The sixth in our series of articles for distributors that are contemplating a sale of their business focuses on the insight financials provide prospective buyers.

by Jane E. Baynard and Scott Benfield

Your prospective buyer has scrutinized your financials and you now find yourself sitting across from them at a big round table. The question de jour: price. You have a very specific idea about the value of your wholesale distribution business. So do they. Chances are these two numbers are quite different. Do you throw your arms up in the air and storm out of the room in frustration?  Not just yet.

Determining the value of a business is the part of the buy-sell transaction most fraught with potential for differences of opinion. Buyers and sellers face conflicting interests and rarely share the same perspective; each has a distinct rationale guided by logic or emotion.

The motives behind the transaction will influence each party’s valuation of the business in addition to the financials discussed in the previous article. The buyer may believe that the purchase will create synergy or an economy of scale because of the way the business will operate under new ownership or see the business as a particularly good lifestyle fit.

These factors will likely increase the amount of money a buyer will pay for a business. The seller may have a greater than normal desire to sell due to financial difficulties or the death or illness of the owner or a member of the owner's family. The external motives of each party will likely significantly influence the value of the transaction.

In order to successfully conclude the transaction, both parties must agree on a satisfactory price and understand how that price was determined.

Factors that determine value
The topic of business valuation is so complex that any explanation short of an entire book does not do it justice. The process takes into account a myriad of variables and a number of assumptions. Shannon Pratt, a noted business valuation expert, names six of the most important factors: 

The six factors named above determine the fair market value. However, businesses rarely change hands at fair market value. Three other factors often come into play in arriving at an agreed upon price. Pratt identifies them as follows:

The definition of fair market value is the price at which property would change hands between a willing buyer and a willing seller, both being adequately informed of all material facts and neither being compelled to buy or to sell. In the marketplace, the buyer and seller nearly always act under different motives and levels of compulsion.

Rule-of-thumb formulas
The guideline for using rule-of-thumb formulas for pricing a business: don't use them. The problem with rule-of thumb formulas is that they address few of the factors that impact a business's value. They rely on a one-size-fits-all approach when, in fact, no two businesses are identical.

Rule-of-thumb formulas do, however, provide a quick means of establishing whether a price for a certain business is in the ballpark. They are normally calculated as a percentage of either sales or asset values, or a combination of both based on statistical averages from other transactions within your industry. The rule-of-thumb formulas represent averages, but many businesses sell significantly above or below the averages based on the unique strengths, weaknesses and circumstances inherent to your particular business.

In order to capture the unique value of your business, disregard rule-of-thumb formulas as anything but a preliminary indicator of ballpark value. Many businesses benefit from the experience of an acquisitions specialist to develop a valuation model that captures the unique attributes of the business.

Comparables
Using comparable sales as a means of valuing a business has the same inherent flaw as rule-of-thumb formulas. Rarely, if ever, are two businesses truly comparable. 

Comparable financial statistics can indicate how a business stacks up against other similar firms; and buyers and sellers alike can use comparables to quantify the unique strengths and attributes of your company. Businesses within the same industry have some significant characteristics in common, and a careful contrasting may allow you and your prospective buyers to draw conclusions about a range of value.

Balance sheet methods of valuation
This approach values the net assets of your firm. The balance sheet method of valuation applies most often when your business generates earnings primarily from its assets rather than from the contributions of its employees.

This method also applies when the cost of starting a business and getting revenues past the break-even point does not greatly exceed the value of the business's assets.

There are a number of balance sheet methods of valuation including book value, adjusted book value and liquidation value. Each has its proper application. The most useful balance sheet method is the adjusted book value method. This method calls for the adjustment of each asset's book value to equal the cost of replacing that asset in its current condition. The total of the adjusted asset values is then offset against the sum of the liabilities to arrive at the net adjusted book value.

Adjustments are frequently made to the book values of the following items:

• Accounts receivable: AR is often adjusted down to reflect the lack of collectability of some receivables. Alternatively, it may be taken out altogether if they remain with the buyer post close.

• Inventory: Inventory is usually adjusted down since it may be difficult to sell all the inventory at cost. Again, there are instances where inventory adjustments stray from the norm.

• Real estate: The PP of PP&E is frequently adjusted up since it has often appreciated in value since it was placed in service. However, prior to making this adjustment, it’s often prudent to check with a real estate appraiser.

• Furniture, fixtures and equipment – The E of PP&E is typically adjusted up if those items in service (probably more than a few years) have been depreciated below their market value, or adjusted down if the items have become obsolete.

Appropriate balance sheet methods of valuation give a good indicator of the value of the net assets of your company. Because net assets are tangible, identifiable, quantifiable and a reasonably predictable store of value, their adjusted value can give buyers and sellers a confident base for your transaction price.

Income statement methods of valuation
Although a balance sheet formula is sometimes the most accurate means to value a business, prospective buyers more commonly use (and IRS Revenue Rulings require) the income statement method to project profits or cash flows produced by the business's assets be weighted more heavily. 

Several income statement methods exist, and the discounted future cash flow method is one of the more frequently used methods. This method calls for the future cash flows (before taxes and before debt service) of the business to be calculated using a straightforward method.

To begin with, the historical cash flows are a good basis from which to project future cash flows. Cash flows usually include:

1. The net profit (or loss) generated by the business.
2. The owner's salary (in excess of an equivalent manager's compensation).
3. Discretionary benefits paid the owner (such as automobile allowance, travel expenses, personal insurance and entertainment). This is typically a key category in closely held business like the majority of wholesale distributors.
4. Interest (unless the buyer will be assuming the debt instrument and the interest payments).
5. Non-recurring expenses (such as non-recurring legal fees).
6. Non-cash expenses (such as depreciation and amortization).
7. Equipment replacements or additions. (This figure should be deducted from the other numbers since it represents an expense the buyer will incur in generating future cash flows).

While the future cash flows may be projected out for a number of years, for many small businesses it is not possible to predict very far into the future before the projections become meaningless. Even with somewhat larger and more substantial businesses, it is difficult to project cash flows for more than five years. Three to five years is sufficient to get a good sample series.

Once the future cash flows have been projected, they must be discounted back to their present value. This is done by selecting a reasonable rate of return (ROR) or cap rate for the buyer's investment. The selected ROR varies substantially from one business to the next and is largely a function of risk. The lower the risk associated with an investment in a business, the lower the required ROR. 

The ROR required is usually in the 20 to 50 percent range and, for most businesses, is in the 30 to 40 percent range. The present value of the future cash flows can then be determined by using a financial calculator or spreadsheet or a set of present value tables that are available in most bookstores. The following example demonstrates how the conversion is made with a 40 percent ROR.

* Based on 40 percent ROR. The discount rate declines in each succeeding year.

** Present value of the sum of discounted projected cash flows. This figure is added to the residual value of the business to arrive at the total value of the company.

The next step is to complete one more calculation - the residual value of the business. The residual value is the present value of the business’s estimated net worth at the end of the period of projected cash flows (in this example, at the end of five years). 

This is calculated by adding the current net worth of the business and future annual additions to the net worth. The annual additions are defined as the sum of each year's after-tax earnings, assuming no dividends are paid to stockholders. In most wholesale distribution business, dividends are not paid to shareholders so an after tax number is used. These additions are added to the current net worth, and that total is discounted to its present value to yield the residual value.

Almost there!
Now, the residual value is added to the present value sum of the projected future cash flows previously computed to arrive at a value or “price” for the business. An example follows.

*** Multiplying the total net worth by the discount rate used in the final year of projected cash flows yields the residual value. Adding the residual value of $272 to the present value sum of projected cash flows of $633 yields a value for the business of $905.

Although this formula is widely used, it cannot be applied in this simplistic form to arrive at a definitive value conclusion. It fails to address issues such as the buyer's working capital investment, the terms of the transaction or the valuing of assets like real estate which may not be needed to produce the projected cash flows. However, it is useful in establishing an indication of value, which can be helpful for negotiation purposes.

In summary, rule-of-thumb formulas, comparables, balance sheet approaches and income statement approaches can all provide insightful indications of your firm’s ballpark value. However, the simplistic nature of these approaches most often fails to encompass the value of your particular firm’s unique strengths and attributes. In order to get the most fair and favorable market valuation of your company, you will most likely need to consider your comparables, balance sheet, income statement, external motivation and a myriad of other variables that influence the value of your business. Many business owners benefit from the experience of an acquisition specialist to appropriately identify the most fair and favorable market value structure to encompass their firm’s uniqueness.

Buyers and sellers often find pricing a firm a contentious issue. If you go to the bargaining table with a clear understanding of your firm’s unique value, and with appropriate documentation to support your claim, you will much more likely succeed in reaching a mutually beneficial, acceptable and understood conclusion to your transaction.

When deciding to sell your business, it is important to estimate the value of your company in the marketplace. We have developed a worksheet that can give you a preliminary estimation of the market value of your firm; just send us an e-mail request and we will forward it straightaway. In the next installment of our series, we will focus on structuring your transaction.

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