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How will they value my business?
That's what we're asking when we start to look at our exit strategy.
If you research this you'll find what looks like a lot of possible valuation methods.
Today I'll talk about what they mean and see if we can simplify the process.
Spoiler alert... we can!
Because the stream cut me off... Remember that doing it yourself doesn't mean going it alone! :)
Need Business BeyonDIY on the go? Check your favorite podcatcher!
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...and many more!
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stephen.krausse@b50p.com
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Businesses are bought and sold based on the perception of future value.
Business owners are often experts in fields outside of business.
We developed Business BeyonDIY to help you cross that chasm.
Show Topics:
Buying a Business
Selling Your Business
Preparing Your Business for Sale
Practical | Actionable | Sustainable
Business owners and entrepreneurs are go-getters. We start things other people don't (sometimes too many things am I right?) and we push through hard times. That means that entrepreneurship involves a lot of DIY.
Some of the most important transactions we make are buying a business; preparing a business for sale and selling a business. We'll almost always want/need help to make these successful but there is still a lot we'll need to do ourselves.
Business BeyonDIY is a Livestream/podcast where we own our DIY nature but find that sweet spot where doing it yourself doesn't mean going it alone.
In this introductory episode, I'll let you know the format of the show, what to expect, and when I'll be live.
I'm looking forward to getting to know you and your business and sharing practical tips that will make your DIY more like DI-Us!
How will they value my business? That's what we're asking when we start looking at our exit strategy. And if you research the topic, you're going to find a lot of methodologies out there. Today, I want to talk about what some of those mean. And find out if we can simplify the process. Spoiler alert, we can. Hey, business owners and entrepreneurs, welcome to Business beyond DIY, where we get you from here to what comes next. I'm your host, Stephen Krause II and I want to help you get the most out of your entrepreneurial journey. So let's get started. Just for those of you who are following the video production of the of the show, I have done a few things, I did move the computer off of my main desk. So hopefully that's less distracting. Little nitpicks that I personally have, I don't like this piece of my shelf showing up in the shot. So I am working on how to how to fix that, you would think it would be easy, but it's less easy than you might think. Anyway, I had looked into getting some transitions done for this week. So I can move from scene to scene a little more fluidly. And like I talked about last time, that actually speaks more to post production than it really does to, you know, the the impact on the user or the viewer. But I didn't have time to do all of that I did do some experiments this morning and figured out that that actually, I need to do a little bit more than I can get done in an hour. So that's a quick update on the show production itself. For those of you who are working on video for your own programs, or your own shows or your own business. And I wanted to share what I have done so far, as I always try to do. So. What is in it for you today? What methods do we use to place a value on a small business? All of the ones that are really applicable, are based on two things, cash flow, and asset value. And so when you do a Google search, and you look for business valuation methods, you're going to find article after article with any number of methods of valuing businesses. And a lot of them are going to be either a not applicable to small business. Or they're going to be some kind of permutation of asset value, or cash flow. So what we can really do, and I think when we go through this, what you'll find is that we can simplify this down to just dealing with asset value, value and cashflow. And I think I can help you, first of all, simplify the process, but then also be able to choose which process makes the most sense. Or understand that you need to combine some processes, or tailor some process that in a way that works for the situation that you're in. So that's it. So the first thing we're going to do is talk a little bit about the methods of evaluation that exist. And like I said, the the well the first one, he said was cashflow, we'll get to that one, the second one is asset value. And as a value actually comes down to two pieces, there's two ways of doing this. There's the balance sheet value, which is basically the value of the assets minus the liabilities, just use a gross figure. And that gives you the balance sheet value of a business. Okay? When you use that methodology, you're going to find there are going to be things that you're going to want to look at more carefully. But overall, that's what that means. The balance sheet value is the balance sheet value. Next, we're talking about liquidation value. And people talk about liquidation value. When I'm talking about liquidation value, what I want you to think about is that liquidation value is not buying a business. That's a process of buying assets that you're going to use for something else, whether you're going to buy the assets and liquidate them and just get the cash or if you're going to integrate those assets into your business
in a different way, but not really as an ongoing concern related to the existing business. So when you're talking about liquidation value, that means those assets are no longer going to be used to produce the products and services that they were before, they're simply going to be moved into some other, they're going to be leveraged in some other way. We're not going to talk about liquidation. Again, because liquidation is not buying a business, that is buying physical stuff that you're going to resell or leverage in your own business in a different way, we're not going to talk about it anymore. The next thing that we have is cash flow. There are three basic cash flow analyses that people use. One is sell sellers, discretionary earnings, which is probably the most popular and the most applicable to small business. There's one called discounted cash flow, which is basically a modified version of sellers discretionary earnings, and probably not actually one that I would recommend that people use, but we'll we'll talk about it a little bit. And then capitalization of cash flow, which is basically cash divided by a discount rate. And all of these mechanisms, those are the cash flow methods that are out there, then you're going to see a couple of other things. If you start searching for valuation methods on the internet, or whatever, or you talk to people, one of them is going to be market value. When we talk about market value, then you're starting to compare what we consider equivalent businesses. And say, because this business is valued at $10 million, therefore, my business should be valued at $12 million, because of these comparisons that we're going to make. The reality here for most small business owners is that this just won't work. Because we're not going to be able to get the financial data for the comparable business. And in order for it to be valid, we have to have a significant number of comparable businesses that we can use to evaluate your business or my business. The data has to be valid and complete, which means we have to be able to believe the financial data that we're seeing. And it has to be complete enough to create it to do an analysis of those comparable businesses, so that we can compare the financials of those businesses to your business. And it has to be reviewable, so we have to be able to really dig into it. That is a lot to ask of businesses that are not publicly traded and don't have to share their data. So when someone says, Well, the market value of my business is $12 million. How they're basing that on anything that's verifiable, we'll probably never know. So I don't recommend using market value. Because I just don't think it's something we can validate. All right. Another method that someone might talk about, I've talked about this before. And like I said, Before, I will say it again, we do not use revenue as a method of valuing a business. If someone wants to use revenue, you just back up and look at a cash flow method, or an asset method. And if the numbers match, great, if the numbers don't match, then you need to go to the negotiating table and say, I'm comfortable offering 11 million for your or I'm comfortable valuing your business at 11 million, or whatever the number is. So we don't use revenue as a methodology. There are also methods of assigning value to shares. And this typically isn't one that I would use, you're going to have to be able to prove that the value of the asset value or cashflow is related to the percentage of the company that you want to purchase. And so you could say that, and this, I guess, let me back up a moment. This comes into play when there are multiple owners, okay, there's really no point in assigning value to shares. If you're going to buy 100% of the shares, or you're going to sell 100% of the shares of the company, there's then you're overcomplicating the the issue. However, if you're buying into a business that does have multiple owners, you may come across something like this. And so you'll be buying.
You know, if you're not buying all of the shares, then you're going to be buying, you know, a a partnership or a piece of that business. And you have to be able to apply some kind of value to that. I again, I don't like to use shares as evaluation method. One of the reasons is that shares have no value if you can't trade them. And so when you buy shares in a small business, the only way you can trade those shares in the future is find another buyer for that small business, there's no market where you can go home, I have 200,000 shares of this small business in my local community, and find somebody who's just going to easily snap, snap those up, they're not liquid. And so they don't, by nature, have any value. And so that's I think, something really important to remember is that that people you might get not confused, but you might allow yourself to believe that there's intrinsic value in the shares, when it's really not. It's the percentage of the business that those Shares represent. And that might be that might seem like a nuance. When you think about well, that's really what shares in a major corporation, a publicly traded corporation are as well, except that those are liquid, which means that you can, there is a market where you can, you can sell those shares, for the most part, at some market value that you can estimate. With a small business, you can't do that. So it's basically, you've got to be able to assign the share value to how much of the asset value or the cash flow value of that business that that share represents. And then assign a value to it based on that, which basically means you've just come up with an extra step. In valuing the business, if you have to split, if you're buying the shares, that one owner has, that is the discussion that you're going to have to have. But remember, it's just a percentage of the value of the business. So you need to value the business, and then figure out how much that owner owns and work backwards and say, Okay, I'm willing to pay you owner this much based on the value of the business. And you need to be very clear that where your responsibility as a buyer ends with how the operating agreement for that business runs, which affects basically the ability of a single shareholder to sell their part of the company. And every operating agreement is different. So hashtag, I'm not a lawyer, right? So get with your business attorney, have them review the operating agreement to make sure that what you're offering is going to be something that the partners are willing to accept and will not be coming back to you later and saying, Hey, we didn't, you couldn't have bought the this part of our company this way, because our operating agreement doesn't allow it. So if you're buying a portion of a company, you need to be very clear that you want to, you want your lawyer to review the operating agreement and all of the incorporation documents for that business, so that you know that what you're buying is valid. Okay, enough on that, let's talk a little bit about let's let's take the first level of simplification. So the first thing we can do is say, when we buy a business, or when we sell a business, it is either going to be based on asset value, or cashflow. That's it. Even if you're going to assign value to shares of stock, it is going to be based on the percentage of the cash flow or assets that those Shares represent. Simple as that. When we look at cash flow, it's always about future cash flow. So it's the ability of a business to produce cash, we need to look at a few things, how many years of financials? Can the owner produce? to backup? Whatever analysis we're going to do? Do they all support a similar pattern? You know, I would probably value most businesses based on the last 12 months.
But it's always better to have a pattern that you can look at for you know, as I would like to see five years for most companies. That way, you can look at the four prior years as a basis and say, Okay, is there an upward trend? Is there a downward trend in any aspect of the business? You know, is there an upward trend in in revenue? Is there an upward trend in cost of goods that is disproportionate to an upward trend in revenue is there are there other trends that we need to look at and those become analysis issues that help you put the final number on the business but they're worth looking at. So when someone comes to you with one year of financials, I'm gonna push back and ask for more. I want to see more of the financials over time in order to make a good evaluate should have the health of the business. It's important to understand anomalies, and but not excuse them. So there are no Mulligan's in business during my career, we have never gone more than eight years without a significant economic disruption. Okay, whether it was recession or, you know, in the more recent history, I mean, we've got natural disaster, if you're talking about maybe a geographic disrupt disruption, you've got recession, we have supply chain issues that may come up, the supply chain for electronics has been tightened over the last few years. And of course, we have right now we have the pandemic, which impacts the economy. So understanding that is okay. But intellectually, we don't want to excuse the behavior of a company during that time, or the performance of the company. During that time, we don't want to say, Oh, 2020 was, or 2021, or both, were affected by the pandemic, so they don't count. And that's a trap we can fall into. Because it's easy to want to give credit for that kind of thing. But what the reality is, we have to be able to weather those kinds of things. So understanding how an event impacted a business is going to be critical to making sure that you know how going forward as a buyer, you're going to weather some kind of issue that comes up. And it will guarantee at least every eight years, there's going to be an economic disruption, that is going to give you a hard time, that's just the way it is there's always something coming up. And it could be more frequent than that. But I've never seen it go less than that. So we have to incorporate that into how we analyze the business, and how we capitalize the business. You know, if on average, the business only needs a certain amount of money to run. But during 2020, it needed twice that because of the impact of the pandemic and we had to push money into the business to keep it going. You have to incorporate that into your plan going forward. So you know that you can capitalize the business long term. So that's one thing, understand anomalies, but don't excuse them.
Then we pick the mat, the cashflow method, that isn't the most appropriate. And we talked about sellers discretionary earnings last week, there's the discounted cash flow method and the capitalization of cash flow. And I will do an episode on calculating each of those, like I talked about before, I'm going to do episodes on on each of the valuation methods that I think are appropriate to small business. And so we'll do asset value calculations we'll do we already did SDE last week, we'll do discounted cash flow. And we will do the capitalization of cash flow in separate episodes. So I'm not going to dig specifically into each of those today, because that would make too long of an episode. The next one is asset value. And it's basically it is going to start with the balance sheet. But I want you to think about it a little differently than that. Okay, because the balance sheet has no intrinsic value either. It's just like shares, shares of stock, the value of the equipment, as a business has no intrinsic value. Okay, it might have liquidation value, that's fine. But that's not what we're talking about. We're talking about buying an ongoing concern or selling an ongoing concern. So when we look at this, we have to look at the value of the assets by their ability to create future cash. So even if we're buying a business based on the assets, we're still looking at the ability of those assets to generate future cash. So it always always ends up coming down to how does this entity make future cash? Whether you're using a cash flow method, or the asset method, don't think of the assets as a sum of the balance sheet. Think of the assets as the sum of the balance sheet and its ability to generate cash. And so we have a few things to look at you have inventory, the saleable inventory. So what do you have in stock that you're buying that you can sell? Do you have the sales channels that are going to be available? Can you replenish the inventory at the same cost as the current owner? Is the inventory perishable? So that's the the finished goods inventory. You have a lot of the same concerns when it comes to raw materials. You know, is it available? Can you read? Can you restock it? What are the lead times? Are the discounts in bulk? Do you have to buy bulk in order to achieve the same cost that the seller did? And are there perishability issues or storage issues, and I talked a little bit about that last week as well. So I will put a link in the up here somewhere to that episode, then we also have vendor relationships, you know, are we going to have the same relationships with the vendors that your current owner has all of those matter when you're looking at the asset value, just as much as any other value, because you have to be able to drive that inventory and those assets forward. And if you if you can't do that in the same way that the current owner is doing it or better, then that impacts the value of the business to you. Equipment, that's going to be an asset as well. And we can we'll we will talk about each of these things in more detail in this specific episode around, you know, buying a business based on assets. But just for short term, what are the what's the condition of the equipment? Is there a lease on the equipment that's going to be transferred? Are you going to have to release it? What are the maintenance costs? Are the maintenance costs suitable? For the equipment that you've purchased? Replacement considerations? Do we need to replace this equipment anytime soon? If it broke tomorrow, would you be able to produce the goods that you need to to keep the business alive? If not, how long would it take to fix or replace that piece of equipment? And how does that impact your business decision? If a piece of equipment is mission critical to the business, you need to understand that and evaluate that as part of your buying process.
The other the other assets that we can talk about are intellectual property, goodwill, the mystical, magical asset that is very hard to put a number on or to validate. But sometimes it's there, kind of combining all of that, how do we make sure that all the assets combined are going to be valuable? You know, we have inventory for sale. That's that's easy. equipment used to produce goods. Okay. And then finally, the intellectual property, what's the value of that the value of intellectual property is the unique selling proposition some feature or benefit that that that intellectual property provides that another way of doing it won't, whatever that looks like. The other piece for intellectual property is that it may increase the barrier to competition. And so that gives us some amount of time where it's difficult to compete with us because we have this intellectual property. And you can't guarantee that forever. But if somebody's selling you a patent, you need to know how long that patent still has before it expires. Or if they have some other intellectual property, how long are you going to be able to count on that? providing you a either a unique selling proposition or barrier to entry for competitors? Okay, so here's the bottom line. There are really only two ways to calculate the value of a business, asset value and cashflow. So as you look at this as a business owner, or as a buyer, don't let it be complicated. Don't let people tell you that it's complicated. There are only two ways and they are not complicated. The calculations are not hard not for any of the cash flow methodologies. The calculations are not hard, and the concepts are not hard. What makes it hard is people tend to overcomplicate it too early in the process. What we need to understand is what are the basic valuation methods and how do they apply to a specific situation? And what I will tell you is that you should calculate both as the seller you want to calculate both so that you know where your buyer might be coming from. And you can make adjustments accordingly. And you can meet objections accordingly. So if someone says no, I want to buy it based on assets and you're saying I want you to buy it based on cash flow. Have a good argument ready Why cash flow is more appropriate. Okay, it's also okay to say I won't sell the assets, I'm only going to do the sale if somebody's willing to pay for a cash flow valuation, but understand what that means, and be able to rationalize it away way that you can demonstrate why that's appropriate for your business. There's only two ways to do it. Asset Value, cash flow. What makes sense for you, like I said, it's going to be dependent on your situation. But as the business owner, that's going to sell some day, I'm going to tell you to plan your exit in advance. And by advance, I mean years. And that's not to make more work for you. It's so that you can achieve the exit that you want. Because just you're assuming that you're magically going to get a $10 million exit on your business is wishful thinking, but planning for a $10 million exit when you know how businesses are valued, is much more achievable? Because you can write down the calculations and say, Okay, if I did it, if I sold today, it would be worth 2 million. If I want to sell at 10 million, what do those numbers have to be? And then you can back into how do I get to that? Right? So we look at how far into the future we want to plan. I like to see people planning 10 years in advance, it seems like a long time until you're trying to sell your business and it hasn't gotten to the point where the valuation is where you want it. So 10 years in advance is a good number to start planning your exit and understanding how to achieve the number you want. At the time that you want to exit.
How much do you want your business to be worth? Like I said, Do the valuations and then back into the numbers that you need to have? And then what numbers right what numbers need what they need to look like. So that comes back to what I call run at ready to exit which means we look at those numbers. And we put in systems and processes into place. So that the business is running in a direction that specifically targets your exit value. And the benefit to that is not only are you going to be working towards achieving your specific desired exit value, or exit conditions, but also you're going to be running a better business all along the way. It's going to require less time, it's going to be more repeatable, it's going to be more profitable. And all of those things benefit you while you own the business. Then again, we calculate both valuations regularly, I would calculate the the value of my business at least annually. So that so that you understand where you are in comparison to where you want to be, are you moving in the direction that you need to? Are you moving in that direction quickly enough to achieve your goals? And if you're not, then you can course correct, which is very important. And that's the bottom line. Thank you for joining me on this on an entrepreneurial journey. I'm Steven Crossy with the 50% and I help entrepreneurs buy and sell businesses with experience driven process and impartial analysis. There are social media links in the description below as well as calendar link if you're ready to talk about your goals and getting from here to what comes next. If you found this video helpful please like and subscribe if you're listening to the podcast five stars reviews. Let the pod catchers know that this show exists and that entrepreneurship matters. Remember that doing it yourself. Doesn't mean going it alone.
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