Question: I own a business with my brother for the past 16 years. I decided to buy my partner/brother out of the business. The business has been running a loss for the past couple of years. How do we put a value on the business without incurring the expense of a Business Expert?
OK, stop immediately and rethink your question. Doing this deal “without incurring the expense of a business expert” is a really bad idea. The biggest danger in this deal isn’t paying too much or too little, but rather doing a deal that leaves either one of you thinking it was unfair. If ever there was a good place to spend some money on an expert, this is it.
Why? Because there are so many different ways to calculate fair value, with so many different results, that without a very good expert and full understanding as you do the deal, somebody is sure to question it later. You could do a keyword search for “valuation” at bplans.com for several articles, but here’s some background:
- Start by thinking about the value of a house. Its value depends on many different factors, including size, condition, the land it’s on, the neighborhood, the needs of the owners, and changing market conditions such as interest rates and local economic factors. Valuing a business is like that but even more complex, because the underlying worth depends on future earnings, and both buyer and seller have to guess future earnings.
There are some simple standards to start with. Consider that large, publicly traded companies are worth some multiple of their annual earnings, traditionally 5 or 10 times earnings or so, but that depends on market conditions. The market values some high-tech growth companies at 50 times their earnings … that’s the play of market factors. Investors like these companies so their relative value goes up.
- When you have a small, privately-owned company, the earnings multiples go way down. Generally buyers realize there is more risk in a small company than a big one. The increase in risk reduces the valuation.
- Another frequently-used formula is based on sales. Your company might be worth as little as half its last year’s sales, as much as 2 or 3 times its last year’s sales, depending on the specifics of what industry, how much growth, how much future potential, etc. This is more important than the earnings-based formulas for you, of course, because you don’t have earnings. It’s quite common with high-tech companies. As with real estate, you can get data on other transactions by industry and size, which could help give you some idea of the latest trends. The formulas change quickly as market conditions change. And although the data is called “comparables,” just like in real estate, it’s a lot harder to interpret because so much depends on the specific case. Growth increases your value, decline decreases it, and there are lots of intangibles related to the future, such as location, intellectual property, etc.
- There are lots of other formulas that might apply. Book value is assets less liabilities. Professionals might take book value and adjust for different factors.
- To make this even more confusing, there are valuation experts certified by the IRS who will assign a value used to determine tax liabilities when companies change hands because of death of divorce. Their valuation can go very low; I know of one case in which a company worth several million dollars was certified worth only a few hundred thousand, for tax purposes, by a registered valuation expert whose verdict was accepted by the IRS.
So getting back to your question, I recommend you and your brother find somebody you can both trust, either an accountant or an attorney or maybe a consultant with great references — be more careful with consultants because there is much less regulation in consulting, therefore it’s harder to determine true professionalism — and go over all of the various formulas, together, and understand how they might yield different results.
Your goal should be getting on the same page, together, in a way that protects you against the danger of doing a deal and then, afterwards, having some new expert coming up with some logically sounding new formula that makes one or the other of you think the deal was unfair. The key to fairness is to base the transaction on a true market value, a real market value, one which will leave neither one of you vulnerable to some half-baked expert opinion after the fact.
Don’t get adversarial. This should not be about negotiation. Avoid having the two of you represented by two separate experts, each voicing a slanted point of view. Look for somebody you can charge with creating a fair deal, somebody who feels like he or she will be available for a pleasant lunch a year later, not taking sides. You should both be clients.
Keep in mind that the goal isn’t winning or losing the deal, it’s making this change in a way that preserves the relationships.
— Tim Berry —