Small Business Valuation — What Is It And Why Does It Matter?

February 17, 2017

Government contractors who have built successful businesses over a period of time often neglect to answer one simple question until very late in the game. The question, “What is my business worth?” has far-reaching implications and comes up in a number of scenarios, such as the sale of the contractor’s business, the creation of long-term incentive plans for employees, estate/business succession planning, and death/divorce of an owner. At least monthly, we receive a call from a client or potential client asking something like, “I want to sell my business and I have an offer on the table. What’s next?” If you know what your business is worth, great—you may be able to proceed immediately to signing an NDA and negotiating a letter of intent, but how many business owners are in the best position to know whether a given offer is fair?
 
Business valuations are performed by certified public accountants who have a special expertise in valuing businesses. A number of methodologies are used, depending on the circumstance. For example, pre-sale valuations will likely differ from valuations performed internally to create, for example, phantom stock or stock appreciation rights plans. The most common valuation methods are:  
 
Asset-based.  This is a factual, objective methodology based on the assets currently on the company’s balance sheet. An asset-based valuation is the most conservative type of business valuation and generates the commonly-known “book value” of a company. Book value is difficult to dispute because it is simply a snapshot of the value of everything on a company’s balance sheet at a given moment; however, its weakness is that it ignores future cash flows generated by those assets. If a business is active and healthy—with growing profits expected to be generated in the future—an asset-based valuation is likely to undershoot a company’s true value.
 
Multiples. Sometimes government contractors use multiples to generate rough values of their businesses. For example, a consulting company may attempt to estimate its value by taking its earnings before interest, tax, depreciation, and amortization (EBITDA) and multiplying the result by a number, often obtained from well-intentioned fellow business owners in the same industry, intended to represent an industry-specific multiple generally acceptable in whatever space the company operates. As you can guess, potential buyers are often not impressed with this type of valuation, as it often serves only as a rough, back-of-the-envelope calculation of valuation that is subject to change once objective factors related to the business come to light in buyer’s due diligence investigation.
 
Discounted Cash Flow. Though not perfect, the discounted cash flow methodology often provides the most reasonable and objective valuation for an ongoing business. For an established business with seasoned management, a potential buyer would be interested in a forecast period of profits, typically lasting 3-5 years. To improve the accuracy of the projection, a discount rate would be applied that calculates the present value of the future cash flows of the company, which are then adjusted by depreciation, changes in working capital and indebtedness. These adjustments will permit seller and buyer to calculate the ratio of a target’s free cash flow to equity, and thus arrive at an asking price for the target that can be objectively explained (albeit typically with some debate).
 
In conclusion, prior to selling one’s business or undertaking any action where business valuation is required, we recommend that you speak to your CPA and attorneys and nail down a reasonable valuation before you proceed.

About the author: Michael A. de Gennaro is a partner with PilieroMazza and heads the Business and Corporate Law Group.  He may be reached at mdegennaro@pilieromazza.com.

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