How to Put a Price Tag On Your Business
Posted Apr 28, 2011 in Management
What is your business worth? No matter how good you are at running your laboratory, you probably don't know how to even begin placing a value on it. You're not alone.
When contemplating the sale of their businesses, many laboratory owners look for a rule-of-thumb formula; however, that's not a suitable means for establishing a price for your laboratory. Although these formulas provide you with a ballpark figure, they don't address all of the variables that affect value: economic conditions, market conditions, earnings history and future earnings capacity, balance of risk and reward. Throw in qualitative factors such as reputation and goodwill, and the puzzle seems nearly impossible. Because of these variables, valuation is not an exact science; many of the decisions made during the process rely solely on good judgment.
There are a number of acceptable valuation methods (see below); the most appropriate one depends on the business being valued, the reason for the valuation and the preference and discretion of the person doing the appraisal. For this reason, the use of an experienced business appraiser is highly recommended. These professionals are trained to quantify the key aspects of your business into an overall dollar figure.
Although much of a professional valuation relies on judgment calls made by the appraiser, the valuation profession does have established parameters and methodologies. "You can have five different valuators analyze your business and you will get five different numbers. However, if those valuations are done correctly, those numbers shouldn't be that far apart," says Jimmy Stokes, CPA, CVA, a professional valuator in Gulfport, Mississippi.
An appraisal can cost anywhere from $3,000 to $8,000; you'll get an analysis of your business's performance, client base, key players and your strengths and weaknesses in each area. Although you don't have to have a professional valuation to sell your laboratory, having one adds a great deal of credibility to your asking price. Perhaps even more importantly, you can avoid setting your price too high and turning off potential buyers or setting it too low, keeping you from realizing the full value of your business. (See below).
To begin the valuation process, you must recast your historical financial statements to make them more meaningful to a buyer. Many small businesses are structured in a way that minimizes taxes, so the true earning power of the company is often hidden. Recasting shows prospective buyers what the company would look like after they buy it. Be sure to document all adjustments so that buyers don't assume you're trying to hide something. Here are some examples of adjustments made to income statements:
- Reduce excessive owner salaries. Say, for example that as the owner of the laboratory, you're paying yourself $100,000, but the going rate for someone in your position with your experience is $60,000. The statements should be adjusted to show what the profit picture would look like if you were replaced with someone at that lower salary.
- Remove perks such as company cars, club memberships or excessive retirement plan costs for the owner.
- Remove one-time expenses such as relocation costs or legal expenditures.
- Consider any practices that you've used to temporarily improve earnings. For example, if you've cut down on equipment maintenance or eliminated your advertising budget in an effort to improve the look of your profits, a buyer is most likely going to want to see those expenses added back in.
Recasting will also involve some adjustments to your balance sheet:
- Remove assets that will not be sold with the company.
- Write off any accounts receivable that are deemed uncollectable.
- Value inventory at current replacement costs.
- Remove any debt that won't be assumed by the buyer.
There are three broad categories of valuation approaches: asset/cost-based, market-based and income/earnings-based; often, valuations are based on a combination of methods. Many of these techniques will be difficult for you to apply on your own; this is the area in which the expertise of a professional appraiser or CPA is critical, especially when it comes to determining discount and capitalization rates (discussed below).
Asset-based approaches are based on the concept that the seller is buying just the hard assets of the company. One formula in this category, for example, is book value—total assets minus total liabilities. However, this figure is far too conservative to use as a price for your laboratory. Book value does not reflect the fair market value of assets and liabilities, since they are shown at their depreciated value.
Also, asset-based approaches ignore intangible assets such as goodwill, earnings history and profit potential. "The vast amount of value in a laboratory is in its goodwill, not in its book value," says Dave Brown, vice president, treasurer and CFO of National Dentex, headquartered in Wayland, Massachusetts. "Sure, when someone buys a laboratory he gets some inventory, equipment and payables, but what a buyer is really paying for is a stream of earnings and that's what creates goodwill."
On the other hand, if the business is deteriorating, those hard assets may be all you have left to sell. In that case, an asset-based approach would be adequate.
Market-based approaches take into account "the going price" of recently sold laboratories of similar size, specialties, location and sales volume. While it is a theoretically sound approach, it can be hard to draw a meaningful comparison since each situation is unique. Also, since the majority of laboratories are closely held businesses, there's not a lot of information made public about their sales.
That may be changing, however, thanks to the information age. "A few years ago it was difficult to get information on privately held transactions, but there are now a few sources to which business appraisers have access that detail more private transactions," says John Kramer, CPA, ASA, CFE, of Blum Shapiro Litigation Consulting Group, West Hartford, Connecticut.
Income/earnings-based approaches are widely used because they look at the "big picture," which includes more intangible assets such as goodwill. Also, they consider the income or cash flow generated by the business, which is crucial to potential buyers. These methods are based on either future or historical earnings.
In order to look at future earnings, you must first do a projection for the next five to 10 years by studying the historical financials and making assumptions that growth or decline patterns will continue. "Look at the trends that have been established. For instance, has the business been pretty flat for the last few years? Or has it been growing consistently?" says Ken Mathys, CFO, Lord's Dental Studio in Green Bay, Wisconsin. "But those projections have to be reasonable. For example, you can't expect a business that has been growing by 5% a year to suddenly begin growing by 15% a year." Although projections are somewhat subjective, an experienced appraiser can apply sound judgment based on the laboratory's historical financial data and other factors such as the economics of your geographical area.
Once these projections are completed, one of the future earnings methods is applied, such as the common discounted cash flow technique, which weighs projected earnings against a prospective buyer's perceived risk. As a buyer's level of risk increases, so will the discount rate. (The perceived level of risk is based on factors such as those discussed below).
Although most buyers are concerned with the future earning capacity of the laboratory, some of them—as well as some appraisers—may find it more appropriate to base the value of your laboratory on its historical earnings. In these cases, the appraiser looks at historical annual earnings and converts future payments into a single present amount.
Once you have your valuation in hand, it's up to you whether that number becomes the actual price at which your lab is put on the market. If you're in a rush to sell, you may decide to advertise it at or even slightly below its assigned value. On the other hand, you may want to assign a higher asking price to allow room for negotiation. Remember, though, when it comes down to negotiation, your valuation is simply a place to start; "fair market value" means different things to different buyers.
For example, someone who wants to buy the laboratory and become the working owner may be willing to pay more than a current laboratory owner who wants to augment his staff and client base.
The actual terms of the sale will also determine how much you're willing to sway from your asking price.
In the end, the "true" value of your laboratory is, of course, the selling price: the maximum a buyer is willing to pay based on his perceived risk and the minimum you are willing to accept for the efforts and commitments you've made to your laboratory over the years.
So You're Not Selling? You May Still Need a Valuation
There are a variety of reasons you may need to establish the value of your business. Those reasons—which generally fall into the category of either tax or non-tax situations—largely dictate the valuation method that's suitable for you.
Non-tax valuations include those conducted when selling your laboratory, getting a divorce, dissolving a partnership or applying for a bank loan. The appropriate valuation methods will vary; for example, a banker may focus on book value for financing purposes (although you should consult your lending institution for its standards), while a partnership breakup may call for an earnings approach.
In divorce litigation, there may be state laws that dictate how the value of a business is to be determined. Although you don't have to have to hire a professional valuator, you may decide to do so if your estranged spouse has hired one or if the value of your business is in dispute. "Hired appraisers are ethically bound to be as unbiased as possible in a divorce situation," says Stokes. In any case, it is the judge who ultimately makes the decision regarding value.
Tax valuations are done for estate planning, offering employee stock ownership options (ESOPs) and when preparing to transfer the business to the next generation. They are the most complicated types of valuations and in many of these situations—such as implementing an ESOP—you are required by the IRS to have a professional appraisal done.
In any case, it would be wise to hire a professional appraiser when you're dealing with the IRS so that you can justify your numbers. According to a March '96 Nation's Business article, the IRS finds businesses to be worth an average of 150% more than the value reported by taxpayers. (When planning your estate, keep this in mind when determining how much life insurance you need to cover estate taxes.)
How to find a business appraiser
Because of the complex nature of valuation, you may decide to hire an appraiser or valuator to help you assign a price for your laboratory. Business appraisers are trained to spot and analyze the elements that influence value, and therefore are well prepared to make the necessary judgment calls during the valuation process.
Generally, appraisers are certified public accountants; there are also a few credentials that appraisers can earn:
- ASA, signifying accreditation by the American Society of Appraisers; 800-ASA-VALU; http://www.appraisers.org.
- CBA, certified business appraiser, issued by the Institute of Business Appraisers; 561-732-3202.
CVA, certified valuation analyst, from the National Association of Certified Valuation Analysts; 800-677-2009; http://www.nacva.com.
To find a qualified appraiser, call one of the numbers listed above or ask your accountant for a referral.
How to add value to your lab
If you're selling your laboratory, you should consider the variety of factors that add to or detract from its value. Being aware of any "red flags" that may worry prospective buyers allows you to remedy those problems before putting your business on the market. "Be prepared for a buyer to come in and do some real scrutinizing of your operation in order to determine his level of risk," says Ken Mathys, CFO, Lord's Dental Studio in Green Bay, Wisconsin.
Here are some of the areas that influence risk and therefore affect value:
Strength of your financial statements. Do you have a good cash flow, or are you just barely paying your bills? Now's the time to get debts paid off and to reduce the number of perks you or family members are receiving from the business in order to increase your EBIT (earnings before interest and taxes).
Client base. Do you have a number of individual dentist-customers sending you work or is your laboratory largely relying on the work of a group practice? Ideally, you don't want all your eggs in one basket. The buyer will also be interested in your client turnover. "If you don't have a reputation of keeping customers, as a buyer, I would worry about bad will. If you have little turnover, then I'd assume you have a good reputation in the industry," says Jimmy Stokes, CPA, CVA, a professional valuator in Gulfport, Mississippi.
Product line. Do you offer a wide variety of services? Have you invested in some of the new systems on the market? "Also consider your value-added services, such as pickup and delivery, practice management seminars and chairside assistance. Touting these advantages can help prospective buyers overcome price sensitivity," says Mathys.
Personnel. Do you have a high turnover or a morale problem? Ours is a labor-intensive business, so expect buyers to take a close look at this area, especially considering the shortage of experienced technicians.
Key person factor. As the owner, are you the only one who interacts with clients, sees cases through to the end, performs quality control checks and makes the decisions? This is a risky situation for a buyer, because it will be impossible to continue "business as usual" after the sale and may result in the departure of clients and even employees. "Laboratory owners often think their businesses are worth a lot more than they are because they don't realize how closely the laboratory's success is tied to their personal involvement," says Dave Brown, vice president, treasurer and CFO of National Dentex, headquartered in Wayland, Massachusetts. This is why you should plan on staying for a period of time after the sale; most buyers will want you to help ease the transition process and minimize the appearance of change to your dentist-clients. You should also train and empower a "number two" person and consider asking him or her to enter into an employment contract, especially if you decide you're not willing to stay for a transition. This assures the buyer that there is someone other than you who is capable of running the operation.
Management systems. Do you have procedures in place for scheduling, workflow and quality management? Also, having documentation like sales reports, product reports, job descriptions and technique manuals enhances the professionalism of your management style.
The condition of your assets. Sell off unproductive equipment and inventory and do any necessary upgrades or repair. Also do some "cleanup," such as painting and organizing files. You should also clean up your accounts receivable by collecting all those that are outstanding.
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