The simple answer to this question is this: your company is worth what someone will pay for it. That said, the method by which an investor values your company involves fairly complex financial modeling. Because strategic investors have different motivations and a variety of valuation methods, here we try and give you a few simple rules to consider when thinking about your company’s value.
To begin, this is not personal. Granted, you and your family have put everything into your business, and now an outsider is trying to place a value on it. It is hard not to take it personally. Private equity investors, however, are seasoned and disciplined. The valuation of your company will be based almost exclusively on the financial health and potential of your company.
If you want a general sense of your company's value, determining your industries average multiple of EBITDA (Earnings before interest, taxes, depreciation, and amortization) is a good start. For instance, if the average multiple in the logistics brokerage industry is 4X, then a logistics broker can assume his company is worth around 4X his EBITDA. Because there are hundreds of transactions a year, market average multiples can help you determine a rough value for your company. Most investment bankers and investors are happy to provide you data on common multiples in your industry to give you a general sense of the market. Just remember that multiples vary and can be misleading.
Whether your multiple goes up or down has a lot to do with risk. Unlike venture capitalists, a private equity investor wants safer investments and is more concerned with losing his shirt than hitting a home run. Whether an equity or strategic investor, the investor's offer inevitably reflects the future value of present cash flow.
Once financial criteria are met, essentially the investor works backward--looking for a reason to say no. Some common red flags considered include:
This is not an exhaustive list, but it provides an idea of the many items that can chip away or add to your value.
Once you have a rough estimate, the final valuation number is usually derived from a weighted average of suggested values. The methods of valuation usually focus on one of three aspects: 1-Assets, 2-Earnings and 3-Comparable Sales. Calculating a value utilizing alternative methods provides a good cross-reference while identifying the approach suggesting the highest value. Remember that prospective buyers differ in their weightings of value based upon earnings, assets or comparable sales; so it is in everyone’s best interest to understand value from all perspectives.
First revise the current balance sheet to better reflect today's market value. This information will also be important in supporting the buyer's ability to obtain loans and/or take a "step-up" basis on assets for tax planning purposes. If an asset sale is anticipated (versus sale of stock) and your valuation is greater than 60% of assets then perhaps the assets are underutilized.
The following tangible assets should be reviewed:
The intangible assets need to be reviewed as well:
Knowing the value of tangible and intangible assets allows the following methods to be applied:
Earnings are the best variable to utilize in valuing an ongoing business. Machinery, management experience, and proprietary information quickly lose much of their value if they cannot generate earnings.
An industry average Price/Earnings multiple is applied to weighted, adjusted earnings.
For example: $5,000,000 pretax earnings x P/E (Price ÷ Annual Earnings) of 5 = $25,000,000
Note: Unlike publicly-held firms, a privately-held company's "earnings" usually means pre-tax earnings.
A capitalization rate must be determined for some valuation methods. The capitalization rate is the buyer's required rate of return. Factors effecting this rate include the rate of return on risk-free T-bills, the nature of the business and history of earnings. The capitalization rate (a build-up of various returns) is best explained in this example:
Return on risk-free investments + 1%
(5-7 yr. Treasury Bills)
Plus return for business risk +8%
(normal equity risk)
Plus return for specific risk +12%
(varies per industry and business)
Minus business growth rate -2%
Capitalization rate =19%
The capitalization rate is sometimes converted to a multiplier by dividing it into 100%. (Example: 100% divided by a capitalization rate of 25% equals a multiplier of 4.)
Capitalization of Earnings
This is the most common method in valuing manufacturing companies. A weighted average of pre-tax, adjusted earnings is multiplied by the cap rate to determine the valuation.
Ex: $5,000,000 pretax earnings X 5.6 (an 18% Cap Rate) = $28,000,000.
Capitalization of Excess Earning
Also called the I.R.S. Formula, this approach adds the calculated intangible asset value to the adjusted tangible assets value to obtain a total value. The intangible assets value is calculated by taking excess earnings (earnings above a normal rate of return on tangible assets) and dividing by a cap rate which varies widely but normally ranges from 22 to 35%.
Discounted Future Earnings
This method is used by companies experiencing high growth rates and expecting significant jumps in earnings. The value is obtained by discounting projected earnings to the present value and then adding back an income or asset residual.
There are other, less frequently used valuation approaches based upon future earnings and cash flow which we will not discuss here.
Comparing the price and terms of similar recent ownership transfers will provide valuable data for setting a valuation. Most of the information available covers publicly-traded companies. Significant adjustments must be taken when comparing publicly to privately-held companies. It's more difficult but well worth the effort to gather information on recent sales of privately-held sales. Most business appraisers have access to market data that includes comparable sale information to assist in the valuation process.
Privately-held companies often sell at a 20-40% discount compared to the values of publicly-held companies. Discounts range from 40 to 70% for minority ownership transfers of privately-held companies. The discounts occur due to a lack of marketability (no public market for shares), less access to financing, instability caused by the owner's departure, less comparable sales information, and less predictable profits.
Upon completing and reviewing a variety of approaches to valuation the most relevant approaches are weighted and a final value is derived.