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How Much is Your Company Worth?
by Michael Sipe

Opinions abound. Seems like everyone has a story to tell.

“Did you hear about Uncle Bert? I understand he sold his goat farm to the playboy son of a Greek shipping tycoon. Heard he got $1.38 per hoof. ‘Cept he had to keep Three Legged Billy. That old goat was stale inventory.”

While there is no shortage of bizarre storytelling, how much a company is worth at any given point in time is established when a buyer and seller actually close a deal.

Everything else is just opinion. 

Granted, there are times when well grounded valuation opinions are extremely important, such as in litigation, IRS disputes, estate tax planning, ESOP administration, and stock option programs. We refer business owners regularly to excellent valuation specialists who can provide clients with needed support in situations like these.

For management planning and exit strategy purposes, however, understanding valuation from a market perspective is critical. Entrepreneurs need to have a sense for how the market will likely respond if their company is placed for sale. It’s also important to understand some of the complexities of putting together real transactions, instead of hypothetical ones. Usually the issues in a market transaction include not just price, but also terms, structure, transition requirements and the chemistry between buyers, sellers, vendors, customers, lenders, and employees.

Therefore, the reply to the question, “How Much is My Company Worth?” is often a resounding, “Well, it depends.”

Private Equities usually markets companies without an asking price. When a prospective buyer asks, “What is the asking price?” our response tends to be, “Well, there is no set asking price. How would you anticipate approaching the transaction?”

Neither response is intended to be coy. In the real world of doing deals, the “price” is usually dependent on a number of other considerations, such as:

Is a stock or an asset deal contemplated? For a given price, the net after-tax results can swing tremendously depending on what is being bought and sold.

• If it’s a stock deal, what will the closing balance sheet look like?
   

• If it’s an asset deal, what assets are being acquired and what liabilities assumed?
   

• What are the terms of payment? 
   

• What is the “currency” of payment, i.e. stock, cash, notes, earnouts, options, fine art or rare three legged billy goats?
   

• What security is there for downstream payments? 
   

• What are the seller’s transition requirements?
   

• Will the seller’s personal guarantees be lifted?
   

• What representations, warranties and indemnifications must the seller provide?
   

• Who is the buyer and how is the “chemistry?”

In short, there’s a lot more to market valuation than might initially meet the eye.

However, familiarity with four main conceptual approaches to market valuation is useful:

1. Asset Approach. Asset approaches to valuation are fundamentally concerned with the value of the tangible assets of a company. In other words, “How much is the ‘stuff’ in the company worth?” An asset price is usually the lowest price a seller will accept, as there is usually little economic reason (other than getting extricated from leases and other contractual obligations) to accept a price lower than asset liquidation value.
    

2. Earnings Approach. Valuations based on earnings are very common. All acquisition valuations have their roots in an assessment of the likely return on the buyer’s investment. Therefore, one often sees valuations derived from a multiple of earnings. This approach sounds simple on the surface, but at least two issues for negotiation immediately arise:
    

   • What earnings? Tax basis, internal, recast, projected, past, present, or future earnings? Pre-tax or post tax? Before interest? What about depreciation and amortization? How much depreciation? What about “one time” or extraordinary events?
      

   • What multiple?
      

3. Cost of Entry. This is a classic “buy or build” approach. Whether one starts a business from scratch, or acquires an existing one, entering a business, industry or market is not without cost. It’s a bit more difficult to estimate the cost of starting a business and bringing it to profitability than it might be to estimate the cost to buy or build an office building or apartment complex. Nonetheless, there is a cost. Sellers usually tend to overestimate this cost and buyers usually tend to underestimate the cost and risk to establish or replicate a business. 
   
   Right or wrong, though, a buyer’s estimate of the cost of entry frequently sets the maximum price that buyer is willing to pay for a business. Say a seller wants $10,000,000 for a company. If a buyer believes it will cost $5,000,000 to start a similar business from scratch, or that an acceptable alternate business can be acquired for $6,000,000, that buyer will not pay $10,000,000 for the seller’s company.
    

4. B.S. The rationale for buying decisions and the prices paid is, at times, difficult to fathom. Sometimes hype, gossip, boardroom conversations, private agendas, competitive pressure, economic euphoria or the phase of the moon seem to drive a deal value. We certainly saw a lot of that a couple of years ago. Not so much now.

Just as one should not base retirement plans on an expectation of winning the lottery, entrepreneurs should not base their business plans or exit strategies on an expectation of a jaw dropping purchase price. If a windfall sale happens, that’s great. The prudent approach, however, is to build a company of genuine and sustainable viability, where even a conservative valuation yields an attractive return on the shareholders’ time, energy and money.

Assessing overall marketability, market value, and likely deal structure can be complex. It is certainly not exact science and it’s still just an opinion until the market actually votes. A valuation estimate coming from a Mergers and Acquisitions specialist is a different kind of opinion than an entrepreneur might obtain from a formal business valuator or CPA, but is extremely useful for management planning purposes, estate planning and exit strategy development.
 

If you would like to discuss your business objectives and the marketability and likely value of your company in confidence and without obligation, we welcome the opportunity to speak with you. Please call Private Equities at 408.295.4299
 

Private Equities
2033 Gateway Place, Suite 600
San Jose, CA  95110
408.295.4299
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