Business Valuation Considerations

Business value is not a specific number and there is no one absolute value that defines it. But rather business value is range and varies greatly based on assumptions used and factors considered. Market value is one type of business value.

Fair market value is the price at which a business changes hands between a willing business buyer and seller. It is important to keep in mind there is no one true value for a business because the value of a business is influenced by many factors. So rather than think of the value of a  business as an absolute number, one should think of it as a range. There are many reasons owners value businesses including buying and selling businesses, employee stock ownership plans, estate taxes, business equity transfer, financing and so on. Business valuation is also required for tax purpose when a business transferred to the next generation.

One place to start is to engage a professional business appraiser. Appraisers tend to conduct detailed analysis and use intrinsic valuation techniques rather than using rules of thumb because it tends to be overly optimistic.  Business appraisers have their pulse on macroeconomic and microeconomic changes effecting the economy and they can help business owner’s trade-off terms with cash when negotiating a term sheet.

There are two factors that affect small business valuations the most namely cash flow and the value of assets it holds. Cash flow is the amount of cash the business generates. Other factors that influence a business include Supply and demand, Interest rates, nature and history of the business, location of the business and so on. When the number of businesses for sale is large the value tends to be lower and vice versa.  If interest rates go up money gets tighter, interest payment becomes larger and the value of the business goes down.

Some additional considerations for business valuation include:

  • Financial condition of the business. The best measure for this is the book value. Book value is the total assets minus total liabilities of the business. The book value of a business can be determined by analyzing the balance sheet and income statement.
  • Ability of the business to generate cash, pay dividends and so on.
  • Prior sales of businesses in the area. In the best case there would be similar businesses in the geographic location that can be used as comparable.

Following is a checklist of documents a business owner requires to value a business.

  • Financial statements which includes balance sheets, income statements for up to the last five fiscal years.
  • Income tax returns for the last five years.
  • Equipment list, depreciation schedule, Accounts Receivable, Accounts payable, inventory list, lease, and prepaid expenses.
  • List of stockholders or partners, with number of shares owned by each or percentage of each partner’s interest.
  • Description of business including competitive analysis and factors that make the business unique.
  • Regulatory filings, associations the business belongs to and relevant trade publications.
  • List of patents, copyrights, trademarks, and other intangible assets.
  • Is the business at risk from new regulations or legislation.

Investing in Commercial Property (Commercial Real Estate)

Broadly speaking real – estate can be classified as commercial, industrial and residential. Commercial Real Estate  is property used solely for business purpose.  It is any property used to produce income. Examples of commercial real estate include malls, restaurants, convenience stores  and office spaces.  Industrial real estate is used for manufacturing and production. Businesses that occupy commercial or industrial real estate usually lease space. Commercial and industrial real-estate is usually owned by investors who own the building and collect rent from each business (tenants). Similar to buying a business, investors should complete due-diligence before investing in commercial property. Key element of due-diligence include Location,  Property Type, Budgets and several other factors listed below.


Location is a critical element of commercial property investing. Investors must understand the soundness of the location, demand / supply dynamics and vacancy  rates. Additionally, investors should ensure that job market, economy and population growth in the area is favorable. Without sufficient research they may land up buying  property in micro markets with high vacancies.

Property Type

There are different types of commercial property available  including retail, office space, industrial, multi-family and land .The most popular being retail and office space.   Investors looking for retail space have several options including free-standing street outlets and shops in malls.  These outlets can be as small as 500 – 1000 square feet. Shop in malls belong to a strata and are pre-sold to individual investors.

Industrial and commercial properties may have capital appreciation and rental yield.  Rental yield is the annual rent divided by the value of the property. Rental yield is critical element for valuing a property. A low yield implies the property is overvalued. Rental yield varies by country and market. For example, commercial properties with rental yield of 11 %to 12% is considered correctly valued in major Indian cities like Mumbai and Bangalore. Commercial property with yield less than that is considered overvalued.

Due – Diligence

In addition to the above factors Investors should check the credentials of the developer, potential infrastructure development in the area, access to public transport and quality of property management. In case of a retail store front -age and visibility are critical.

The buyer usually provides the seller a due diligence checklist.  The checklist includes request for information related to tenant information, building information, operating information, financial information and other miscellaneous items. Tenant information include rent roll showing the rents paid. Rent information must include tenant’s name, suite number, size of premises and several other attributes. Operating information should include financial statements of the property for the  past three years, current operating and capital expense budgets for the property, utility bills for the last three years, tax bills and more. Financial information includes understanding the break-up of cash flows. This includes collecting data on vacancy factor, maintenance expenses, property tax, building insurance, lease term, lock-in period and expiry dates for leases, long-term capital appreciation potential, cost of refurbishment and potential for refinancing. Additionally, the buyer should obtain new third party inspection report and title report.

Whatever information is provided by the seller, they usually include a provision in the purchase agreement stating the information contained in the documents must be verified by the buyer. It does not constitute a representation of warranty of the seller as to their accuracy.


Negotiating a Term Sheet

The term sheet is not a legal document. It is used to negotiate the broad parameters of an investment. The actual agreement is set in several other documents including the stock purchase agreement and investor rights agreement.

Term sheets are non-binding agreement between parties involved except for certain terms that include confidentiality and no-shop provision. Most deals that get negotiated using a term sheet are finalized. Term sheets have an exit date and agreements must be signed before the expiry date.

Term sheets can be for a debt offering or equity offering. Terms common to debt offering and equity offerings include pre-money valuation, amount to be invested, post-money valuation and cap-tables. Debt-offering terms include convertible offering, fixed or indeterminate conversion price, automatic or optional conversion, assets used for security and interest rate. Interest rates are not usually negotiated if it is in a reasonable range. Anything between 3% and 8% is considered reasonable.

Equity offering terms include shares (common or preferred), liquidation preference, conversion price and valuation, automatic conversion, anti-dilution, pre-emptive rights, protective provisions, voting rights and shareholder rights.

Additional common terms in a term sheet include full legal name, type of security (debenture, common shares, and preferred shares), size of round, price per security, number of closings, number of tranches and milestones, targeted closing date, use of proceeds and expiration date.

A term sheet can be for a note deal (debt) or for an equity deal. Usually it is cheaper and quicker to do a convertible note deal because there are a lot fewer terms to negotiate and draft as compared to an equity deal. Additionally, a convertible note term sheet kicks the valuation can down the road to when the note matures. For example, in case of a convertible note deal if the investor invests in 100 thousand when the deal matures (say after 1 year) the investor will get $106 thousand worth equity at the negotiated equity price.

The convertible note puts a stop in the valuation discussion and frees up the business to go and get work done. In effect the valuation discussion is pushed to a later point in time when the business is more established. Convertible notes are only useful if it includes terms that protect the investor from runaway valuation. For example, the investor may invest $100,000 in a business at an early stage, but then if the company gets an investment in millions of dollars the original investor is completely diluted. Suddenly the investor who took the biggest risk has the lowest percentage in the company and correctly compensated for the risk. Convertible debt makes sense only if the term sheet has terms to protect the original investor investing through convertible debt.

The most negotiated terms in a term sheet are valuation, type of security, board of directors, significant financing threshold, IPO threshold, drag along threshold, anti-dilution provisions, pay-to-play and management carve-out.

The term sheet is usually served up by the investor to the entrepreneur. However, in case of a seed round or party round it may fall up to the entrepreneur to create and serve up term sheet and serve it to the investor. Both investors and entrepreneurs should take the opportunity to get legal advice before signing a term sheet.

Ideally, all inside rounds of financing should be shopped around using term sheets. Doing so facilitates a market check that helps determine the correct valuation for the business, which is the correct outcome for everyone involved. That said a term sheet may include a no-shop provision.  During due-diligence investors should be mindful of this provision because can affect the valuation of the company long-term.

Exploding terms sheets are term sheets that must be signed in a very short time. Ideally, investors should avoid exploding term sheets because it does not give them sufficient time to complete due-diligence on the company.

Business Transfer

Business transaction starts with due diligence investigation and negotiation. Usually the prospective buyer makes a written offer (Letter of Intent) that sets the broad parameters of the negotiated deal. The negotiated deal must include consensus regarding price, payment structure, price allocation and all other details that comprise the final deal.

Once all the terms of the offer are accepted by both parties a Purchase-and-Sales agreement is drawn up. The agreement must be drawn up by an attorney who specializes in commercial law possibly with the assistance of an accountant and business broker. The details of the Purchase-and-Sales agreement must be based on the accepted offer. Banks (lenders) also need the agreement signed by both parties to analyze the deal and issue loans.


 The Purchase-and-Sale (P&S) agreement is a contract that shows the buyer has decided to acquire the business and the seller has decided to sell the business for a certain price within a certain period of time. This document covers everything negotiated and listed in the letter of intent (term sheet).

The P&S agreement is legal and binding once it is signed by both parties.  It is the conclusion of in-debt investigation and due-diligence by the buyer and seller. At this point the seller has determined the buyer has the financial and business capability to see through the transaction. The Purchase-and-Sale agreement can be several pages with exhibits and attachments that address all the necessary points to be covered. It is important for the buyer and seller to understand the elements covered in the agreement. Listed below are a few items covered in the P&S agreement.

Buyer, Seller and Business Names Names of the business buyer, business seller and the name and location of the business.
Asset Inclusion and Exclusion List of assets included with the sale of the business.  Assets include equipment, machinery, inventory, accounts receivable (AR), brand (business name), goodwill, real estate and so on. The P&S agreement shall also list all items that must be excluded from the agreement cash and real estate.
Price The total purchase price for the business. This section must breakdown the price into its component including down payment.
Closing Date (Time frame) Closing date for the business transaction. It can take 3 to 6 months to get a commercial loan, so the closing date must be a few weeks away.
Liabilities (Accounts Payable) The business seller usually retains responsibility for Accounts Payable (AP). All current business loans must be re-paid by the seller so that the new owner has clear titles on all assets. If the buyer takes on any expenses it should be reflected in the selling price.
Accounts Receivable  Accounts Receivable (AR) that is money owed to the business is also typically retained by the seller. In some cases the AR may be sold with the business by adjusting the selling price higher. If the AR is sold with the business the seller must provide a detailed list containing amounts, counter party details and expected dates.
Payment Terms This section includes the amount of cash that will be paid on the closing day, deferred payment scheme and seller financing details.
Inventory Contains list of all inventory items included in the sale. The inventory should be counted when the agreement is created and once again just before the deal closes.
Seller Agreements This section usually includes non-compete covenant, inspection reports (federal, state and local, environmental) and other actions required by the seller such as repairs and transfer of licenses.
Taxes Taxes due should be paid by the seller before the closing date.
Escrow Agreements Escrow Agreements are created only if there is an outstanding obligation where some work needs to be done by the seller after the closing date. In this case money is held in an escrow account and released when the obligations have been satisfied.
Seller’s Representations and Warranties This one of the important parts of the agreement. It is used to ensure the seller has provided correct business information through the due-diligence process.

Business Transition

The process of buying a business includes several activities. The business buyer must search for an appropriate business, analyze the business and financial data, develop a viable offer, close the sale and transition to the new business. The business transition step is critical because after the sale is finalized the original owner may not be available to answer questions.

The business seller should start grooming the business for sale several years before actually putting up. This period is crucial because it allows the business seller to organize the following documents:

  1. Prepare financial statements for three to five years.
  2. Corporate tax returns for three to five years.
  3. Inventory value and capital expense and equipment.
  4. Customer lists and list of employees.
  5. Documents related to leases and franchise agreements.
  6. Artifacts related to transitioning the business to the new owner.

Completing all artifacts for smooth transition significantly increases the chances of a business being sold as it reduces risk of owning a business for the new owner. Some common areas both buyers and sellers must discuss include:

  1. The business seller must be clear why he is putting up the business is for sale and document the reasons. The buyer must ask this question and the business seller must provide a detailed explanation.
  2. The buyer and seller must determine the value of the business and set an asking price range. The asking price breakdown must include asset value, interest expenses, business quality, business value and goodwill. Goodwill amount is the difference between the total value of assets and the selling price.
  3. The business seller must create a marketing plan that contains the type of business, the industry the business belongs to along with trends and projections for the industry. The marketing plan must include market share, growth potential, target market and other elements. The marketing plan must include competitive analysis and rank the competition.
  4. Location of the business and the history of the location. Both parties must be clear if the business can be re-located and / or merged with another business.
  5. The seller must create a customer list. The customer is the most valuable asset in a business, so it critical for the buyer to understand the customer profile and behavior. The Buyer must evaluate any customers who account for more than 10% of the business as losing this business can significantly impact profitability.
  6. Define all products, services and document their history if they have changed over time. The business seller must document how the products or services are priced and create a list of all suppliers.
  7. The seller must also document proprietary processes or trade secrets that must be transferred to the new owner.
  8. All operational tasks related to how products and services are produced from start to finish. Buyers must gain access to payment terms of suppliers, operating manuals and handbooks and any other information that can help them understand the day-to-day operation of the business.
  9. Job descriptions and pay rates of all employees. The new owner usually has the opportunity to re-hire existing employees and review their current and future responsibilities, wages and benefits.
  10. Buyer and seller financing. Buyer financing is the ability of a new buyer to raise sufficient money to buy the business. Seller financing is the seller’s willingness to finance part of the business. The discussion on financing must include liabilities. Usually all debts are paid by the seller unless there is a mutual written agreement stating the amount of debt the new owner will take on.

All the items above are important considerations to reduce the dependency on the current owner and simplify business transition. If the owner of the business agrees to assist with transition after the sale, the decision should be included in the purchase and sale agreement. The agreement must include specific tasks that the owner will perform during the transition period and the length of time for which he will perform the tasks.


Determine Business Buyer Persona

Business for SaleDo develop a negotiating strategy the business seller needs to understand the buyer of the business (Seller Due-Diligence). There are several types of business buyer personas where the buyer can be an individual or a business.

Financial Buyers – Financial buyers look for value, spruce up the business and then sell it. Financial buyers are looking for profitability or signs of profitability and stability that are right around the corner. Sometimes they are looking to merge a business with another to benefit from synergies (Synergistic Buyer) with another similar operation in the industry. Financial buyers analyze the businesses numbers in great detail and calculate the price using valuation metrics and comparable deals. They are most driven by proven return on investment (ROI) and tend to get large amounts of financing to purchase a company. In summary the objective of a financial buyer is to negotiate a deal where the deal can be paid of through operating profits, growth over time or immediate profits from some arbitrage.

PE groups raise capital raised through high net worth individuals, family trusts, pensions and others and are the most common type of financial buyers. Their objective is to maximize value for their investor pool.

Strategic buyers – Strategic Buyers look for buy and hold opportunities where they can enter new markets, increase the market share or foreclose some element of competition. Typically these buyers come from the industry (Industry Buyer) and understand the business and its marketplace. A strategic buyer may be a big company already operating in the industry and wants to acquire a business as a platform to enter a new market or to add new products and services to the marketing mix. Sometimes the purchase can be about getting people or management. Strategic buyers may pay more because they understand the value of the acquisition is more than the financial value of the business. The acquired business provides a new leverage. Strategic deals get done quicker and are usually preferred. Strategic business deals tend to be of larger sizes.

Special-Purpose buyers – There are many types of special-purpose buyers. They may be business buyers are private citizens doing private deals. The buyer may be a public company attempting to defend decreasing market share or defend market share from a competitor. In some cases these deals are emotional and the buyer just cannot stand by and watch a business being sold to someone else. For an emotional buyer, price is not the most critical factor in the sale.

In addition to the above classification, an individual buyer can be classified as:

Lifestyle Business – An individual buys a business that revolves around his / her hobbies, personal interest or social life. Sea sports, nigh-clubs, fashion shops, dancing schools are examples of life style businesses.

Owner / Manager – The business buyer wants to make a living and a profit from the business by operating the business.

Owner / Manager as required – The buyer is capable of running the business but does not want to manage the business personally on a day to day basis. Typically absentee owner businesses are non-cash businesses. Cash businesses like cafeterias and bars are very difficult to control without the owner.

Passive Investor – High net worth investors invest in businesses in the same way as they would have listed in shares, bonds and property. They usually hire professional management to run the business.

The business seller must identify the persona (or archetype) of the potential business buyer. Business buyers for main street businesses ($0 – $ 2MM) tend to be individuals who have experience in the sector or companies acquiring businesses for growth. Small main-street businesses with valuation of less than 500K are almost always individuals. First time buyers tend to buy smaller businesses that typically have a valuation of less than 500K.

Business buyers in the lower middle market ($2MM – $5MM) are dominated by strategic corporate buyers and private-equity groups. Private equity groups buy twice as many businesses as compared to strategic corporate buyers, so lower middle market businesses must target private equity groups. In the same vein, the best time to sell a lower middle market business is when private groups have raised a lot of money. As such, it helps to keep a watch on business cycles for private equity groups.

Primer on Business Due Diligence

Business Due DiligenceDue diligence is the process of finding out undisclosed information and confirming that the information provided is accurate. For a business buyer, it is the process of working through all the details provided by the business seller.

During the due diligence phase the business buyer must access to all the businesses books, financials statements and other records. The due diligence phase provides the business buyer with a window to determine if the information provided is accurate. The process can take several days and sometimes up to a month. The Due diligence process is broad and must include financials, marketing and strategy amongst other things. Financial due diligence also includes business-valuation, identifying undisclosed liabilities and a lot more.

Due Diligence Approach

Due diligence is the process of systematically evaluating the target company’s documents and other artifacts. If significant discrepancies are found it can result in being a deal breaker or result in the deal being re-negotiated.

Overall, due diligence can be classified in the following categories:

• Management Due Diligence
• Legal Due Diligence
• Financial Due Diligence
• Marketing Due Diligence
• Operational Due Diligence

Information required within each category must be acquired through interviews, financial statements and legal and other documents. The person conducting the due diligence may need to contact the target businesses lawyers, bankers, accountants, clients and suppliers to gather details about the business.

Financial Due Diligence

Financial due diligence requires the business buyer to look into the financial health of the company. It provides the business investor or acquirer information on the debt of the company, capacity to expand and more. Understanding the capital structure of the business is a critical element of financial due diligence because too much debt or poor cash flow can prevent growth and sustainability of a business.

Typically financial due diligence involves review the following documents:

  1. All published financial statements for the last 4 to 5 years including balance sheets, income statements and cash flow statements. This includes interim financial statements for the current quarter.
  2. All tax returns and tax payment schedules
  3. Appraisals on tangible assets including real estate owned by the business

Cash Flow (Financial) Due Diligence

Cash flow is the amount of cash being generated or spent during a specific period of time. It is the change in cash position or in the cash account due to revenue, expenses, operating costs and investments. Cash flow is typically impacted by:

• Accounts Receivable  (AR)
• Accounts Payable (AP)
• Capital Expenditures (CAPEX)
• Debt Servicing
• Tax Payments and other timing issues

Managing Cash flow is of paramount importance to operating a business on day to day basis. Accounting rules that govern the creation of financial statements are used to measure profit and loss. Therefore Balance Sheets and Income Statements do not provide an accurate and timely view of a company’s cash position. Not managing cash flow can result in a cash crisis. For example, if cash is blocked in accounts receivables (AR) and investments, a business can find itself in a cash crisis even though the balance sheet is healthy.

Cash flow can be classified as:

• Cash from Operations
• Investment cash flow
• Financing cash flow

A Cash flow statement is a financial statement that shows companies incoming and outgoing cash for a specific duration. When buying a business, studying the businesses cash flow statements (3 to 5 years) plays an important role and must be completed during the due-diligence process.

Marketing Due Diligence

Marketing Due diligence involves the review of the overall marketing strategy and marketing plan of the business being acquired. Typically a summary of the marketing plan is provided in the investment proposal.

During the Due diligence process the investor or the acquirer must review the underlying market research including the size of the market, market segmentation, competitive pressures, threat of new entrants into the market, threat from substitutes and more. It is important to understand the overall size of the market (industry) the business operates in, the size of the market for the business and more. Reports provided by external agencies provide significant credibility to the marketing plan.

• Review marketing plan and marketing strategy documents
• Marketing material for last few years
• Interviews with the marketing manager or the person involved with marketing
• External and internal research data

Legal Due Diligence

Under legal due diligence the business buyer needs to make sure the business does not have legal problems and is being correctly operated. Legal Due diligence requires the business buyer to review all legal contracts and agreements made by the firm. Several legal artifacts must be reviewed including:

• Review all contracts. A company in business can have several contracts in place including contracts with suppliers, customers, employees and others.
• Agreements with employees
• Corporate charter and bylaws
• Non-Disclosure Agreements (NDA) with employees
• Patents, copyrights and other assets in the company
• Minutes and consent from board of directors and shareholders
• Litigation related documentation and summary of current and pending disputes
• Review tax documentation from a legal stand point
• All artifacts related to the issuance of securities

There are several checklists available online to guide you through the process of conducting legal due diligence.