How to Value a Business
How to Value a Business
I have previously discussed the mechanics of buying an existing franchised business as an alternative to establishing a new franchise, especially in systems that are mature and have few open markets remaining. Whether you are buying such a business or preparing to sell one (a topic I’ll be tackling in the next article), determining a fair and realistic price is one of the greatest challenges.
Public companies have it easy. Valuation is simply a matter of market capitalization—current stock price times number of shares outstanding. But the small, privately-held businesses that change hands on a daily basis lack the luxury of such a clear-cut benchmark. Various rules of thumb exist for determining shorthand valuations—two times revenue, for example, or three to four times EBITDA (earnings before interest, taxes, depreciation, and amortization).
Yet the fact of the matter is that an accurate valuation is rather more complicated for any but the simplest business. If you are preparing to sink a substantial sum of money into a purchase—or conversely, to put a price on something you’ve spent blood, sweat, tears, and time to build—wouldn’t you prefer something a bit more thorough than a cocktail napkin or back-of-the-envelope calculation?
Start with the Assets: The Balance Sheet
The balance sheet is one of the triumvirate of basic financial reports (the other two being the income statement, also known as the profit and loss statement or just P&L, and the statement of cash flows). It lists the assets, liabilities, and resultant owners’ equity for a company. Assets have hard values, so this should be an excellent starting point for valuing a company.
True…to an extent. In other cases, not so much.
Keep in mind that the balance sheet is a product of accounting practices, and while I am a CFO and accounting practices are certainly dear to my heart, it is important to understand the limitations those practices bring to the balance sheet.
Let’s start with a very basic (and very fair) question: Where do the numbers on the balance sheet originate? When it comes to physical assets like land, buildings, FF&E (furniture, fixtures, and equipment), and improvements (things like a new HVAC unit, a new roof, or an addition), the value is the amount paid for the asset in question. So if we buy a hypothetical restaurant and pay $750,000 in cash, our hypothetical accountant must enter the transaction into our books and assign values to each component. (For simplicity, we’ll assume for now that we bought only the restaurant and not any operations. We can open that can of worms later.)
In the absence of an appraisal or other objective source that assigns separate values, we must somehow distinguish between the value of the land and the value of the building. Why? According to both accepted accounting practices and federal tax regulations, the building can be depreciated, but the land cannot. (The building will age, wear, and eventually have to be renovated or replaced to remain useful, but the lot upon which it stands will still be there.) If arbitrary values must be assigned, a safe rule of thumb is to allot 85 percent of the purchase price to the building and 15 percent to the land.
We can’t stop there, however. The restaurant also contains equipment and furnishings, and those have some value. Typically an inventory will be conducted as part of the due diligence preceding the sale, and the owner should be able to disclose what was paid for everything in the restaurant. The equipment and furnishings package for a typical quick-service restaurant can easily run to $300,000 or more. Part of the purchase price must therefore be applied to FF&E.
If you’ve ever bought a new car and experienced the sharp drop in value that takes place the moment it is driven off the lot, you know that even if it’s nearly new, the FF&E in this restaurant is no longer worth the $300,000 that for the purposes of this example we’ll say it cost. No buyer would pay that for it. So how to value it? Per IRS rules, most FF&E of the type found in restaurants is depreciated over seven years. That means you can deduct one-seventh of the original purchase price per year of age to arrive at a fair market value (FMV) that the IRS would not likely challenge. Obviously, if the FF&E is seven or more years old, it has no value for transaction purposes.
If we assume that the FF&E in our hypothetical restaurant is three years old, we can assign it a value of (in round numbers) $171,500. That leaves $578,500 for the land and building, which based on the 85/15 rule means the building is valued at $491,725 and the land at $86,775.
Those are the numbers that will appear on the balance sheet.
Now, are they realistic? Maybe, and maybe not. The FF&E number is probably excessive. It’s highly unlikely that everything could be sold for that amount. As for the land and building, it depends on the condition of the building, the location of the lot, economic and real estate market conditions in the surrounding area, and more.
Fast-forward ten years. Assuming that the restaurant has been renovated (most franchisors will require a “reimage” at least that often) and that nothing strange has happened to the real estate market (à la the 2008 debacle), the land and building will actually be worth more than the $578,500 that appears on the balance sheet. (This is an oversimplification, because capital improvements like the aforementioned renovation would have been booked to improvements and would also appear on the balance sheet, but bear with me.) Yet even if the land and building are now worth $800,000, that’s not what the balance sheet will say.
That’s because the appreciation in value is an unrealized gain. In other words, until you actually sell it for $800,000, it’s not worth that much. Consider investing in stocks. If you buy 1,000 shares of a stock at $50 and the share price rises to $70, its value is now $70,000 versus the $50,000 you paid. Yet that $20,000 (and more) could evaporate five minutes after the opening bell tomorrow. So until you sell and “lock in” the gain, it is an unrealized or “paper” gain and nothing more.
So the balance sheet can mislead in two different ways. An asset might be worth significantly less than its booked value, as in the case of FF&E. On the other hand, an asset might actually be worth significantly more than what is shown, as in the case of real estate that has appreciated. This is why the due diligence process must include a careful examination of the exact nature of the assets to be purchased.
One final word on the balance sheet: Keep in mind that not every asset will transfer as part of the sale. Cash and accounts receivable are both assets that will show up on the balance sheet, but it is extremely rare for either to be included in a sale. Be certain to deduct any assets not conveyed by the transaction.
Assessing the Revenue Model
Businesses sell things, so it would seem that revenue (meaning sales, not net income) should be a fair guide to valuation. Plenty of statistical data is available indicating what a “typical” multiple of revenue is used to value companies in a particular industry. Yet if you examine such data, you’ll usually find a tremendous range in those multiples—a range so broad as to be nearly useless. Even using the mean (average) multiple makes a lot of assumptions about how comparable some very different companies might be.
Revenue is important as an indicator of performance, and revenue trends (is it growing, by how much, and how have growth rates held up over time, for example) are even more important. Using revenue for valuation, however, in my opinion leaves much to be desired.
As I have mentioned elsewhere, in the early 1990s I managed in the retail grocery industry for a privately-held regional chain with about 115 stores. We did about $1 billion a year in revenue—people have to eat, after all. Yet the industry is competitive, and for much of the product line perishability is an issue, so our net profit margin was roughly 1 percent, or $10 million.
Now, while $10 million is a nice number, it is far less impressive than $1 billion. Someone valuing the company at $2 billion (two times revenue) would need 200 years to recoup that investment assuming net income remained the same. This rule of thumb might have more validity on a smaller scale with smaller businesses, but I still don’t care for it.
Another popular model is based on a multiple of EBITDA, which as previously discussed is earnings before interest, taxes, depreciation, and amortization. Why are these factors excluded?
Interest is based on debt maintenance, which will vary based on the new owner’s circumstances and so bears little relation to the status quo. The seller might have almost no debt (and therefore almost no interest expense) while the buyer is about to be mortgaged to the hilt to swing the purchase and therefore will carry a much higher interest cost. Conversely, the seller might be in debt up to his eyebrows while the buyer will make a straight cash purchase.
Similarly, taxes are a product of the owner’s financial circumstances and should therefore be estimated based on the buyer’s tax burden.
Finally, depreciation and amortization are non-cash expenses (that is, they do not detract from cash flow).
Common EBITDA multiples are three or four, though as low as two and as high as five are sometimes seen as well. I find this technique a good guide and a quick way to assess whether a seller is pricing his or her business at least somewhat reasonably. It should not, however, be the final word.
Free Cash Flow
I said earlier that businesses sell things, but what an owner really wants from a business is cash. You can sell things all day long, day in and day out, and still produce very little cash. This is where the statement of cash flows comes into play.
Managers tend to focus on the P&L, but as a guide to the health of a business the cash flow statement is crucial. In some situations the P&L can make things look rosier than they are.
For example, a business that sells extensively on credit will generate all kinds of revenue and may even have a great net income number. Yet until those credit sales are collected, there is no cash to pay employees or vendors or buy new inventory. Poor cash flow—sometimes resulting from owners who will do just about anything to make the sale—is a major killer of small businesses.
The P&L, balance sheet, and cash flow statement must all be evaluated to properly gauge the health of a business. The cash flow statement can also be distorted, after all. It can look better than the P&L might indicate if bills aren’t being paid timely and accounts payable are piling up, which conserves cash in the short term but isn’t good for continued operations in the long term. Lots of uncollected revenue that makes the P&L look good will create a large accounts receivable balance that makes the cash flow statement anemic.
Also, remember that debt maintenance does not appear on the P&L aside from the interest portion. The reduction of principal hits the cash flow statement and balance sheet. While the owner’s debt does not affect what the business will be worth to you as a buyer, it can provide a clue as to why the seller is willing to accept what seems to be an unusually low price—something that should always be cause for suspicion. In addition, since any associated debt will have to be paid off from the sale proceeds, the amount will give you an idea of what the seller’s absolute minimum price is likely to be.
One final word on net income, EBITDA, and cash flow: Examine the financial statements closely for factors unique to the current ownership, especially for businesses that are making little to nothing or even losing money on paper. Small business owners in particular often transfer what would normally be personal expenses such as car notes, insurance, cell phone bills, travel and entertainment expenses, and the like to the business. They may also pay themselves (and often family members as well) generous salaries and bonuses. If the net income is only $10,000 but the owners and their children draw a total of $400,000 in wages, the company’s value is much more than that net income figure would suggest.
As with EBITDA, multiples of three to four times cash flow are a reasonable basis for valuation.
Putting It All Together
A sound valuation relies on multiple factors, all vetted to the extent possible by due diligence. Revenue is a useful guide to performance and provides some indicator of future direction. Assets (accurately valued) plus a multiple of cash flow represent a good starting point for a total value.
One type of asset we did not touch on is the intangible asset. In some industries this might be intellectual property like patents (which can easily be worth a million dollars each). In franchised businesses the franchise fee itself, which represents the right to do business using that brand, has value. Determining what this contributes to valuation is a question of what it would cost to buy into the franchise today and more importantly how much of the original term of the franchise agreement remains (assuming the franchisor’s practice is to transfer the existing agreement).
The final aspect involves some prognostication and your best estimate of future conditions. First, is the business growing, stable, or declining? How established is the franchise system, and how quickly is it growing? Is the franchisor innovating, or has the brand stagnated? Unless you plan to turn around and sell within a very few years, these things matter.
Second, what significant difference can you make in the acquired business? Do you have the financial wherewithal to catch up deferred maintenance, renovate tired facilities, hire new operations talent, or answer other currently unfunded needs? Do you have a special expertise in the industry that will allow you to improve operations and revenue? In the end it’s as much about what you can do with the business as it is about what the current owner has done.