valuing a business-goodwill

Voltex

3 methods Ive seen used to value a business are:

1. Net assets- less intangibles unless independently valued and a careful valuation of current assets (obsolete stock and a provision for bad debts).
2. Historic earnings basis- basically average historical profits x an adj. P/E ratio over the number of ordinary shares in the business.
3. Future earnings basis- which is simply the average future profits x adj. P/E ratio over the number of ordinary shares.

smcgiff

Voltex wrote: »

3 methods Ive seen used to value a business are:

1. Net assets- less intangibles unless independently valued and a careful valuation of current assets (obsolete stock and a provision for bad debts).
2. Historic earnings basis- basically average historical profits x an adj. P/E ratio over the number of ordinary shares in the business.
3. Future earnings basis- which is simply the average future profits x adj. P/E ratio over the number of ordinary shares.

Method 1 is only applicable in a fire sale, and 2 and 3 really only relevant to listed companies.

None of them are likely to be of use to the OP.

Voltex

smcgiff wrote: »

Method 1 is only applicable in a fire sale, and 2 and 3 really only relevant to listed companies.

None of them are likely to be of use to the OP.

Unless your adj encompasses the llc element over listed comparable.

Peterdalkey

plain english?

barneystinson

Voltex wrote: »

The bigger problem is that the more you "learn" the more aware you become of the volume of what you don't know.

I prefer an efficient and effective use of the English language.

OMG are you actually this far up your own .... ?!

It's not very efficient or effective when the other party is left saying, "ummmmm, what did all that jargon mean?!".

barneystinson

Peterdalkey wrote: »

plain english?

He was obviously communicating too efficiently and effectively for you Peter...

Peterdalkey

barneystinson wrote: »

He was obviously communicating too efficiently and effectively for you Peter...

what do you mean?

bmwguy

smcgiff wrote: »

Good advice here from SBwife,

Your plan is sound OP, trying to create synergies and make better use of the target's opportunities.

As for how much to pay... It's not unusual for the seller to seek more than what the purchaser should pay (taking everything into account) especially if the seller wasn't considering sale before approach.

Times turnover or profit is a common approach, but you'd want to know a lot more about the target company to be more specific.

Thanks, I'm kind of new to this but its exciting all the same. I've actually gone back to college to study for CIMA exams which is fairly relevent. Both companies are in manufacturing. Cant really say what industries though , small tight knit industry that would possibly make us very identifiable

Voltex

Peterdalkey wrote: »

plain english?

When comparing apples to oranges you'd want to have a an adjustment factor that allows apples to be different from oranges while at the same time getting a relative answer.

Voltex

barneystinson wrote: »

OMG are you actually this far up your own .... ?!

It's not very efficient or effective when the other party is left saying, "ummmmm, what did all that jargon mean?!".

Apologies if you got confused with jargon somewhere?
Tell me where, and ill try and help you understand it a bit better.

barneystinson

Voltex wrote: »

Apologies if you got confused with jargon somewhere?
Tell me where, and ill try and help you understand it a bit better.

No I'm fine, I don't have a problem interpreting your jibber jabber, but to illustrate my point, Exhibit A:

DubTony wrote: »

I tried to read this thread but couldn't find my dictionary/thesaurus.

:pac:

And Exhibit B:

Peterdalkey wrote: »

tis always a danger with book-learning!!

And Exhibit C:

Peterdalkey wrote: »

plain english?

Voltex

barneystinson wrote: »

No I'm fine, I don't have a problem interpreting your jibber jabber, but to illustrate my point, Exhibit A:

And Exhibit B:


And Exhibit C:

...and your own contribution to this thread is??
Its always easier to complain and moan without offering potential solutions...that's why Joe Duffy is so popular.

Margret Thatcher had a rule where her cabinet colleagues could only inform her of a problem when they had a possible/potential solution to hand...something I have taken and live by.

barneystinson

Voltex wrote: »

...and your own contribution to this thread is??
Its always easier to complain and moan without offering potential solutions...that's why Joe Duffy is so popular.

Margret Thatcher had a rule where her cabinet colleagues could only inform her of a problem when they had a possible/potential solution to hand...something I have taken and live by.

I haven't made a contribution because I think the OP's approach is sound, and there's nothing really to be added to SBwife's sensible and plain English contributions in the first 24hrs of the thread.

I frequently enough deal with/examine the valuation of family run SME's (from a taxes perspective, so quite often there is no actual consideration), and 4-5 times maintainable earnings will probably be a reasonable range.

About the most useful thing you've contributed, in the context of a thread about buying a small company, was the quote from Buffett (no words longer than 5 letters you'll note!).

SeanSouth

This thread is interesting but its not the way it works in practice.

I'm involved in valuing businesses for a living and what we're getting here is the theoretical accounting 101 approach to valuing the business which in my oppinion is not adequate. There is a huge difference between valuing a large business and a small business and you can't value a business while ignoring the market, availability of credit etc etc. A business sold today is worth a lot less than it was in 2006. The valuer needs to know the calculations but also needs to know the market and needs to be able to forecast future cash flows reasonably accurately.

First off, let's have a look at a small family company with total assets of less than 500K. The vast majority of companies in Ireland today are as such.
Small companies are rarely sold complete. What happens in 99% of cases is that the goodwill and fixed assets are sold out from the company and any stocks are then sold at "valuation" The seller is left with the shell of the company including debtors creditors etc which is then wound up separately. It would be foolhardy to purchase a small company outright not knowing what hidden liabilities are hidden within. The next task is to value the goodwill. Multiples of net income will not work here. Some directors / shareholders might pay themselves 20K per year, others 40K and others might pay themselves nothing. These different approaches to remuneration will result in a different net income and could ultimately give rise to an incorrect valuation in inexperienced hands. Its important to realise as well that a business derives value from its expected future cash flows and for that reason when valuing the goodwill of a small business, we use a term called SELLERS DISCRETIONARY CASH FLOW (SDCF) To calculate SDCF, we take PBIT (Profit before interest and tax) and add back any non-cash items such as depreciation. We also add back all owners salary, pension contributions and any other owner benefits. After SDCF is calculated a multiple of between 1-3 is applied. A multiple of 1 is applied where the owner "is the business" and a high risk exists that the business will fall away after the existing owner departs. A multiple of 3 is applied where the risk is minimal. Most valuations today fall in the range of 1.5 to 2.Applying the multiple is where the skill comes in. General business performance past and future needs to be taken into account. Knowledge of the market is important, all risks need to be assessed separately etc etc. And then of course the skill of the negotiator is crucial.

Selling a bigger company is a completely different process. Usually the entire company is sold (the shares are sold) When a company is being sold in its entirety, then the agreement will be much more complex and a careful process of due diligence needs to be undertaken. Larger companies are usually sold on the basis of multiples of PBITDA or price / earnings ratios. Unfortunately, Haven't got time to go into detail now :-) Someone buying a small company is invariably purchasing a job or a lifestyle. Someone purchasing a large company is making an investment. Very very different.

Peterdalkey

Excellent post by SeanSouth. The point about due diligence is an important one as it is expensive and the costs are likely to be far too high relative to the purchase price. However it is the only way to ensure that all the potential latent risks/liabilities are discovered, thus the advice not to buy the shares is spot on.
The valuation methodology is very interesting, pragmatic and useful and very well articulated in plain language,. Well done!

bmwguy

SeanSouth wrote: »

This thread is interesting but its not the way it works in practice.

I'm involved in valuing businesses for a living and what we're getting here is the theoretical accounting 101 approach to valuing the business which in my oppinion is not adequate. There is a huge difference between valuing a large business and a small business and you can't value a business while ignoring the market, availability of credit etc etc. A business sold today is worth a lot less than it was in 2006. The valuer needs to know the calculations but also needs to know the market and needs to be able to forecast future cash flows reasonably accurately.

First off, let's have a look at a small family company with total assets of less than 500K. The vast majority of companies in Ireland today are as such.
Small companies are rarely sold complete. What happens in 99% of cases is that the goodwill and fixed assets are sold out from the company and any stocks are then sold at "valuation" The seller is left with the shell of the company including debtors creditors etc which is then wound up separately. It would be foolhardy to purchase a small company outright not knowing what hidden liabilities are hidden within. The next task is to value the goodwill. Multiples of net income will not work here. Some directors / shareholders might pay themselves 20K per year, others 40K and others might pay themselves nothing. These different approaches to remuneration will result in a different net income and could ultimately give rise to an incorrect valuation in inexperienced hands. Its important to realise as well that a business derives value from its expected future cash flows and for that reason when valuing the goodwill of a small business, we use a term called SELLERS DISCRETIONARY CASH FLOW (SDCF) To calculate SDCF, we take PBIT (Profit before interest and tax) and add back any non-cash items such as depreciation. We also add back all owners salary, pension contributions and any other owner benefits. After SDCF is calculated a multiple of between 1-3 is applied. A multiple of 1 is applied where the owner "is the business" and a high risk exists that the business will fall away after the existing owner departs. A multiple of 3 is applied where the risk is minimal. Most valuations today fall in the range of 1.5 to 2.Applying the multiple is where the skill comes in. General business performance past and future needs to be taken into account. Knowledge of the market is important, all risks need to be assessed separately etc etc. And then of course the skill of the negotiator is crucial.

Selling a bigger company is a completely different process. Usually the entire company is sold (the shares are sold) When a company is being sold in its entirety, then the agreement will be much more complex and a careful process of due diligence needs to be undertaken. Larger companies are usually sold on the basis of multiples of PBITDA or price / earnings ratios. Unfortunately, Haven't got time to go into detail now :-) Someone buying a small company is invariably purchasing a job or a lifestyle. Someone purchasing a large company is making an investment. Very very different.

Hi Sean South, OP here. You have hit on one of my key uncertainties - whether to base price on past (including present) cash flows or on future cash flows taking the value we add into place. I would like to think we can add value, actually I know we can, but base purchase price on historical data. I am of the argument that we should not pay for our own expertise and what we can bring to this business. So plan is, as I think I have said before, to pay 5 times historical PBIT but recoup the investment much quicker than 5 years.

SeanSouth

That's a very interesting question and is really a question of price Vs value.
The price to be paid for a business and its value are two different things.

Buyers will normally only pay a price that relates to current performance and past performance. In extenuating circumstances, a buyer may be willing to pay a premium for future potential but hardly ever.

Value on the other hand is what it is worth to the buyer. When calculating value we will look to see what the business is worth to a new buyer in terms of discounted future cashflows, their ability to develop it and/or synergise it with other businesses. The value in this context should always be greater than the price. Additionally the value to two different buyers may be different.

SeanSouth

BMWGUY - As mentioned above I wouldnt be inclined to price a small business based on a raw 5 X PBIT. You'll have to do a bit more work than that. For example You'll have to take into account what the current owner is paying him or herself out of the business and the accounts will need adjusting for a number of other typical matters. If for example the existing owner is taking a very small salary and getting his wife to work for free at the weekend. its quite possible that you will come to the wrong valuation with 5 X PBIT. You also need to take the industry into account.

Take an example of two identical businesses. Both Businesses have sales of 500K, Gross Profit of 250K Overheads of150K.

One owner awards himself with salary of 70K and his wife works part-time for 20K The other owner awards himself with salary of 20K and his wife works for free.

PBIT in the 1st case is 10K
PBIT in the 2nd case is 80K

The only difference between the 1st business and the 2nd business is that the owner pays himself more in the 1st case. It shouldn't mean that the first business is worth 50K and the 2nd business 400K.

When I hear people talking about valuing small businesses based on multiples of net income, I get very concerned. In most cases its a nonsense. Ive seen accountants do it also. An other contributor earlier in the thread recommended that the value be based on a multiple of turnover !! Yikes.

The reality is that there is no quick and dirty way of valuing a business by multiplying an abstract figure X 5 or X 4 or X 6 unless you really know what you are doing.You really need to go through the accounts forensically to calculate an adjusted profit figure. Another example is where the vendor is using a business premises that is "owned" and for which there is no charge in the accounts.When the business is sold it relocates and the new owner is often faced with paying rent on an alternative premises which immediately impacts the bottom line. This would be a typical adjustment to the accounts before applying the multiple. So the reality is that you will probably use a multiple of some sorts but in all cases the accounts will need adjustments before the multiple is applied. You will also need to know what multiple to use. We tend to use bigger multiples with bigger more stable businesses. Applying a raw multiple to an unadjusted profit figure is like trying to pin the tail on the proverbial donkey with a blindfold on.
The result is often as meaningless as the example given above. One guy will value the business at 50K and the other will value it at 400K and neither of those will be correct. Neither of them will be remotely close.

bmwguy

SeanSouth wrote: »

That's a very interesting question and is really a question of price Vs value.
The price to be paid for a business and its value are two different things.

Buyers will normally only pay a price that relates to current performance and past performance. In extenuating circumstances, a buyer may be willing to pay a premium for future potential but hardly ever.

Value on the other hand is what it is worth to the buyer. When calculating value we will look to see what the business is worth to a new buyer in terms of discounted future cashflows, their ability to develop it and/or synergise it with other businesses. The value in this context should always be greater than the price. Additionally the value to two different buyers may be different.

Yeah we agree there, I want to get a bargain where price is less than value we think it can bring us.

pedroeibar1

bmwguy wrote: »

Yeah we agree there, I want to get a bargain where price is less than value we think it can bring us.

In making that response I think you have missed what SeanSouth is saying. If that is your bottom line you are not going to succeed because you are focussing on a 'bargain' which is the wrong thing. You have to take a realistic long-term view of the acquisition. There have been some interesting posts here but because most are in response to your opening question of ‘valuation’ many replies are academic and quite far from (and ignore) commercial reality.

Valuation on an assets or profits figure or any other basis is meaningless in the overall scheme of things in a small transaction – you must know (as Sean S said) what the acquisition is going to bring to the new entity in the future. It's your industry - only you can know where you can save/make money by using your business model. Do you know what costs you can strip out to change the dynamic? Where? How?

Apart from all of that: - for starters, fact, the seller will choose the transaction type, it’s their call unless they are in a forced sale situation. Will it be an asset sale or share sale? Or a hybrid? A share sale usually means a quicker transaction involving lower costs and involving less extensive/onerous warranties. They might want to retain certain assets along with the possibility of realizing some losses to offset against profits for tax purposes. What are they likely to want? How does that fit with you? Are those assets charged? To whom? Will the charge-holders consent to the transfer?

Part of cost/benefit analysis is the cost of and length of time it will take you to integrate the new business into your existing operation. For example, how long/easy/difficult will it be to integrate the two IT systems? Can the acquisition’s system be easily migrated? (or is it better than yours’? – and don’t believe your IT people!) What is going to happen to your cash-flow? What does your bank have to say? What is customer loyalty like? Importantly, how will your suppliers view the transaction? Will they have to – and more importantly are they prepared - to increase (perhaps substantially?) their credit limits on the new combined entity? Have you considered the position of your key supplier? (In a prior life, a mega-million merger was predicated on our decision – as a key supplier - on our credit/exposure limit.)

Depending on sale method there can be serious disadvantages to the vendors than can be a deal-breaker: extracting sale proceeds usually involves double taxation. On top of that the seller will usually retain liability for pre-completion actions more directly and extensively in a business sale; offsetting that sometimes a higher base cost will be offered in a share sale than in an asset sale. A result is that the seller is left with a ‘shell’ entity which probably will be redundant and will need to be liquidated. Is that a runner? What will be the cost? What will be the market perception? Is there a reputational cost to you as the buyer? (Contagion?)

If it is an asset purchase, the main advantage for you is that you can leave behind assets and liabilities that you don’t want. Excluding the debtors might be attractive to you, but the vendor will have a tough time collecting those outstandings when the business is defunct. Will he agree to that? The approach to an asset purchase is very important if the seller has solvency issues .... if that is the case, the eventual liquidator, and finally the ODCE (if awake) are going to have a view, which the vendor will be aware of. Another advantage is that while employment contracts transfer to the buyer under EU Law, this does not necessarily require the transfer of all pension-related obligations, which can give you some leverage in dealing with the eventual employment costs (pensions issues are critically important in today’s market.)
Have you considered Stamp Duty? it’s payable at 1% on shares and for other assets the rate is generally 6%.

Both buyer and seller must consider the relative benefits of a share sale or an asset sale, and also to consider whether a hybrid would work best, such as a hive down where the seller sells the assets – some of which might be shares - into a different /specially created entity, which you as buyer acquires.

You are entering a minefield, you need professional advice.

Peterdalkey

In most deals I have seen, the vendor came out on top, largely due to the purchaser either paying too much or being too optimistic in their projections for the business going forward. In one case one of the former employees of the target managed to take nearly 50% of the existing business with him into his new company at zero cost to him. The purchaser bought and paid for a dozen eggs but only ever got 6!! It was not the vendors fault, the purchaser clearly failed to identify the risk of not securing the transfer of employment of this key employee. The purchaser thought he was making a big saving on wages but he was a critical asset required to make the deal work for the purchaser!!

Buyers, in my view, should be pessimistic rather than optimistic in the process and work numbers on less than optimal financial projections. It is really extremely easy to pay too much and virtually impossible to pay too little!!

DubTony

Peterdalkey wrote: »

In most deals I have seen, the vendor came out on top, largely due to the purchaser either paying too much or being too optimistic in their projections for the business going forward. In one case one of the former employees of the target managed to take nearly 50% of the existing business with him into his new company at zero cost to him. The purchaser bought and paid for a dozen eggs but only ever got 6!! It was not the vendors fault, the purchaser clearly failed to identify the risk of not securing the transfer of employment of this key employee. The purchaser thought he was making a big saving on wages but he was a critical asset required to make the deal work for the purchaser!!

That's really interesting, and shows how important key people are in the management and success of a small business. Something that should also be considered is how key the owner is to the business. While some might be happy to sit back while driving the business, and let their employees be their shop front, many are customer facing and are the only reason for whatever success is achieved. Without them the business can be just a shell with absolutely no good will whatsoever.

pedroeibar1

I have seen purchasers overoptimistic and lose out, but that has been the exception. It has not been my experience that the vendor inevitably is the winner. If so, why would anyone ever bother to make an acquisition?
The converse usually is the case because the vendor has failed to recognise pre-existing opportunities for development / market / product potential / cost savings and the new owner has seen and exploited them, adding considerable value to the enterprise. Maybe the vendor ‘wins’ because he has sold before he runs his business into the ground?
If a purchaser is stupid enough not to identify and tie-down the key issues (including people) in an acquisition he deserves the outcome. That is one of the first topics any advisor will mention and what share purchase agreements, non-compete clauses, golden handcuffs, etc., are designed to cover.

Peterdalkey

No doubt the OP and others interested in the topic will take the various contributions into account in forming their own conclusions, including what might be appropriate for an acquisition that has sales revenues of €500K per annum.

Lobby Con Shine

Don't forget the stamp duty!

Excellent contributions on this thread. Glad I came in to read it. Masterclass from Sean South. Great stuff.

SeanSouth

In my experience also, I find that it is the buyer that usually comes out on top.
Most buyers of small businesses are seeking out a "bargain" and will only buy a "bargain" 25% - 30% return on capital investment is not uncommon for medium to low risk transactions.

Peterdalkey

SeanSouth wrote: »

In my experience also, I find that it is the buyer that usually comes out on top.
Most buyers of small businesses are seeking out a "bargain" and will only buy a "bargain" 25% - 30% return on capital investment is not uncommon for medium to low risk transactions.

This is not surprising, if they have been using your realistic valuation methodology as outlined in your previous post and then factor in whatever the acquirer brings to the business. Risk needs to be rewarded, along with the promoters increased inputs into the acquired business, with an appropriate return.
It is good to know that my experience of the outcomes is in the moinority.