How the sale value of a business is properly determined

The value of a business is commonly a large portion of its owner’s net worth. Understanding what the business is really worth, or could be worth, allows an owner to make important decisions regarding key issues like retirement, estate planning and choosing a business successor.

A frequent question owners ask is, “What is my business worth?” The answer is not necessarily what the assets would sell for — a common misunderstanding of owners.

Smart Business spoke with James F. Schultz, principal at Cendrowski Corporate Advisors LLC, about how the sale value of a business is properly determined.

Learning what your organization is really worth can bring dividends

The first step is to hire an independent valuator to determine the realistic sales price of the business. This important step should be done by a professional experienced in merger and acquisition processes and in valuation analyses. The valuator will look at the business and use the standard valuation approaches of asset, income and market to estimate the enterprise value of the business.

For most operating businesses, the income and/or market approach will have the most influence in estimating the sale value of the business. Research is needed into the industry of the business to find trends and key economic factors driving profitability.

Next, a look at sales of comparable businesses in the industry can provide various multipliers of income factors that can be applied to the business. If comparable sales are not available, estimating proper investment returns on income based on risk/reward analysis will estimate value.

When applying the income approach, it may be necessary to identify synergies/cost savings created from the sale. This will enable the valuator to establish investment value (to an acquirer) rather than fair market value (to a hypothetical purchaser).

In cases where the return on investment is low and/or little labor is involved, the asset method may be more applicable.

What happens after the enterprise value is estimated?

The next step is to estimate what the purchaser will actually receive from the seller. Most sale transactions today are structured as asset sales rather than stock sales. In an asset sale transaction, specifically identified assets and liabilities of the selling company will be transferred to the purchaser. The purchaser will require all the fixed assets necessary to run the business, which can range from computer systems to manufacturing machinery.

In addition to the fixed assets, the purchaser acquires various intangible assets and rights relative to trade names, patents, goodwill, occupancy/lease rights, client lists and vendor lists, to name a few. The more difficult item to quantify is the level of working capital that the purchaser will require as part of the sale transaction.

The purchaser is looking to acquire an operating business and the necessary liquidity to allow the business to continue to operate in a smooth fashion without requiring additional equity amounts.

The items typically included in working capital are accounts receivable, inventory and accounts payable. The net value of those amounts need to provide a liquid cushion to continue business operations. The sale negotiations will normally determine the appropriate level of liquidity, and an adjustment of the purchase price may be required if the level is not met or if there is an excess when the sale closes.

In most cases, the purchaser will not assume liabilities other than trade payables.

After estimating the purchaser’s requirements, what are the final steps?

The final step is to analyze the existing balance sheet of the company for items that will not be transferred to the purchaser. This typically consists of cash, investments and other non-operating assets on the asset side, and all liabilities excluding trade accounts payable on the liability side. The net value from the combination of the aforesaid items is then added to/subtracted from the enterprise value. The result of that computation is the estimated net sale proceeds of the business.

In order to determine what the owner will be able to put in the bank, an estimate of the income taxes related to the sale transaction should be calculated. That amount is subtracted from the estimated sale proceeds to determine the after-tax cash available to the owner.

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