One of the principle, if not most critical, considerations that either a buyer or a seller of a business has is valuation. There are a number of well-used tools and approaches to business valuation that are commonly grouped into one of three categories:
- Cash Flow/Income-based Valuations: as a business is ultimately only as good as the cash flows that it generates, this approach involves estimating the cash flow generation potential of the business over time. Net Present Value (NPV) is one of the most common approaches used here.
- Market-based Valuations: this approach involves evaluating comparable companies in the market, deriving benchmarks for how these companies are valued and then applying these benchmarks to your company. The most common approach here is using a multiple of earnings, typically EBITDA (Earnings before Interest, Tax, Depreciation and Amortization).
- Asset-based Valuation: this approach involves estimating the value of all of the assets in a company, both tangible and intangible, and using that to estimate value. This is frequently used in instances where there are lots of intangible assets and/or limited current income in the business.
A less frequently used method for businesses (but one which is used for real estate) would be to estimate replacement costs i.e., how much would I need to invest to build a similar business and use that as a basis for value.
There is no one right way to value a business and, although valuation professionals do not like to hear this, there is a healthy balance of both “art” and “science” in deriving a fair valuation. In fact perhaps the most reliable method that Avalon has found in valuing small/midsize privately held companies is to ask the owner what they think their business is worth and then divide that number by two!
If you are a small or midsize business and are considering selling your business, or are a buyer seeking acquisitions of this size company, a few tips on how to handle valuation considerations are:
- Be aware of how the other party thinks about valuation, and also how your particular industry customarily looks at value. Different industries use different valuation metrics, and also command much different valuations.
- Size does matter; companies that are $20 M in revenue and lower command much lower relative valuations than large companies in the same industry.
- Be current in your knowledge; EBITDA multiples, for example, will change depending on overall market and economic conditions, and that 7x that you could have gotten 18 months ago might now be more like 5x.
- Use multiple methods to estimate value.
Ultimately, the right valuation is what a buyer and seller can agree to, and keep in mind that there might be other options (e.g., earnouts, contingent payments) that can help bridge gaps.