Question: In a previous column you talked about the importance of having an "exit strategy." I'm building my business up every year, and I plan to sell it at some point. How will I know what it's worth? And what is a selling price based on?
Answer: Building your business for later sale is an admirable exit strategy. Putting a value on a business is a little bit of science and a lot of art. There's no single method or formula. Plus, every business has its own unique character and attributes. Let's talk about this.
You could try to set a price for your business by yourself, or you could get outside professional help. We'll look at those options in a moment.
To be frank, you will probably think your business is worth more than it is. This is very common. Business appraisers often start the conversation with a metaphor like this: To you, your business is a beautiful original oil painting of your daughter. To a buyer, it's a piece of canvas with some paint on it. That's pretty harsh, but it brings some reality back to the discussion. Realize that a potential buyer is only willing to buy their future, not your past.
The purpose of a business valuation is to arrive at an opinion as to the "fair market value" of your business. In short, this is defined as the price a willing buyer and a willing seller would agree on, where both are not under pressure and have all relevant information.
For background, there are some established guidelines for putting a price on a business. Many of these come from an IRS Revenue Ruling back in 1959, which is still considered the authority on small businesses valuation. The IRS got involved because it was too easy for people to avoid taxation by gifting or selling a business to a relative at an artificially low price. The "59-40 Ruling" is still in use for federal tax purposes. And the guidelines that it established have become customary for use in general business valuation as well.
The gold standards for valuation professionals are Certified Business Appraisers and CPAs with an extra Accredited Business Valuation credential. Others may have specialized or local knowledge. For example, commercial bankers or business brokers can give a ballpark estimate of value because they have a big advantage: They're close to the market and see the latest listings and sales activity.
There are three common approaches to putting a value on a business. Here's a quick rundown:
? The asset-based approach is a general way of determining a value. Your business owns physical assets like inventory and equipment, and monetary assets. You may also have intangibles, like intellectual property (i.e. trademarks) and other things of value.
? The income approach values a business based primarily on its current and future profit performance. If you have clear financial statements and projections, you're miles ahead here. The main focus is on "seller's discretionary cash flow," which entails adjusting the income statement for certain factors. A business with high profitability may have additional value, called goodwill (or commonly, "blue sky"). Google "seller's discretionary cash flow" for more information on this important concept.
? The market approach compares the company to similar companies recently sold. This is often difficult because comparable business sales are infrequent.
Where possible, the appraiser should look at all of the approaches. The most valid and current approach should get the most weight. This is usually the income approach.
Here's a very important point: don't fixate on a dollar number. The terms and structure of the deal are much more important than the price figure alone. Let's look at a very exaggerated example to make this crystal clear. Someone offers to buy your business right now for $1 million. That's a whopping price. Here are the terms: payment will be a dollar per year for a million years. And you must agree to stay on and run the business for 10 years for free. In this ridiculous example the buyer would get your business for free, and you'd get essentially nothing. But look, you sold it for $1 million.
Last, a fun side note. Until 1920, the value of a business was basically the value of its assets less its liabilities (thus, its net worth). But with the enactment of Prohibition, many businesses dealing in alcoholic beverages had great political clout. They were able to wheedle tax breaks for financial damages from the U.S. government. To determine the tax benefits to these businesses, their "goodwill value" had to be determined. That was the start of the business valuation profession.
