Money Management - January 2004

Know the True Value of Your Business —

Even if It Isn’t for Sale

by Ric Kellogg

What would you do if someone made you an offer to purchase your business? Even if you’re not interested in selling right now, it’s wise to know what your business is worth. You never know when a lucrative offer may come your way. Or, more important, if you are interested in selling, knowing the true value of your company can help you recognize an offer that may be too low.

The difference between value and price

Although the terms are often interchangeable, "price" and "value" are not the same. Price suggests an actual compromise between buyer and seller, while value is theoretical. You should determine your business’s value before you begin negotiating its price. A valuation sets the price at which the business would change hands between a willing buyer and seller, with neither actually having to act. In order to come to a proper business valuation, the Internal Revenue Service uses the following criteria: the business’s earning capacity; the book value and financial condition of the company; the nature of the business and its history; the condition of the industry and general economic outlook; the value and sales of the company’s stock; the company’s dividend-paying capacity; the market price of publicly-traded stocks in comparable businesses; and the value of intangible assets, such as goodwill, licenses and patents.

What valuation methods are used

Along with considering IRS factors, appraisers generally take one of these approaches to valuing a business:

The earnings approach. This approach considers the past net income, cash flow, present income and any future projections. Results are capitalized by a standard multiplier to arrive at a current value. This approach gives added weight to earnings from the most stable periods, or recent earnings.

The asset valuation method. Here, assets are appraised independently. Tangible assets considered are cash, accounts receivable, inventory and equipment. Intangible assets taken into consideration are goodwill and patents. Usually, this appraisal method results in a lower figure, since future earning potential is not considered. The asset valuation method is a useful tool to determine the business’s minimum value.

The market comparable approach. This method serves as a basic guideline and is not used to actually value a business. It simply determines a basic price structure by surveying similar companies in the same industry that have been bought and sold recently.

When buyer meets seller

Theoretically, the price buyer and seller agree upon is the fair market value of the business. However, in the real world, buyers and sellers hardly come up with the same dollar amount. The business owner’s valuation often is higher than the buyer’s because the owner anticipates greater future earnings. Buyers, on the other hand, are conservative about forecasted profits. The differences in price discrepancies are often settled through a method of compromise called earnouts. With earnouts, the price of the business is contingent upon future earnings, perhaps as a percentage of revenues. Both the buyer and the seller must settle on the terms of the earnout, such as how profits are to be determined, dispute resolution and maximum payment.

Know how to recognize a lucrative offer

Knowing how to value your business isn’t just for those who are ready to sell. It’s wise to know your company’s value, since you never know when an offer will come along that you just can’t refuse. Before making any decisions, you should seek the advice of your own lawyer and tax advisor.

Ric Kellogg
William (Ric) Kellogg, is vice president and registered representative of AXA Advisors, LLC, an insurance brokerage affiliate.