Dennis Covington | Principal
• Private businesses can have multiple values depending on who the potential buyers are—and what each the buyer’s needs are.
• Business owners need to realize that taxes and expenses are part of the sales process.
• There are at least 7 different ways to value a private business: Here we will explore Financial and Investment Value, Strategic Value and Intangible Asset Value.
This would be a simple question to answer if your company was publicly traded. If you’re working in the private business world and you’ve tried to gauge whether you can afford to retire, you probably have been stumped figuring out what to use for the after-tax value of a business sale.
Owners almost never really understand the value of their businesses. This is because they don’t know that businesses can live in multiple value worlds, depending on who the potential buyers are and the valuation method used.
The concept of value worlds
Depending on who the buyer is, or if there even is a buyer, the value of your business can vary dramatically. Let’s say you have a business that does $5 million in sales and produces $150,000 in profit. You would think your business could be sold for about $750,000 (5 times its profit). But what if this business had only one customer that accounted for $4 million of the company’s $5 million in sales, and what if that customer was looking at other suppliers? Some valuation methods would take that vulnerability into account while others would not.
Let’s look at another business that has a patented process that serves to build a large moat around the company. Like the first company in our example, this company does $5 million in sales, but it has profits of $500,000 and has plans to grow to $50 million with a profit margin of 20 percent. In this case, one type of buyer might offer $2.5 million and another buyer might be willing to pay $25 million.
Understanding where your business falls in the land of value worlds will mean the difference between pursuing the right strategy and pursuing one in which disaster might strike.
First, you need to know what value worlds are and where your business falls.
The different value worlds
Here are the seven value worlds that I recommend you understand before making such a big decision about the enterprise you have worked so hard to build:
1. Financial or Investment Value
2. Strategic Value
3. Intangible Asset Value
4. Liquidation Value
5. Market Value
6. Fair Market Value
7. Owner’s Value
The key is to know which world you are going to show up in today and what you can do to move toward higher-value worlds.
Let’s now take a look at each of the value worlds:
1. Financial value
This is used by a private equity firm or by any other buyer that is considering purchasing your company primarily as an investment. Financial value buyers are often good buyers, but they have no motivation to pay any more than what the financial statements would suggest so they can get a reasonable financial return on their investment.
A financial buyer is the one who would pay about $2.5 million for the second company in our example, the one with $500,000 in annual profits. A financial buyer looks at what the company has done and what will likely happen in the short term. They don’t have a reason to pay higher multiples (or goodwill) because they look at the business as an investment and not an opportunity.
A financial buyer would have a great deal of interest in our second business and probably no interest in our first example.
2. Strategic Value
A strategic value buyer is one that will look at the business and believe the value in owning the business is much higher than simply a financial return. The strategic buyer might be a competitor, or it might be a larger company that thinks your business has a good fit with their business. The strategic buyer believes that combining the two companies would make the value of the target company higher than a financial buyer might think.
Strategic buyers might have an interest in the first company. If the product line fits in well, they could get rid of all the overhead, and if they felt they could hold the large customer, they might want to buy—but with lots of strings attached.
A strategic buyer would love to own the second company. If it’s a larger company, the buyer would believe it could add the product line and help the acquired company take advantage of the opportunity. As much as a strategic buyer would like to own the second company in our example, it would likely lose out to our next type of buyer (an intangible asset value buyer).
3. Intangible Asset Value
This buyer wants a company, and the amount of money it pays has no apparent relationship to the amount of profit the company produces. My favorite example of this type of deal was when Microsoft bought Skype. The multiple of profits was so high that no one even mentioned it. Microsoft bought Skype because of the intellectual property Skype had. (It also didn’t hurt that a full bidding war erupted over that acquisition.)
The second company in our example would be a perfect acquisition target for an intangible asset sale buyer. A larger company could scale the technology and move this company easily to $50 million in sales. For this type of buyer, even a $5 million purchase price might not get the deal done.
In part 2 of this article, we’ll look closer at Values 4-7: Liquidation Value, Market Value, Fair Market Value and Owner’s Value.
Remember, your business isn’t really valued on how much you’ve put into it; it’s valued based on how much a rational buyer is willing to pay (i.e. What’s in it for Them?). Sometimes it’s best to work on increasing value and to move into a more attractive value world before selling. The more informed you are; the better your chances of having a financially (and emotionally) satisfying exit.