Business Valuations Not Static
Business values are not static and change over time based on financial performance, risk, and market conditions. The value of privately owned businesses are generally illiquid, or not easily converted into cash. This contrasts with the value of other asset classes such as publicly traded stocks or bonds which are liquid and easily converted into cash. The illiquidity of businesses means that business owners can not simply press a button and sell their business (as they would when, say, selling stock in Apple). Businesses typically take 6-12 months to sell, with the length of time often dependent on the return on investment for potential buyers. A professional business broker must value a business in the context of its expected future performance and the current business and economic trends rather than solely on its past success.
Business Valuations Change with Financial Performance
Since there is no liquid market with real time pricing for private businesses, the asking price should incorporate the most recent and up to date financials. Business owners should be comfortable with the asking price for the duration of the listing term (twelve months or less). Raising the asking price during the term of a broker’s listing contract is impermissible since the listing contract sets the maximum asking price, and doing so will turn away already interested prospects. Lowering the asking price during the listing term does happen if the seller decides that doing so will attract more buyers. Business valuations ultimately change based on the long-term financial performance of the business. Other important factors that change business valuations are the tangible assets included in the sale along with the ownership structure of the business.
Annual Financial Statements Justify Changes in Business Valuation
- In order to properly value a business, its adjusted owner benefit must be determined by examining the most recent annual financial statement such as a tax return or twelve month profit and loss statement.
- The adjusted owner benefit is the true and normalized economic profit derived by a working owner of a business.
- This is determined by calculating the Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) and then adding back the owner’s salary, personal expenses of the owner that flowed through the financial statement, and other adjustments to reflect a normalized operating environment.
- Without a proper annual financial statement, an accurate portrayal of the adjusted owner benefit is generally not possible.
- For externally financed deals, lenders typically base their business appraisal in large part on the most recent tax return of the business.
- Tax returns are of course only available every twelve months, and hence business valuations that rely on up to date tax returns change slowly over time.
- Business owners may also produce profit and loss statements from the Trailing Twelve Months (TTM) before their year-end tax return becomes available.
- A TTM profit and loss report may be used for valuation purposes but it is important to remember that lenders require the most recent tax return when appraising a business.
Changes in Tangible Value
Many businesses – especially those in service-related industries such as landscaping or appliance repair – grow their tangible assets over time. A tangible asset is primarily a physical asset with a monetary value which depreciates in value. Examples include equipment, machinery, inventory, and accounts receivable. Tangible assets show up on a company’s balance sheet as either a current asset (convertible into cash within one year) or a long term asset (used by the company for more than one year). Annually reviewing a company’s balance sheet reveals the changing value of tangible assets. Business valuations always take into account a company’s net tangible assets (after liabilities), which is typically the minimum floor of a company’s valuation.
Accounts Receivable Changes Affect Business Valuations
Accounts receivable (A/R) is money owed to a business by a customer or payor for products or services previously rendered. Because A/R has a quantifiable value which can be easily measured, it is considered a tangible asset. Accounts receivable may or may not be included in a business sale. When included in a business sale, A/R is a valuable source of working capital for a buyer as it will provide cash flow after the sale that may be used to fund operating expenses. The changes in A/R over time may be seen from periodic A/R aging reports, which details the length of time each customer’s account is outstanding. Note that increases in A/R may signify that a business has a problem collecting money from its customers, which leads to bad debt.
Ownership Structure Changes Affect Business Valuations
Businesses with passive or absentee owner-operators are generally valued at a premium compared to businesses with active owner-operators. This is particularly the case where active owner-operators have personal relationships with key customers, employees, or suppliers. Buyers are willing to pay a premium for relatively absentee-owned businesses because they are more certain that the business will keep performing at the same level after the seller leaves. They do not need to worry about potential business disruptions and loss of sales once the seller is no longer involved in the business. Over time, business owners can best prepare their business for sale by reducing or eliminating their own active day to day role.
Since privately owned businesses are an illiquid asset class, valuation changes are not reflected in ‘real time.’ Rather, changes in business valuations are primarily dependent upon the annual financial statement, balance sheet, and long-term changes in the operational structure of the business. It is the role of the business broker to price a business properly using the most recent financials, and then to create a liquid selling market as possible by confidentially advertising and showing the business to as many qualified prospects as possible.
Give Martin at Five Star Business Brokers of Palm Beach County a call today at 561-827-1181 for a FREE evaluation of your business.