How a Business is Valued

How Your Business is Valued

Methods buyers use to price your business

In order to understand the value of your company, you first need to understand how the market and potential investors perceive and value your business.

They value your company based on its expected future performance, and then reduce it to a value today by the return they need to invest in your company. This return is largely determined by how risky your company appears to the buyer and how likely they feel that it can achieve its expected future performance.

In technical terms, the present value of your company’s expected future cash flows (i.e. the money that will be left over after you pay for all of your capital investments and operating expenses) discounted to today’s value by the riskiness of investing in your specific company (i.e. whether you actually achieve those projected cash flows).

The higher a company’s perceived risk, the more investors will discount its future expected earnings – and the lower the company’s value

As a rule of thumb, the higher the discount rate (i.e. the more risky the investment), the more future benefits or cash flows are discounted to today’s value.   The lower the discount rate (i.e. the safer the investment), the more valuable a company becomes.

Example: Two Companies (A&B) in the same business and industry with the same expected profits, but Company B perceived 3x risky

(This is a simplified calculation for illustration purposes where we are just taking 10 years of future earnings and taking the sum of the present values)

Company A at 37.2 million is much higher because it is perceived as “safer” than Company B, and therefore its projected 10-year earnings are taken with greater confidence.

It is due to the perceived riskiness of their companies that many owners fail when it comes time for them to try to exit. 

How Risky does your business appear to a buyer?
Compare you business with how over 60,000 other companies have scored on 8 key drivers of Business Value

The Intangibles Drive up How a Business is Valued

Until a sale goes through, the value of your company will not be one value set in stone, but a range of values based on several dynamic factors, including its performance and prospects, its current preparedness for an exit, and its level of attractiveness to different types of buyers.

An important point to remember is that

Premiums are paid for the intangible value your company is able to generate.

If your business performs and generates enough profit to create operating or goodwill value, than it is creating intangible value.

Conversely, if your business is under-performing and not even generating enough profits to meet its required rate of return, then the value of your company will simply be the value of its tangible assets (property, equipment, etc).

The problem for many business owners is they have not taken the months and years needed to prepare their business for an exit. As a result, the intangible value they created is mostly locked up in them personally so it cannot be transferred to the new owners and so that value is left on the table.

The Intangible Value Premium

Nearly 50% of private companies that are sold only provided their owners the value of their tangible assets. They were not able to create intangible value and so no premium was applied.

Of the other 50% who did create intangible value, their owners received on average a 79% premium for the intangible assets.  In other words, only 21% of that final price was based on the Company’s tangible assets.

Value is In the Eyes of the Beholder

Ultimately, the value of your company is dependent upon what someone is willing to pay for it.

The Fair Market Value is the value of the company to yourself and so is the minimum value you should entertain for your business.

(The technical definition: The price at which the asset would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of the relevant facts.)

(To accurately measure your Fair Market Value, you must be able to identify where your company sits on the 8 key business value drivers, and how these are determining the worth of your business).

However, this is not the only value to your company.  In terms of buyers, there are two types that can have significantly different estimates between them as to the value of your company.  These are “Financial Buyers” and “Strategic Buyers”

Financial Buyer

Financial Buyers are basically investors who supply funding to get a return but are not looking to acquire or provide strategic enhancements to the business so will not pay a premium above Fair Market Value. These are the most common buyers of private companies.

These can be investors looking simply for higher returns on their capital and also often Private Equity Firms looking to buy the company, drive up its value and sell later at a higher multiple. In many cases they will use debt when purchasing the company to make the returns even higher (if able to successfully sell down the road).

For example, you might have a PE firm looking to buy several small companies in an industry, consolidate them to make a bigger company and than sell at a higher multiple (multiples increase by company size.. so 2 + 2 +2 will equal 8 instead of 6). They will not pay a strategic premium (unless they are doing a strategic consolidation) so the prices you would get from them are usually near Fair Market Value.

Financial Buyers are the most common buyers you will come across if and when it comes time to exit.

Strategic Buyer

Strategic Buyers on the other hand look look at your business from a strategic perspective. For example, would acquiring your business allow them to sell more of their existing products and / or services.?

Or would acquiring your allow them to remove a competitor and dominate a niche or region. Perahps, a supplier or customer wants to vertically integrate by purchasing you.

In short, Strategic Buyers look for compelling strategic areas which they can enhance and create more value through buying you. Therefore, they are willing to pay a premium for the business often above its fair market value.

Scenario: Strategic vs Financial Buyer

Imagine you own a profitable food truck in an office area where there is only one competitor who is of similar size. Because of your favorable position, you are able to generate USD 100,000 Free Cash Flow per year with a discount factor (required rate of return) of 20%.

You are looking to retire early by selling the business for a hefty profit

A Financial Buyer approaches and offers the fair market value of $500,000. He does not want to run your business but he is confident you have a strong management team that can run the truck after you leave.

He is all about the rate of return on your expected future profits and so his offer reflects that expectation and he has no flexibility on it.

However, you understand the concept of diverse types of buyers valuing your business differently, so you decide to approach your competitor and see if he is interested in placing a higher bid

Certainly, your competitor is interested. As a Strategic Buyer he understands that by buying your truck he would own the only food trucks in that office area.

He could use both trucks to cross sell the menu and so not only sell more of your stuff but his too.

In addition, by having this small monopoly, he believes he can raise prices 5% and improve his margin by 10%. Running the numbers, he estimates your truck would provide him $ 350,000 in free cash flow per year.

He estimates his enhancements would nearly double the valuation of your food truck and so offers you $650,000 in cash.

In this simplified story, the Strategic Buyer Competitor is valuing your food truck much higher because he is incorporating the enhancements your truck will make to his combined business.

Similarly, he sees the value in you retiring and not selling to a new potential competitor. Therefore, he is willing to provide a premium, and maybe a significant one, over the stand alone Fair Market Value.

The Sophiall Solution helps you identify potential strategic buyers and how to be in a position of strength when they call.

Start with Four Simple Steps

Transform your Business to Live the Life you Want

Step 1: Understand

Get up to speed on what needs to be done. Access our educational tools and resources to help you understand where to start and turn your business into an independent asset that builds wealth and sells one day.

Step 2: Benchmark

Take three free assessments on:

1) the value of your business and its attractiveness to buyers and investors,

2) your motivations and mental readiness to exit without regrets, and

3) the financial return and timing you need from your exit to achieve your long-term financial goals

Step 3: Plan

Schedule your free initial consultation, evaluate your assessments, and choose the best membership plan for you to increase the value and independence of your business.

Step 4: Execute

Use the Sophiall Solution and Value BuilderTM systems to implement the plan you have chosen, and transform your business from your job into an asset that builds and captures its total wealth for you.

An asset that others will want to pay top money one day.