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  • The Subjective, Sophisticated Science of Business Valuation

    Feb 4, 2020

    The value of most products and services sold in the marketplace are established by two dominant factors. The first factor is the cost of creating the item employing a combination of materials, labor, and the overhead expense needed to facilitate the creation of the product.  This foundation of value is true whether the product is a pizza, the repair of a sailboat, or construction of a new manufacturing facility. Logically, a new product or service cannot be sold for less than this foundational value in a business model that has long term viability. The second factor is the market demand for the product or service and the level of competition trying to satisfy the demand.  The higher the demand and lower the competition the more profit potential for the company supplying the product or service.  These two factors greatly influence the pricing of products and services in most segments of the economy.

    These two factors apply to the valuation of privately held companies and family businesses as both the cost associated with building & maintaining the infrastructure of a company and demand for businesses in specific industries and/or geographic locations in the mergers & acquisitions marketplace impact the value paid for a business.  However, two additional factors not relevant to pricing a product or service for sale have an equal or greater impact on the value a business will sell for in the market.  

    Return on Investment

    The purchase of a business at its core is an investment decision. A transaction will only be completed if the buyer is satisfied with their anticipated investment return post acquisition.  Stated another way, capital is employed to facilitate annual income return to ownership with anticipation of an eventual exit strategy resulting in appreciation in asset value, if business acumen & execution were sound during the tenure of ownership. The acceptable allocation to the buyer between anticipated shortterm dividend returns and the return received when the appreciated asset is sold depends on the transaction and buyer.  This overlay to the basic valuation premises outlined above for a majority of products & services adds an element to valuing a business that requires accounting, finance, and investment knowledge.  

    As an example of this concept, think of a business acquisition in terms of a field growing grapes in the coveted Red Mountain AVA in Washington, a purchaser of the vineyard anticipates being able to grow, harvest, and sell grapes at a profit for multiple years and at an undefined future date sell the vineyard to a party wishing to continue the business model.   The unique element to a business acquisition is that both short term investment returns and a future sale at an equal or greater value than the purchase price are anticipated. This element makes a business purchase an investment decision. This is not true for a significant majority of purchases. A dinner at the finest restaurant is enjoyed in the moment, but offers no return on investment or ability to complete a future sale.  The purchase of a new automobile offers transportation and quality of life elements, but offers a future of maintenance expenditures and an eventual sale at a diminished value from the purchase price.  Determining the appropriate investment return as part of a business valuation process takes significant knowledge and experience.   If a valuation is desired to facilitate a business sale or acquisition, it is recommended that a party engage a professional with knowledge & experience valuing companies in the relevant industry and geographic location.  

    The investment return element of business valuation generally takes the form of the multiple selected to apply to an EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) figure.  In the Main Street & Middle Market transactions facilitated by IBA, multiples traditionally range from 2 to 7.  To calculate the return on investment associated with a multiple divide the multiple into 100 (e.g., 100/4 results in a 25% return on investment.)  The selection of the wrong multiple can result in a business being sold at a value price or sitting on the market for an extended time with little buyer engagement.   For example, a business with an EBITDA of $500,000 could be valued at a $1.5 million (3 Multiple – 33 1/3% ROI), $2.0 million (4 Multiple – 25% ROI), or $2.5 million (5 Multiple – 20% ROI) by a professional intermediary with relevant knowledge of the marketplace and be right in all three valuations depending on the industry and location of the business. Sellers have higher risk than buyers in a wrong valuation, as both outcomes of a wrong valuation are detrimental.  Buyers will not buy a business if it offers a lower than acceptable return on investment.  Conversely, they will pursue aggressively most value propositions in the marketplace offering better than a standard return on investment.

    One of a Kind Product

    The second factor influencing business values in the marketplace is philosophically the complete opposite of the scientific analysis of return on investment calculations described in the last section.  This valuation influence draws from the dominion of the art world where “one of a kind” artistic creations sell for values with no reference to the cost of the materials.   The reality of the business brokerage world is that each business is unique in location, staff, and product offering.  No two businesses are exactly the same.   Even the most “cookie cutter” franchised business model with rigid systems, operates with different employees possessing different skill sets, in locations with different overhead costs, and different customer demographics, even if the businesses operate in the same city. The differences only get enhanced the further the franchises are geographically separated as tax environments and licensing requirements differ between states.  The best way to assess the “art” value component of a business is to engage with a business broker who knows the marketplace for similar companies in the relevant geographic area.  Knowledge of buyer demand for a specific business model is only known by parties engaged in the marketplace actively completing transactions.   IBA recently facilitated transactions where owners of precision machine shops and dog boarding facilities received multiple offers and sold their businesses for values above what standard return on investment valuation models would convey was the “by the book” market values for the companies.  It was our pleasure to facilitate those transactions for our “sell side” clients and see satisfied buyers achieve their acquisition objectives in a competitive marketplace.

    Business valuation is a subjective, sophisticated science.   It takes significant experience, knowledge, and a high professional skill set to be able to correctly assess the market value of a privately held company or family business.  Even then, multiple “experts” will often disagree on values within a range, as valuation is at the end of the day an “best guess opinion.  True value can only be determined when an equally motivated buyer & seller shake hands on a deal.  

    IBA is unique in the marketplace in that we offer professional opinions of the market value of businesses to our potential clients on a complimentary basis as a method of demonstrating our market leading knowledge, experience, and professional skill set in the Pacific Northwest.  We also use this process to carefully select our projects, as our 100% paid on performance business model requires we complete a high percentage of our engagements (Traditionally 80 – 90% annually) for successful continuity.

    If you are thinking about selling your business in 2020, our deep & talented team of business brokers with diverse industry experience would welcome the opportunity to provide an overview of the services that have made IBA the Pacific Northwest’s 1st choice by entrepreneurs wishing to sell a business in Washington, Oregon, or Alaska since 1975.

    IBA, the Pacific Northwest’s premier business brokerage firm since 1975, is available as an information resource to the media, business brokerage, mergers & acquisitions, and real estate communities on subjects relevant to the purchase & sale of privately held companies and family owned businesses.  IBA is recognized as one of the best business brokerage firms in the nation based on its long track record of successfully negotiating “win-win” business sale transactions in environments of full disclosure employing “best practices”.

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