Tags: Deal Maker

How Much is it Worth?

“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” – Warren Buffett 

One of the most important things a business owner ever does is to create and implement strategies to make their business viable in the long term. There are a lot of parts to that success; one thing that comes up repeatedly is the idea of allowing key employees to buy part of the business.

There are pros and cons to allowing employees to buy in, but that’s not the point of this post. Nor is the purpose today to talk about how to structure a buy in (How will insiders afford to pay for the business? Will it be seller financed? Etc.). Let’s assume you’ve decided that in your case it’s the right thing to do and you know how to structure it. Maybe you’re selling the whole business and getting out, or maybe you’re just selling a small piece as a reward/incentive for a key person. Whatever the case, somehow you have to figure out what that portion of the business is worth. 

That’s where things get tricky. If I want to own part of GE, I can get online and figure out the price in about 30 seconds. But what about a smaller business? What about a business that’s not publicly traded? What if the portion you’re selling to a key employee is a minority interest with no real authority? What is that worth?

There are dozens of ways to look at it, but I think there are 3 that are the most straightforward:

  • Option #1 – Get an appraisal. This seems like an obvious answer, but all appraisals are not created equal. Can you find somebody who actually understands what a business in your industry is worth? What assumptions are they making as part of the appraisal? The benefit of the appraisal is you get a straightforward answer and you can move on. The problem is how that answer is developed.
  • Option #2 – Use book value. This is easy math. Book value per share is just the amount of equity in the business divided by the total number of shares outstanding. The end result is X$ per share. The problem with this method is that book value doesn’t take into account the future, trends, risks, etc. It’s just math. It’s extremely simple – and like most extremely simple things, it might not always be fair.
  • Option #3 – Use multiples. In a number of industries, values are determined by multiplying the businesses income (usually before tax & a few other items) times some number and that’s the value. Some industries use a multiple of revenues instead. Again, it’s pretty easy math. The problem is determining the multiple. What’s fair? If industry norm is 3x earnings, what if your business is a little different than industry norm?
  • Option #4 – Be creative. I’ve seen some businesses use some portion of each of these as well as some other facts or circumstances that they think are relevant. Maybe 1/3 of the value is based on book value, 1/3 on something else, etc. Then maybe you discount it for lack of marketability or some other reason. The point is that you can make it as complicated as you want, but in the end everybody has to agree on it. And there’s no guarantee that you can imagine a way that’s any fairer than anything else.

There’s no way to value a business that’s both simple and fair. In my experience, simple usually wins out and most small businesses end up simply using book value. Whatever you do, though, make sure it’s in writing ahead of time. The worst option of all is doing nothing. 

Matt Heemstra is the Director of Growth & Profit Solutions for Cain Ellsworth & Company, LLP.  He spends his time helping businesses and their leaders develop their potential.  To read Matt’s other blogs here or contact him here.

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