ELITE ADVISOR BEST PRACTICES
What’s Your Client’s Business Worth?
The answer’s not so simple when you’re talking about nonpublic companies.
By Josh Patrick
- Private businesses can have multiple values depending on who the potential buyers are.
- Business owners need to realize taxes and expenses are part of the sales process.
- Advisors who know how to help clients move between value worlds add lots of value to their relationships.
This would be a simple question to answer if your client’s company were publicly traded. If you’re working in the private business world and you’ve tried to help your clients know whether they can afford to retire, you probably have been stumped figuring out what to use for the after-tax value of a business sale.
Many planners just take the value their client gives them and run with it. This is the simplest approach and may be what your client wants, but it’s a bad idea. Owners almost never really understand the value of their businesses. This is because they don’t know that businesses can live in multiple value worlds, depending on who the potential buyers are and the valuation method used.
The concept of value worlds
Rob Slee, an investment banker with Robertson Foley in Charlotte, North Carolina, has developed a concept for valuing private businesses that I suggest you use. Depending on who the buyer is, or if there even is a buyer, the value of your client’s business can vary dramatically.
Let’s say you have a client who has a business that does $5 million in sales and produces $150,000 in profit. You would think this business could be sold for about $750,000 (5 times its profit). But what if this business had only one customer that accounted for $4 million of the company’s $5 million in sales, and what if that customer was looking at other suppliers? Some valuation methods would take that vulnerability into account while others would not.
Let’s look at another business that has a patented process that serves to build a large moat around the company. Like the first company in our example, this company does $5 million in sales but has profits of $500,000 and has plans to grow to $50 million with a profit margin of 20 percent. In this case, one type of buyer might offer $2.5 million and another buyer might be willing to pay $25 million.
Understanding where your client’s business falls in the land of value worlds will mean the difference between pursuing the right strategy and pursuing one in which disaster might strike.
The one person who can help them think about this the right way is you, the financial planner. But first, you need to know what value worlds are and where your client’s business falls.
The different value worlds
Here are the seven value worlds that I recommend you understand and communicate clearly to your clients:
- Financial or Investment Value
- Strategic Value
- Intangible Asset Value
- Liquidation Value
- Market Value
- Fair Market Value
- Owner’s Value
The key is to help your clients first know what world they’re going to show up in today and what they can do to move toward higher-value worlds.
Let’s now take a look at each of the value worlds.
1. Financial value
This is used by a private equity firm or by any other buyer that is considering purchasing your client’s company primarily as an investment. Financial value buyers are often good buyers, but they have no motivation to pay any more than what the financial statements would suggest so they can get a reasonable financial return on their investment.
A financial buyer is the one who would pay about $2.5 million for the second company in our example, the one with $500,000 in annual profits. A financial buyer looks at what the company has done and what will likely happen in the short term. They don’t have a reason to pay higher multiples (or goodwill) because they look at the business as an investment and not an opportunity.
A financial buyer would have a great deal of interest in our second business and probably no interest in our first example.
2. Strategic Value
A strategic value buyer is one that will look at the business and believe the value in owning the business is much higher than simply a financial return. The strategic buyer might be a competitor, or it might be a larger company that thinks your client’s business has a good fit with their business. The strategic buyer believes that combining the two companies would make the value of the target company higher than a financial buyer might think.
Strategic buyers might have an interest in the first company. If the product line fits in well, they could get rid of all the overhead, and if they felt they could hold the large customer, they might want to buy—but with lots of strings attached.
A strategic buyer would love to own the second company. If it’s a larger company, the buyer would believe it could add the product line and help the acquired company take advantage of the opportunity. As much as a strategic buyer would like to own the second company in our example, it would likely lose out to our next type of buyer (an intangible asset value buyer).
3. Intangible Asset Value
This buyer wants a company, and the amount of money it pays has no apparent relationship to the amount of profit the company produces. My favorite example of this type of deal was when Microsoft bought Skype. The multiple of profits was so high that no one even mentioned it. Microsoft bought Skype because of the intellectual property Skype had. (It also didn’t hurt that a full bidding war erupted over that acquisition.)
The second company in our example would be a perfect acquisition target for an intangible asset sale buyer. A larger company could scale the technology and move this company easily to $50 million in sales. For this type of buyer, even a $5 million purchase price might not get the deal done.
4. Liquidation Value
This value is the sad one. Let’s take our first example. The business has 80 percent of its business in one basket—with one big customer—and that customer is looking at other suppliers.
Fast forward to a year later when the large customer decides to move its business to another supplier. There is a good chance that this $5 million business won’t be economically viable at $1 million. The owner at this point has no alternative but to liquidate the assets and try to stay out of bankruptcy.
When you have a client in this situation—there might be no buyer or, even worse, the business could easily be at risk—you can still provide great value by helping your client understand the cold reality of the situation. Too often businesses are liquidated when they could have been saved with an intervention by an astute advisor.
5. Market Value
Market value is the range of values a company could sell for. This is what a buyer is likely to offer and the terms that the buyer might use. Market value is a technique for showing your clients how their businesses will look to different types of buyers. Your value can be in helping clients realize which is the right buyer for their company.
When doing a financial plan for a business owner, it’s often a good idea to use a computer program that allows for various values and outcomes. This way your clients get to see what a range of outcomes could be for their businesses.
Market value is what real buyers are willing to pay for a business. You’ll really never know what the true market value of a company is until you actually try to sell it.
6. Fair market value
If you go to a valuation expert, you’ll get an estimate of the prices that a willing buyer and willing seller would agree to.
The truth is that fair market valuations are always wrong. When Mr. Market gets ahold of a business, there will be a completely different set of valuations used. The value from a fair market valuation will either be higher or lower than the market value.
Fair market valuation is important when businesses are being transferred to families or when there is an ESOP (Employee Stock Ownership Plan) involved. Both scenarios require a fair market valuation as part of the business transfer process.
7. Owner’s Value
This is the most dangerous value of all. Owners will almost always value their businesses at a significantly higher price than any buyer is willing to pay. The danger is that if you accept the owner’s valuation as real, then any financial plan that you put together for the owner could be complete fiction.
The fact is most businesses will not get the owner to retirement without additional income and savings. You’ll need to help your clients understand that investment real estate and qualified retirement plans are crucial if they want to ever leave their business and never have to work for someone else.
Remember to factor taxes in the equation
When planning for the retirement of a business-owner client, knowing what the tax bite will be is another determining factor in whether the business is valuable enough for retirement. The difference can be as much as 30 to 40 percent of the proceeds left over from the initial sales price.
You will also want to factor in the closing costs of a transaction. It’s not unusual for 10 to 15 percent of the sales price to be eaten up by business brokers, accountants and lawyers.
The challenge of valuing a business is knowing what the enterprise is worth to someone else. Sometimes it’s best to work on increasing value and helping your client move into a more attractive value world before selling. The more informed you are, the more value you can bring to clients who own businesses.