we have completed the process, our goal is for the owner to have a firm understanding of the factors that affect the value of their company, including where in the range of values they fit, and why. This helps them either crystallize their decision to sell or helps them decide to hold off and prepare the company for sale in the future, after taking steps to increase its value.
Taking a Structured Approach to Business Valuation
An estimate with a potential range of value of 30% to 50% isn’t accurate enough for most sellers to decide if they want to sell. On the other hand, a valuation with a range of 10% to 20% is sufficient for most owners to decide on their next action steps.
This deep level of analysis helps us understand the client’s business. Taking a structured approach is critical to ensure that no stone is left unturned. Overlooking one small factor can dramatically affect the expert’s assessment. This is precisely why we take all potential clients through such a thorough process when valuing their businesses. In addition to custom questions based on their industry, every client receives the same list of 100 queries, many of which may seem monotonous but which give us the information we need to make a sound estimate. This takes time to do correctly. We have examined several hundred transactions and have produced a checklist and questionnaire that helps us consistently identify the salient factors that can affect the potential value of a business.
Note that we do not request tax returns until later in the process. Tax returns are used to verify the accuracy, at least to some extent, of the financial statements used later in the process.
We examine the adjusted/normalized financial statements to spot trends that can have a demonstrable impact on value. Note the cells shaded in red or green that help us spot trends that may impact the value of the company.
We also examine monthly revenue trends to help us understand the growth prospects and risk factors of the company. Companies with steady growth are worth more than riskier businesses with unstable revenue.
We also conduct an analysis of the monthly revenue year over year. This helps us to determine if seasonal changes or other trends are consistent. This also helps us determine if the business is cyclical or counter-cyclical.
Examining three to five years of balance sheets helps us assess the quality of the accounting records. The balance sheets should tie into the profit & loss statements.
Questions to Ask When Valuing a Business
Here are some of the questions we ask to properly assess the value of a company:
- Is there a difference between cash and accrual-based financials?
- Is accrual accounting being properly done?
- Are the owners receiving a salary? If so, is the salary at the market level, below, or above?
- Are family members working in the business? If so, is their salary below, at, or above the market level?
- How many hours per week are the owners working?
- What are the growth prospects for the company?
- What are the risk factors for the company?
- How does the company compare to its peers?
- How do the company’s gross margins compare with others in the industry?
- Does the company have any valuable intellectual property?
- Are the revenues steady, increasing, or decreasing?
- Are there customer-concentration issues?
- Is there recurring revenue?
- Is there a large, repeat customer base?
- Can the business be easily relocated to another geographic market?
- Is the seller willing to finance a portion of the purchase price?
- Is the real estate owned or leased? If owned, is the business paying a market rate for the rent?
- Have employees signed employment agreements or non-competes?
- How strong is the management team, if there is one?
- How long has the business been in operation?
- Is the business likely to be sold to an individual, a strategic buyer, or a financial buyer?
- Is the seller aware of any recent acquisitions in the industry?
- How accurate are the financial and accounting records?
- Is any equipment leased? If so, is it a capital or operating lease?
- How much working capital is required to operate the company?
- What is the nature of competition in the industry? Saturated, consolidated, fragmented, small mom and pops?
- How is technology affecting the company and its industry?
- What is the customer attention/attrition rate?
- What is the employee turnover rate?
- Has revenue been steadily growing in recent years?
- Is the business seasonal? Cyclical? Counter-cyclical?
- Are gross profit margins holding steady, increasing, or decreasing?
- Is the seller willing to sign a non-compete? If so, for how long?
- What are the barriers to entry into the industry?
- How much is spent per year on capital improvements? (Sophisticated buyers subtract an amount for working capital, which includes a deduction for an annual investment in capital equipment.)
- How do average transaction values for the business compare with others in the industry?
- Does the business have any trade secrets?
- Does the business have contracts with customers?
- Is the lease above or below market? Is the property available for sale?
- Does the business have any products currently in development that can add significant value to the business?
- How do the margins in the business compare with its peers in the industry?
- Are the accounts receivable healthy?
- How scalable is the business?
- Can the marketing methods be easily automated and reproduced or has the business depended too much on the owner’s personal selling, networking, or marketing efforts?
- Are key employees willing to stay?
- Does the business carry adequate insurance policies?
- Is the business using LIFO, FIFO, or some other form of inventory accounting method? If so, has this dramatically affected earnings?
- Is any inventory obsolete? If so, has it already been written off the books?
- Can pricing be increased? Worth noting: price increases fall straight to the bottom line.
- Has the business recently loosened trade credit to boost revenue short-term?
- Is there any pending litigation?
Your business is likely your most valuable asset. It’s worth it to pay an experienced professional for a well-researched, informed opinion of value. Morgan & Westfield will not only give you a number, we will also provide you with a range of values and expert advice on where in that range you fit. We will also tell you what you can do to influence the value of your business. Our goal is to intelligently discuss with you the factors that have the greatest impact on the value of your company.
Are you considering selling your business? Contact us today for an initial assessment of what your company is worth and to set up a free consultation to discuss how we can help.