Valuing A Business – Determining How Much To Pay For Your Next Acquisition.

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For many entrepreneurs (but not all), the natural evolution of business ownership travels from one singular business to multiple units.  Although for many the thought of spreading yourself further to operate another business makes no logical sense, others see the potential advantages inherent in the acquisition of multiple business operations.  Benefits such as leveraging economies of scale, local trends, and human resources increase potential returns on investment that make purchasing business units a legitimate, viable growth strategy.

There are, however, a myriad of businesses for sale that present beautifully on their exterior, but conceal hidden dangers on the outside, and it’s the job of pragmatic, disciplined entrepreneurs to separate the proverbial wheat from the chaff by unearthing negative characteristics where they exist, staying away from business units that show potential conflicts, and jumping on opportunities revealed through rigorous due diligence.

Once you’ve recognized a business opportunity that fits with your strategic plan, how do you go about determining a price for it?  The vendor surely has a price set, and that price may or may not be realistic.  Surely, however, you wouldn’t take his or her word for it and just accept whatever price is presented to you (your lawyer wouldn’t let you do this).

What is required now is a diligent, thorough valuation process that the business can be subjected to which will draw out the value of the components of the business.  But how do you do this?

The eventual price that a business (or whatever product or service) is going to change ownership at is the amount between a willing buyer and seller when neither is acting under compulsion and when both have reasonable knowledge of the relevant facts.  Intuitive in the process should be the absence of emotion in the transaction, but also important is sufficient knowledge upon which to make an informed decision of the price to pay.  This is where a structured valuation process comes in.

The Valuation Process

 Pro-Forma Statement Generation

The first step in the valuation due diligence exercise is to prepare a pro-forma of the expected revenues and expenses on the business.  Doing so requires an analysis of each income statement item and excluding all those “discretionary” items.

Discretionary items are those income and expense amounts that are not necessary to operate the business.  For example, owner’s salary amounts can be added to back to net income because they are not a necessary expense.

Included in the Pro Forma exercise is the review of:

-Working Capital

-Income Statement

-Balance Sheet

-Cash Flow Statement

An estimate of all these items is necessary to get a disciplined picture of the prospects of the business.  When the working capital requirements are known, then we an also assess by the cash flow statement whether or not the business operations, pricing structure, etc… is sufficient to finance the working capital requirements.  If the answer to this question is no, then either the pricing model needs to be changed or a new product/service mix must be introduced into the offerings of the business to inject revenue growth.

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Valuation

The following are the 3 main valuation methods used to value a business

Asset Based Approach

Used primarily to value businesses where the main value is contained within the assets held by the business.  Such businesses will also be cyclical in nature, making it difficult to provide an accurate valuation based on income levels alone.  An example is the automotive industry.

Market approach

The approach requiring the least amount of work, the market approach looks for similar business sales, and compares the characteristics and components of those sales with the business being valued, and the prices at which those businesses were sold are then used as a benchmark for the business being valued , with any variances being separately valued and added/subtracted as necessary.  Any adjustments for inflation are appropriate.

Income approach

The most popular valuation method, the income approach takes the income level of the business, and forecasts income out to the foreseeable future (normally 3 to 5 years).

The Discounted Cash-Flow Method is the most popular of the income approaches.  Once income has been forecasted, the income levels of future years are then discounted back to the present by subtracting any effects produced by inflation.  The cumulative yearly net income amounts over the forecasted period are then added to arrive at a value for the business.

 The industry that the business is in will normally influence the method to be used.  However, there are cases where the final results of 2 or 3 methods will be similar, in which case an average will be used to arrive at a final valuation.

Valuation Reasonability Assessment & Conclusion

 Once the valuation has been calculated, it needs to be confirmed and reviewed for reasonability.  At this stage, and tax consequences are then considered and tax planning is undertaken to mitigate tax liabilities.

Part 2

The valuation process doesn’t end there, however.  Other key areas of due diligence include:

1. Analysis of population demographics to assess the likelihood of growth.
2. City Planning to determine future geographical growth prospects.
3. Marketability of Business.

A full valuation of a business includes a comprehensive and thorough examination of all components of a business, including quantitative, qualitative (ie: markets, customers), and economic considerations.  Only when you have undertaken a disciplined diligence approach to determining the value of a business that looks good to you, will you be able to make a reasoned, business decision regarding whether or not the business fits with your business strategy.

Nicholas Kilpatrick is a partner at the accounting firm of Burgess Kilpatrick in Vancouver, B.C.  He concentrates on business development, and has worked with business owners to increase profitability at all stages of their businesses.  He can be reached at nkilpatrick@burgesskilpatrick.com or at 604-327-9234.