There are many ways and opinions on how to assess the value of a business. Because not all of them make sense, here are some thoughts on what can be a win-win for both parties:
First, whether you are a publicly traded or privately held company, at the end of the day you are paying for a future revenue and earnings stream. There may be “hard assets” you are acquiring, such as inventory, current receivables, fixed assets, and maybe even something proprietary such as software code. However, when you net it out, you really want to purchase a future revenue and earnings stream or, at a minimum, the opportunity to develop and harvest one. As many of you know, you cannot continue to grow in a positive fashion organically year in and year out.
Second, unless desperate, most sellers are not going to sell their companies for “book value,” meaning the hard, tangible assets minus the hard liabilities. They will want something for their sweat equity above what they can basically liquidate the business for. This will likely make your CPA a bit uncomfortable. Based on accounting guidelines, anything that is purchased in excess above the fair market value of the assets equals “goodwill.” Yet, this does not need to frighten a buyer away from a deal. Here’s why:
- Your accountants are there to assess the fair value of hard assets and liabilities. This is important as it provides a “floor” as to what you are purchasing at a minimum. You want to know this floor value going into a transaction so that you understand the downside if it does not work out the way you planned.
- Your advisor should perform a comparable companies valuation analysis to ensure you are not paying too much above or below what the market will bear. This analysis should be included as part of the advisor’s services.
- Valuation metrics should be evaluated. This includes enterprise value (total consideration paid including interest bearing debt assumption) to EBITDA, EBIT, and Net Income. Again, you’re paying for a future revenue and earnings stream.
- It’s important to calculate your total payback in terms of after tax dollars. Getting your original investment back in about five years is often considered a good deal.
- Another thing to factor in is your IRR (Internal Rate of Return) on the deal. Meaning, what rate are you getting annually for your money invested? Typically, 15% to 20% return is a good place to be.
- If you are a public company, your advisor should also perform a sensitivity analysis, in which they combine your numbers and the seller’s to make sure the deal will have a positive impact on your company. It will also show you different downside and upside scenarios based on performance assumptions.
- Finally, you should establish your valuation methodology and basic deal structure up front with your board and management. After this is set, it’s important that you do not deviate much from it even if the market indicates you are significantly below what is getting done in your industry.
Knowing how to assess the value of a business calls for considering these factors and more. If you’re in the market to buy, an established advisor can assist in constructing a growth thru acquisition plan and ensure a win-win deal for both you and the seller.
Steve Pomeroy is the founder of Big Change Advisors, an M&A consulting firm in Los Angeles focusing on middle market companies in the IT services space. Since 1992, Big Change leaders have completed over 36 transactions including M&A, Capital Sourcing, and Public Offerings representing over $800 million in total transaction value. Big Change Advisors donates a percentage of all fees to help serve the homeless through the Los Angeles Mission. To request a free consultant, contact us.