By Frank Legan

As an owner or manager of a company, do you really know its value? Are you certain about the profits you’ve generated in the past year? Can you identify where your business is gaining value and where it might be slipping?

If you answered “no” to any of these questions, it might mean you’re jeopardizing your company’s future. Read on to discover how business valuations work and how you can begin assessing your business’s true worth.

Why Would You Want a Business Valuation?

Business valuations are excellent for obtaining the information needed to:

• Understand the business’s value before deciding whether or not to put your business up for sale
• Determine value while working on a buy-sell agreement or considering the update of your buy-sell agreement
• Consider estate planning needs
• Compare your business performance relative to others in the industry

About Business Valuation

In understanding and interpreting the value of a business, it’s important to recognize there are many different types and levels of value. The most common way to estimate the business value is to use the fair market value on a going concern basis, which assumes 100% interest in both the business assets and equity.

When valuing the entire company (100% control interest), it is necessary to distinguish between the value of “assets” (asset deal) and the value of “equity” (stock deal). In practice, owner-operated businesses are either sold on an “asset sale basis” or on an “equity sale basis” with the purchase agreement reflecting the unique aspects of each scenario.

A variety of factors will determine the chosen mode of sale, with buyer and seller negotiating price and an array of other “terms and conditions,” including the type of sale.

The “asset sale” value will always differ from the “stock sale” value due to the specific group of assets and liabilities that are included or excluded in each format. In determining which estimations of value are of most relevance to the business owner, the reason behind the valuation will typically address this question. Business brokers hired to assist buyers and owners most commonly value businesses under the “asset sale” scenario through multiples of discretionary earnings, while valuations for divorce or estate taxes will be based primarily on the “equity sale” scenario.

The general differences between the asset and equity transaction structure are:

Asset Sale (Asset Value)

Includes only inventory, supplies, fixed assets, and intangible assets. Excludes all liquid financial assets and all liabilities. The buyer operates from a newly formed legal entity.

Equity Sale (Equity Value)

Includes the assets listed above plus liquid financial assets minus all liabilities (short term and long term). Involves the full transfer of the legal entity including all account balances and current tax attributes.

Naturally, the “value” associated with these two distinct transactions can be substantially different. In practical terms:

Asset sale: The seller keeps the cash and receivables but delivers the business free and clear of all debt.

Equity sale: The buyer is acquiring all of the assets and liabilities, on and off the balance sheet.

In the “real world,” there are many variations on these basic structures, e.g., an asset sale might include accounts receivable or an equity sale might exclude long-term debt, etc. They are both “fair market value on a going concern basis” estimates.

Enterprise Value

In middle-market transactions, it’s also helpful to distinguish between “equity value” and “enterprise value.” Enterprise value is a reflection of the firm’s value as a functioning entity, and it is helpful in that it facilitates the comparison of companies with varying levels of debt.

Which Business Value Conclusion Is Most Important?

The answer to this question depends chiefly upon the purpose for the valuation engagement. If you are negotiating the sale or purchase of a business via an asset sale, then it is the asset value which is most relevant. If you are filing an estate/gift tax return, it’s the equity value which is most important. When evaluating middle-market companies for merger and acquisition purposes, both equity and enterprise value will be useful. If your business is rapidly deteriorating and you’re contemplating reorganization, then liquidation value may be of most relevance.

Key Performance Indicators

In the valuation report available to you, it will also cover a number of key performance indicators (KPIs). They are calculated based on an analysis of company-specific data and how that data relates to various industry-specific averages linked to millions of other businesses. 

These KPIs are helpful in measuring financial and operational health and growth of a business. The report available to you will clearly show if your company is outperforming, underperforming, or meeting industry standards.

Some of the KPIs included in the report include:

• Cash flow to revenue
• Cash to revenue
• Receivables (conversion)
• Inventory to revenue
• Fixed assets to revenue
• Total debt to revenue
• Receivables to revenue (pre-tax)
• Inventory to income (pre-tax)
• Fixed assets to income (pre-tax)
• Total debt to income (pre-tax)

Work With a Trusted Professional

Having a seasoned financial professional by your side can greatly impact how accurately your business’s value is assessed. Let Cedar Brook Group guide you through the process for a true valuation of your business.  If you’re ready to take the first step in determining your business’s worth, reach out to us at 440-683-9213 or flegan@cedarbrookfinancial.com or schedule a complimentary introductory call online!

About Frank

Frank Legan is Partner, Financial Advisor, and member of the Forward Look Committee at Cedar Brook Group, one of the largest independent wealth management firms in Northeast Ohio. Frank spends his days designing and implementing personalized financial planning strategies for corporate executives, closely held business owners, artists, families, and retirees. He focuses on lifetime income strategies, investment advice, and estate planning services. He also works with businesses to develop strategic and succession planning strategies. Frank has a Bachelor of Arts in Political Science from the University of Dayton, as well as a Master of Public Administration focused on municipal management from Cleveland State University. Prior to joining Cedar Brook Group, Frank was a financial advisor in the private client group at Merrill Lynch and with NatCity/PNC Investments. Frank is active in his community, serving on various councils, boards, and committees. Frank serves as Chairman Emeritus of the Board of Directors for Catholic Charities Diocese of Cleveland. When he’s not working, you can find Frank spending time with his wife, Laura, their daughter, Reese, and their beloved collie, Charlie. Frank and his family are volunteers at St. Francis of Assisi church in Gates Mills. To learn more about Frank, connect with him on LinkedIn.

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