The following article was written by Brandon Jacob, a CPA and principal at Contractors Financial Opportunity, LLC.
Having an accurate understanding of the value of your business is critical when planning for the eventual business sale, regardless of whether you intend to sell to a family member, employee or an outside third party. It is also critical to understand what drives the worth of your business and how potential buyers will value or establish a purchase price during negotiations.
What is the value of your contracting business? We’d be willing to bet more than one person would claim that the value is equal to whatever someone is willing to pay for it. This response is common, but not necessarily accurate. The value of your business is a calculation based on several different characteristics and factors that are unique to your business alone. What one person is willing to pay you for your business is simply one person’s estimate of your business’ worth to them, and not necessarily the fair market value of your business.
Fair market value
For estate planning purposes, the IRS generally accepts fair market value. As defined by the IRS, the fair market value of any business is:
“The price at which the property 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, and both parties have reasonable knowledge of relevant facts.”
But what about a valuation for a business transaction? Let’s say you are in the process of selling your business and you want to know what you should expect from a buyer. For the sale of your business, fair market value is an excellent benchmark. Understanding the fair market value of your business will help you successfully negotiate the price, terms and structure of the sale of your business.
Does this mean that a buyer may offer more or less than the fair market value? Absolutely! A buyer acting under a compulsion might pay more. A compulsion in this case might be the buyer’s need to capture a specific group of customers serviced by your business and possibly under this scenario, the offer may be greater than fair market value. It works in the opposite as well. The opposite is actually more likely the case. For example, buyers may be searching for a good deal. Let’s say their intention is to buy one company and they have one year to complete their search. Early on, there is no compulsion, and they may be less likely to pay fair market value. As their deadline approaches, the compulsion increases and so might their offer.
What is being valued?
Business owners often confuse the difference between a valuation and an appraisal. A business valuation is not an appraisal. An appraisal is used to determine the value of the tangible assets owned by a business and does not take into consideration intangible assets or earnings potential. Certain assets, such as real estate, may be appraised as part of an overall business valuation. Tangible and intangible assets are divided up as follows:
- Tangible: Includes vehicles, tools, sheet metal brakes, office furniture, computers, gauges, tools, forklifts, etc.
- Intangible: Includes telephone numbers, customer lists, operating history, company name, files, records, computer files, computer databases, customer names, customer lists, company records, etc.
As you can see, tangible assets are those assets that can be touched or felt, whereas intangible assets are typically non-physical. A business valuation is designed to determine the value of both tangible and intangible assets, and this is important to contracting businesses because a significant amount of the value may actually fall within the intangible assets.
Steps in valuation
The steps required to value a contracting business are as follows:
- Determine the purpose of the valuation
- Gather historical financial data
- Adjust historical financial data
- Determine which valuation approach works best for the situation
- Calculate the enterprise value
- Understand the balance sheet and how it affects the final valuation
What is the purpose?
There are several reasons a business valuation may be required, and they are typically separated into two groups; tax valuations and non-tax valuations.
- Estate tax
- Gift tax
- Charitable contributions
- Buy/sell agreements
- Litigation support (Divorce, etc.)
It is essential to understand that a valuation for tax purposes can be more involved, must follow stricter guidelines and can be more costly to complete than a non-tax valuation. For this article, we will assume the intended purpose of the valuation is to determine a benchmark for the sale of a contracting business, which would be a non-tax valuation.
A business valuation focuses on the historical earnings of the business, regardless of the type of business. Why? Because a buyer will be interested in future earnings of the business and the best way to predicting future earnings is by analyzing past performance.
What about potential? We have often heard owners who wished that the value of their business was based on potential who have made statements like, “If only I had more techs” or “I am only serving a tiny portion of my market.”
Unfortunately, valuation (with some exceptions) does not work in this manner. The reality is that every contracting business has greater potential, and any knowledgeable buyer knows that. The buyer intends to put forth an effort to achieve that potential. Ask yourself this question: Who should be rewarded for capturing that potential, you or the buyer?
Gather your historical financial statements from at least three years prior; five years is even better. A current value will consider historical data but will place a greater emphasis on the most recent information. Beyond five years, the data becomes irrelevant to the current valuation.
The real numbers
There is a high probability that your historical financial statements will require adjustments before the real financial picture of the business can be fully understood. A significant amount of private businesses that we have valued needed modifications; this step is part of all our valuations. Another common term for these adjustments is “add-backs.” Common add-backs include, but are not limited to:
- Excessive rent paid on real estate owned by the owner
- Excessive officer compensation
- Non-reoccurring expenditures
- Expenditures deemed to be “non-business” in nature
- Capital assets purchased and expensed
Shrewd buyers skeptically scrutinize all add-backs suggested by sellers. Add-backs can be an area of abuse when the seller, trying to report higher profitability to the buyer, adds-back actual operating costs as non-business expenditures. Nevertheless, add-backs are a crucial step in determining the real profitability of any privately-held business.
Is there a method to the madness?
There are three generally accepted valuation methods used to value a business. There are specific situations where one method may be better than others. The methods are:
- Market approach
- Asset approach
- Earnings approach
Let’s say there are five similar businesses in your market. Each performs $1 million a year and sold this year for $500,000. Based on this information, one might conclude that the sixth $1-million-a-year business would have a fair market value of $500,000. Simple, right? In theory, it is. In reality, however, finding enough historical data for similar companies that have recently sold within your marketplace may be challenging, if not impossible. Therefore, the market approach may not be a practical approach to valuing your business.
The significant dollars of most business valuations are not in the tangible assets. Don’t get us wrong, your service fleet costs real dollars and has real value to a buyer, but, regarding the overall value, these assets are only one piece of the puzzle. The other pieces include the intangible assets. If your adjusted historical financial statements indicate that the business is not capable of producing profits–or worse, its survivability is questionable–then the intangible assets have little or no value. No earnings equate to no intangible worth. In this case, the asset approach is used. Valuing an unprofitable business based upon the tangible assets involves determining the fair market value of all the assets that are owned by the business. The sum of all the tangible assets is the fair market value.
Where the asset approach is used to value an unprofitable/failing business, the earrings approach is used to value a business that has demonstrated the ability to produce earnings and therefore has both tangible and intangible assets with worth.
There are several different methods used to apply the earnings approach, and all have the same premise–the value of a business is based on a factor applied to an earnings indicator of the business. The most common factor is known as the “multiplier.” A multiplier is applied to an earnings indicator such as adjusted EBITDA, pre-tax net income or after-tax net income.
EBITDA, or “earnings before interest, tax, depreciation and amortization,” represents the cash flows generated from your business. EBITDA is used as an earnings indicator because buyers are typically concerned about making enough cash flow to pay for the purchased company. When EBITDA is applied to a multiple, the result is the enterprise value.
What is included in enterprise value?
The enterprise value includes the following:
- The worth of the tangible assets used in the business
- The worth of the intangible assets of the business
Not included in the enterprise value are:
- Accounts receivable
- Accounts payable
The earnings multiple
Whereas the earnings indicator is obtained from the adjusted historical financial statements, the earnings multiple is more subjective. Don’t be fooled; there are sound theories that go into formulating earnings multiples. A multiple represents an expected rate of return for an investment. The higher the risk associated with the investment, the higher should be the expected return. A simplistic way to compare the multiple to an expected rate of return is to divide the multiple by one as demonstrated in the table below:
Multiple 1.0 2.0 3.0 4.0 5.0 10.0
Return 100% 50% 33% 25% 20% 10%
Based on the above table, would anyone ever use a multiple of 10 to purchase a small, privately-held business? Probably not, considering that there are several safer alternative investments (stocks and bonds) that offer a 10 percent return with less risk. Expecting a 20 percent return, based on the risks of investing in any small business, is probably as low of an expected return as one would accept. That is why multiples used to value contracting businesses exceeding five times EBITDA are uncommon.
Multiple ranges vary and should be taken into serious consideration when used to value a business. A slight increase or decrease in a multiple can significantly affect the overall value of a business. If a business reports historical EBITDA of $100,000, the enterprise value would be as follows utilizing a range of different multiples:
EBITDA $100,000 $100.000 $100.000 $100.000 $100.000
Multiple 2.0 2.5 3.0 3.5 4.0
Enterprise value $200,000 $250,000 $300,000 $350,000 $400,000
For every half point added to the multiple, the enterprise value of the business increases by $50,000. Determining the right earnings multiple to be used is subjective and involved. To make sure you are not under or overvaluing your business, consider seeking the advice of someone who not only has professional business valuation experience, but who also has industry-specific knowledge as well.
Putting it all together
Assume your business has an EBITDA of $200,000 and the correct earnings multiple is said to be 3.5. Also, assume the business currently has $150,000 of vehicle debt. The actual adjusted enterprise value would be as follows:
Earnings multiple 3.5
Enterprise value $700.000
Vehicle debt ($150,000)
Adjusted enterprise value $550,000
The final piece to the equation is working capital. All businesses require working capital to survive and flourish. A buyer will expect some level working capital to be left in the business. Therefore, when calculating the fair market value of a business, working capital is taken into consideration. Working capital is the difference between current assets and current liabilities. The amount of working capital required varies based on the business. One way to calculate the expected minimum level of working capital is to determine the average working capital in the business in the last 12 months. Then, you can compare that average to the actual working capital at the time of valuation. Actual working capital will fluctuate, especially if the contracting business is seasonal (think HVAC), so there may be a shortage or excess level of working capital contained within the business as of the valuation date. A shortage of working capital would be deducted from the adjusted enterprise value, and an overage would be added to the adjusted enterprise value.
Assume the business with a $550,000 adjusted enterprise value (from above) has the calculated need for a minimal of $125,000 in working capital. Now assume the following are the current asset and current liability balances as of the valuation date:
- Cash: $70,000
- Accounts receivable: $90,000
- Inventory: $15,000
- Accounts payable: $25,000
- Other accruals: $10,000
The calculation to determine the shortfall or excess working capital is as follows:
Accounts receivable $90,000
Accounts payable ($25,000)
Other accruals ($10,000)
Working capital $140,000
Expected minimum level of working capital $125,000
Excess working capital as of valuation date $15,000
The $15,000 excess working capital would be added to the $550,000 adjusted enterprise value to total a $565,000 fair market value to account for the $15,000 in excess working capital on the valuation day.
A common reason for a business owner to need to know the value of his business is in preparation of a sale. Entering into the transaction with an understanding of the value of your business will enable you to better negotiate the sales price, terms and structure with a buyer. Because a business valuation is not something a business owner calculates every day, the steps outlined in this article should be followed carefully to ensure the calculated value is accurate and reliable.
It is also important to point out that a valuation is as of a specific date. The valuation, especially the working capital piece of the puzzle, changes constantly. When preparing to sell your business, it is wise to update the valuation continually. As the business owner approaches retirement, the frequency of valuation updates should increase.
Brandon Jacob is a CPA and principal at Contractors Financial Opportunity, LLC. He is recognized industry-wide for his experience and knowledge in valuations, mergers, acquisitions and the ability to assist contractors in successful exit strategies.
Live Oak Bank provides loans to service and maintenance contractors across the country for succession financing, refinancing seller notes, working capital and more. To learn more about what Live Oak offers, reach out to Brandon Bolen at email@example.com or view additional resources.