Methods for valuing a business

Methods for Valuing a Business

On almost every episode of ABC’s “Shark Tank,” the main topic entrepreneurs have to justify to the Sharks is how they arrived at the value of their business. The Sharks, as experienced entrepreneurs and investors, know all factors of a business’s financial makeup that should be considered in determining the value of the business. Often times, the entrepreneurs are inexperienced and propose valuations that far exceed the true value of the business, at least in the eyes of the Sharks. But what factors are the Sharks considering when they come up with their idea of the value of the business? And should you, as a prospective buyer, employ the same strategies and calculations as the Sharks do?

As a general rule, a business is worth what a willing buyer will pay for it, and a willing seller will accept for it. There are certainly many qualified professionals that do thorough analyses on a company’s financials, the market, and various industry factors, and they arrive at a professional business valuation. But, typically, that undertaking is very expensive, and if a buyer is in the early stages of due diligence, you may be unwilling to incur such a cost (and the seller may be unwilling to allow access to their information for such an undertaking). The purpose of this article will be to provide you, a prospective buyer, with an understanding of common tools and methods that are used by experienced buyers and investors, like the Sharks, to evaluate what you should be willing to pay for the target business.

 

Understand the Anticipated Earnings

If you have watched any episode of Shark Tank, the first question the Sharks ask to the entrepreneur is, “What are your sales?” and more specifically, “What do you anticipate your annual sales to be for the current year?” The Sharks are asking this question for a basic determination of the business’s EBITDA. EBITDA is a business’s earnings (revenue from sales), before interest, taxes, depreciation, and amortization. The value of the business is arrived at by taking that EBITDA number and multiplying it by an “earnings multiple.” The “earnings multiple” is a market driven number that takes into account a business’s goodwill, management, industry factors and several other factors.

EBITDA

For example, some businesses can demand an earnings multiple of 5 or 6 times EBITDA, while some businesses, because of industry and market conditions, tend to demand earnings multiples of 2 or 3 times EBITDA (or less). Since the earnings multiple is generally open to interpretation of the various factors that go into it, this is usually the main point of negotiation when discussing the purchase price of the business. The potential purchaser will push for a lower multiple to keep the price down, and the seller will always push for a higher multiple. And as we stated at the outset, more times than not, you arrive at a purchase price that you are willing to pay and the seller is willing to accept.

Multiples vary by industry. Understand the seller's asking price.

 

What Are the Assets of the Business?

Described above is only one method for valuing a business. Another method a buyer can employ to arrive at a value for a target business is based on the business’s assets. This approach, rather than looking at earnings, places a fair market value on the business’s assets. Assets could include real estate, intellectual property, equipment, and generally anything else that the company can sell. The most common way to value a business using this asset approach is to accumulate all of the assets of the business, reduce it by the amount of debt or other liabilities the company has in connection with those assets, and the difference is your net asset value. An issue that arises with this approach is determining asset values for “intangible assets.” Intangible assets include goodwill, brand recognition, trade secrets, business know-how, and similar assets which are generally open to interpretation as to their asset value. This valuation method is generally employed for businesses that have very little intangible assets and more hard assets that are easier to place a value on.

 

What Are the Comparable Sales?

Some businesses can also utilize a business valuation approach that is very similar to the real estate market by taking a look at the comparable sales in the market, and using that information to come up with a value of your business. This method is very simple and straight-forward by looking at other similar business to the one you are looking to acquire, and determining at what purchase price those businesses were purchased. This approach works well for larger, public companies since a lot of that information is available to the public and somewhat easy to access. In the smaller, middle-markets, it is much more difficult to accumulate enough information to make an accurate determination based on value.

The concept of business valuation is always very complicated. However, when looking to buy a business, it is important to recognize that you do not have to be 100% accurate in your calculation of a purchase price. You should, however, do your homework, apply these methods to the business you are looking to acquire, and like the Sharks on Shark Tank, become comfortable with a purchase price you are willing to pay to for the business. Most importantly, make sure you stick to it. There is no harm in walking away from a deal because the seller is asking too much for the company, because in the end, the purchase price you pay for the business is a major factor in the long-term growth and success of your investment.

 

Contact Cohen Pollock Merlin Turner

When you have a business idea, it’s always in your best interest to contact a business lawyer to learn about options and opportunities that are available. At Cohen Pollock Merlin Turner, corporate lawyers in Atlanta, Georgia, provide outside counsel for business ventures to help guide and educate you through the process.

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Legal Disclaimer: This blog post is for informational purposes only and is not intended to be, and should not be interpreted as, legal advice. Please contact an attorney with any questions pertaining to the information contained herein.