How do you determine the worth of a business?
Any estimate of a business’s value is more art than science. There is no magic formula that will simply tell you with any degree of certainty the value of your business.
Generally, a business’s value is set by negotiations between a willing buyer and a willing seller who have no particular compulsion to buy or sell, with both parties having reasonable knowledge of the relevant facts concerning the business. For the buyer, it’s determined and confirmed through due diligence before and during the negotiation process. That value would be the price, in cash or cash equivalents, which a buyer would reasonably be expected to pay, and a seller would reasonably be expected to accept.
But if you haven’t had someone offer to buy your business or are just considering the purchase of a business, a good range of potential values is not hard to calculate. While working on some buy-out terms of a syndication a number of years back, I was introduced to a fairly simple and quick method to determine, at least in general terms, the value of a business. Look at the last two to three years’ income statements. If sales and profits have been relatively stable, compute the average over that period for your net profits before tax, then add back depreciation and amortization charges and the annual interest paid on interest-bearing loans. (If sales and profits have increased significantly over that period, then use the most recent year without an average. If there has been a decline, then look at other factors.)
The result of that calculation is your average EBITDA over the two to three year period or for your last and best year. That’s an acronym for Earnings Before Interest, Taxes, Depreciation, and Amortization. That is the cash flow that is generated with the depreciation and amortization charges added back, and independent of the amount and extent of the company’s financing and its tax status.
Now, multiply the EBITDA by a factor that is usually between 3.0 and 7.0. If the business is in a very competitive industry with lots of competition and low levels of proprietary elements, the multiplier would be on the low side. If the business has less competition and holds proprietary elements that tend to reduce competition, the multiplier would be on the higher side.
After deciding on that critical multiplier for your business and applying it to your EBITDA, then subtract all of your company’s interest-bearing debts. The assumed debts are as much a part of the purchase price as the cash being paid on the purchase price.
The business is worth is also heavily influenced by more than the competitive nature of your market and the proprietary elements or intellectual property held by the business. The structure of the transaction will also have an influence on the price. For an all cash purchase, the price will be lower than one for which the seller will provide a significant part of the financing by holding a purchase money note issued by the buyer.
Also, most buyers prefer to purchase assets and assume certain of the recorded liabilities. Such an asset purchase transaction usually has a higher price than a stock purchase. In the asset transaction, the buyer has the tax advantages of writing up the value of the acquired assets to their fair market value on the closing date, then depreciating them from that higher cost basis. In addition, the asset purchase offers the buyer more protection than a stock purchase against unknown or unrecorded liabilities.
In a stock purchase transaction, the buyer is buying the entire balance sheet of the business and cannot write up the value of the acquired assets. The buyer can also be subjected to contingent liabilities which accrue to the acquired company that maintains its existence and obligations, both recorded and unknown, after the closing.
Choosing an asset or stock purchase will have significant tax consequences for the seller and, therefore, have an impact on the seller’s after-tax proceeds. In a stock purchase, the seller is taxed at capital gains rates for the difference between the selling price and cost basis in the stock. In an asset purchase, other than for a company taxed as an S Corp., the corporation selling its assets will be taxed on that sale and the subsequent distribution by the business to its shareholders of the proceeds from the sale is again taxed at the individual’s tax level.
None of the above-mentioned formulas are magic, but providing this information to a qualified lawyer or accountant will assist them in helping you determine the worth of the business you want to buy or sell, and the most advantageous way to structure the sale or purchase of a business to mitigate significant tax consequences based on your needs and desires.