Deals Closed in 2014 – Statistical Analysis

Approximately 50% deals took between four months to six months to close in 2014. See illustration below. Based on this distribution, on an average, a business will take 8.5 months to sell. The time required to sell a business depends on a number of factors including type of business and asking price for the business and type of buyer. Types of business include Manufacturing, Business services, Consumer goods & services, Health care & biotech, Wholesale & distribution and several others. There are two types of buyer’s strategic buyer and financial buyer. Understanding the buyer type is perhaps the single most important factor when it comes to engaging a buyer and negotiating a deal.

Time to sell Business

There are several reasons a business transaction may fall through. Top three reasons are valuation gap in pricing (29%), insufficient cash flow (22%), and lack of capital to finance (12%). Valuation gap is responsible for almost 30% deals not going through. Both the buyer and seller must complete valuation of the business independently and come up with a valuation range. If there is an overlap then zone of probable agreement (ZOPA) exists and there is a good chance the two parties will find a number during negotiations.

Insufficient cash-flow and lack of capital to finance is another major reason to deals do not go through. It is important to qualify buyers before negotiating a deal.

Reasons For Failing

Of the 30% deals that did not go through because of valuation gap, 65% of the deals had a gap between 10% and 30%. As expected the numbers deals failing for less than 10% gap is very low. When the numbers are so close the buyers and sellers should generally be able to agree on a number and come to a deal.

About 50% are strategic buyers and 50% are financial buyers. Financial buyers will not negotiate much as they have to stick to their financial models. Strategic buyers on the other hand have longer term view and may have synergies with existing assets. On a an average, 21% strategic buyers paid 0-10% more and 29% paid 11-20% more.

Valuation Gap Business Deals

For these reasons it is critical for sellers clearly understand the buyer persona. Financial buyers look for value and evaluate business financial statements in detail. They leave very little room for premium and remain close to the valuation price. They are driven by Return on Investment (ROI) and use large amounts of financing. A financial buyer may not hold the business for long. They may fix the business, improve the financial statements and sell the business.

Strategic buyers on the other hand tend to stay in the business for long periods of time. They may buy the business to enter into a new market, increase market share or foreclose a competitor from acquiring the business. In terms of duration, strategic deals are also done much faster. Strategic deals are preferred because they are done within six months, there are lower chances of valuation gap pricing issues and seller may walk away with a small premium between 10% and 30%.


Role of intangible assets in Business Valuation

Business ValuationIntangible assets are assets that are not physical but have legal rights attached to them and create value for the owner. They sometimes make up a very large component of a business but are not factored into intrinsic valuation of the business. A lot of value is created out of the accounting system and intangibles assets could account to as much as 80% of the intrinsic value of a business in some cases. As important as intangible assets are, business owners usually do not have a clear understanding of these assets. While rule of thumb valuation techniques factor in some of these benefits, valuing intangible assets and then adding it to the intrinsic valuation should be the preferred approach to valuing a business.

The time spent in planning, marketing, human capital, building relationships and developing a corporate culture are expensed on the income statement to calculate net income or net profit. While this is appropriate and required from an accounting point of view, cumulative investment in areas like developing an agile and customer focused corporate culture must be identified recognized as intangible assets.

Intangible capital of a business usually falls in the following areas:

  • Brand value which is the Net Present Value (NPV) of the estimated future cash flows attributable to the Brand. A strong brand is a distinct asset owned by a business and can be easily monetized by keeping prices higher than the competition.
  • Systems of differentiation developed by the business to compete in its marketplace.
  • Customer relationships which includes a loyal customer base and loyalty systems. Businesses should leverage concepts such as customer acquisition cost (CAC) and life time value (LTV) of a customer to value its customer base.
  • Business Processes related to customers acquisition including paid and unpaid activities.
  • Internal Business Processes and technical expertise.
  • Favorable location for the business.
  • Patents, Copyrights, Trademarks, Trade names, Non-compete agreements and R&D.
  • Relationships with partners including supply chain related business processes.
  • Supply agreements, Licensing agreements, Service contracts and Franchise agreements.
  • Unique corporate culture and corporate reputation.

When a buyer, seller or investor is conducting due-diligence on a company, he/ she must value at intangible assets in addition to calculating the intrinsic value of the business. All parties must be aware of all intangibles and know if the company has low intrinsic valuation with high intangible assets or vice versa. That said there may be an arbitrage opportunity if one party recognizes an intangible asset that the other party has discounted or not identified. Understanding intangibles also provides a view into the health of an organization.

The process of valuing intangible assets starts with first identifying and listing all intangible assets, which requires thorough understanding of the business. The next step is to attach a fair value to each intangible asset and to estimate the economic life of each intangible asset. Finally, businesses can get a value by using the company’s discount rate to calculate the present value of all intangible assets listed.

Other approaches to factor intangibles into the value of a business are to add a premium to the intrinsic value of the business. The magnitude of the premium will depend on the industry and the sector. Alternatively, a few intangible assets like patents can be added as assets to the balance sheet as long as it allowed by the accounting standards.

Small Business Valuation using Stock Market Data

Business Stock MarketBusinesses must conduct formal valuation before buying a business, selling a business or merging with another business. However, business must also value their company one or two times a year to keep track of progress and for planning. Informal valuations may be completed internally by the owner or his delegate.

The secret sauce for any valuation is coming up with a valuation multiple. Rule of Thumb valuation is one approach to determining a multiple for your business. Rules of thumb are established from previous business sales. Businesses can get the rule of thumb for an industry from the respective industry association or a business broker who specializes in the industry. For example, Grocery stores are valued at 15% of annuals sales + inventory. However, many times the rule of thumb is not easily available or does not exist. Businesses may also not want to use rule of thumb for valuation. Another approach, discussed at length in this post, is to use market based multiples for valuation. In such cases valuation can be based on publicly traded companies within the same industry.

Enterprise Value (EV) is a commonly used for valuation. Conceptually, Enterprise Value is the take-over the value of a company. It is the net amount of cash required to acquire a business. In the event of a buyout, the acquirer takes on the debt and the cash in the business. So, Enterprise Valuation can be calculated using the following formula.

EV = Market capitalization + Debt + Minority Interest + Preferred Shared – Cash

EBITDA (Earnings before interest, taxes, depreciation, and amortization) is fundamental to valuing a business. EBITDA is a rough estimate of a businesses Free Cash Flow (FCF) and is the most commonly used metric for business valuation. Smaller businesses tend to use Sellers Discretionary Earnings (SDE) for valuation, which is also derived from EBITDA.

Once a business calculates its EBITDA the business value can be calculated by multiplying EBITDA with the Market Valuation Multiple. Market valuation multiple by industry is listed in table below. The following steps and assumptions were used to calculate the market multiple:

  1. US public company data has been used to calculate the multiple as such the data may not be relevant in other countries.
  2. Data is used in the calculation is from 2nd-Jan–2013.The EV / EBITDA multiples may have changed in the last few months.
  3. All public companies have been classified by industry.
  4. Step 1: Calculate EV / EBITDA for each company in the US (includes NYSE and NASD).
  5. Step 2: Calculate the average EV / EBITDA for each industry.
  6. Step 3: Public companies are much larger and demand a premium. So, we have discounted the multiple by 25%, 33% and 50%.  The table includes the original values as well, so you may discount it by a different amount for you industry

Market Multiples Business Valuation

Industry EV/EBITDA (EV/EBITDA)  Discount 25% (EV/EBITDA)  Discount 33% (EV/EBITDA)  Discount 50%
Precious Metals 11.370 8.528 7.618 5.685
Financial Svcs. (Div.) 14.660 10.995 9.822 7.330
Natural Gas Utility 9.960 7.470 6.673 4.980
Public/Private Equity 6.750 5.063 4.523 3.375
Shoe 7.130 5.348 4.777 3.565
Investment Co. 15.720 11.790 10.532 7.860
Retail/Wholesale Food 7.360 5.520 4.931 3.680
Packaging & Container 7.200 5.400 4.824 3.600
Entertainment 12.610 9.458 8.449 6.305
Trucking 9.410 7.058 6.305 4.705
Metal Fabricating 8.350 6.263 5.595 4.175
Heavy Truck & Equip 9.530 7.148 6.385 4.765
Semiconductor 16.220 12.165 10.867 8.110
Household Products 11.750 8.813 7.873 5.875
Auto Parts 13.100 9.825 8.777 6.550
Engineering & Const 13.240 9.930 8.871 6.620
Reinsurance 3.310 2.483 2.218 1.655
Metals & Mining (Div.) 16.270 12.203 10.901 8.135
Air Transport 5.960 4.470 3.993 2.980
Electric Utility (East) 9.210 6.908 6.171 4.605
Electrical Equipment 17.900 13.425 11.993 8.950
Retail (Hardlines) 9.340 7.005 6.258 4.670
Office Equip/Supplies 6.340 4.755 4.248 3.170
Petroleum (Integrated) 5.080 3.810 3.404 2.540
Water Utility 10.730 8.048 7.189 5.365
Petroleum (Producing) 14.980 11.235 10.037 7.490
Retail (Softlines) 11.050 8.288 7.404 5.525
Beverage 17.550 13.163 11.759 8.775
Railroad 11.020 8.265 7.383 5.510
Wireless Networking 15.640 11.730 10.479 7.820
Electric Util. (Central) 10.210 7.658 6.841 5.105
Pharmacy Services 11.760 8.820 7.879 5.880
Advertising 5.380 4.035 3.605 2.690
Furn/Home Furnishings 7.950 5.963 5.327 3.975
Retail Automotive 12.090 9.068 8.100 6.045
Insurance (Prop/Cas.) 4.240 3.180 2.841 2.120
Toiletries/Cosmetics 9.480 7.110 6.352 4.740
Steel 10.320 7.740 6.914 5.160
Telecom. Equipment 19.450 14.588 13.032 9.725
Bank (Midwest) 4.590 3.443 3.075 2.295
Telecom. Services 9.160 6.870 6.137 4.580
Telecom. Utility 5.670 4.253 3.799 2.835
Bank 4.590 3.443 3.075 2.295
Oil/Gas Distribution 18.060 13.545 12.100 9.030
Building Materials 21.240 15.930 14.231 10.620
Power 19.300 14.475 12.931 9.650
Electric Utility (West) 8.300 6.225 5.561 4.150
Cable TV 7.430 5.573 4.978 3.715
Healthcare Information 25.140 18.855 16.844 12.570
Oilfield Svcs/Equip. 13.070 9.803 8.757 6.535
Entertainment Tech 13.850 10.388 9.280 6.925
Semiconductor Equip 7.680 5.760 5.146 3.840
Hotel/Gaming 16.440 12.330 11.015 8.220
Retail Store 8.930 6.698 5.983 4.465
Maritime 14.740 11.055 9.876 7.370
Coal 5.850 4.388 3.920 2.925
Thrift 4.390 3.293 2.941 2.195
Publishing 6.090 4.568 4.080 3.045
Recreation 15.070 11.303 10.097 7.535
Chemical (Basic) 7.290 5.468 4.884 3.645
Chemical (Diversified) 9.440 7.080 6.325 4.720
Electronics 13.170 9.878 8.824 6.585
Aerospace/Defense 16.860 12.645 11.296 8.430
Foreign Electronics 4.460 3.345 2.988 2.230
Human Resources 10.380 7.785 6.955 5.190
Computer Software 38.060 28.545 25.500 19.030
Food Processing 11.200 8.400 7.504 5.600
Med Supp Invasive 25.060 18.795 16.790 12.530
Newspaper 8.330 6.248 5.581 4.165
Educational Services 4.760 3.570 3.189 2.380
Industrial Services 20.230 15.173 13.554 10.115
Automotive 8.290 6.218 5.554 4.145
R.E.I.T. 10.460 7.845 7.008 5.230
Insurance (Life) 7.330 5.498 4.911 3.665
Pipeline MLPs 15.630 11.723 10.472 7.815
IT Services 20.350 15.263 13.635 10.175
Chemical (Specialty) 11.380 8.535 7.625 5.690
Funeral Services 11.670 8.753 7.819 5.835
Internet 35.070 26.303 23.497 17.535
Information Services 22.140 16.605 14.834 11.070
Natural Gas (Div.) 14.550 10.913 9.749 7.275
Medical Services 12.410 9.308 8.315 6.205
Securities Brokerage 6.020 4.515 4.033 3.010
Machinery 12.120 9.090 8.120 6.060
Restaurant 9.34 7.01 6.26 4.67

Disclaimer: Businesses must work with a business professional such as a business broker or chartered accountant (CA) to get a formal value for their business. The techniques described here can be used for informal internal valuations.

Business Valuation Metrics (Seller’s Discretionary Earnings)

Businesses exist to make a profit for their Shareholders. Profit is also known as income or earnings for large-cap public companies. There are three terms that represent the concept of profit and it is critical small businesses understand the difference. Profit or earnings can be expressed as Net Income, EBITDA (Earnings before Income Taxes and Depreciation) and SDE (Seller Discretionary Earnings).

Net Income also known as bottom-line is the most commonly used metric to quantify profit for middle market and large cap companies. It can be easily found on the Income Statement. However, Net Income (NI) provides a skewed picture for small business that may be owner operated. Typically, small businesses want to reduce taxes, so they maximize expenses to reduce their EBIT (Earnings before Interest and Taxes). As such, Net Income is not a good metric for small businesses.

Another metric for profit commonly used by large and middle market companies and private equity groups is EBITDA. Private equity groups like to use EBITDA because it is a quick approximation of the businesses operating cash flow. EBITDA is also useful for larger businesses because it expenses the management and operations. Private equity groups do not get involved in day to day management of the company, so it is important to factor in management cost. The rationale that makes EBITDA good for mid to large companies is what makes it bad for small businesses, where the owner expenses must be added back to EBITDA get a true picture for earnings.

Seller’s Discretionary Earnings (SDE) is the mostly widely used metric for small business valuation. SDE represents the earnings of a small business more accurately because it makes adjustments for owner operator expenses. The simplest way to conceptualize SDE calculation is by taking the EBITDA and recasting owner expenses. Owner’s expenses must include owner’s salary, bonus and all benefits. The technique may be used to roughly estimate the SDE for a small business. Conversely, one can conceptually go from SDE to EBITDA by subtracting owner’s expenses. So, EDITDA = SDE – (Owner’s Salary + Benefits) and SDE = EBITDA + (Owner’s Salary + Benefits). When SDE is used with a multiple to value a business it’s called multiple of discretionary earnings. Multiple of discretionary earnings are best suited for owner operated businesses. Besides buying and selling businesses, SDE is also useful for comparing businesses. Seller’s Discretionary Earnings (SDE) is also sometimes called Seller’s Discretionary Cash Flow.

Business deals on the main street (0 – $2 Million) are typically based on SDE. Business deals in the lower middle market ($2 Million – $5 Million) are usually based on EBITDA. For vast majority of main street businesses working capital is not included in the value of the business.

There are several techniques to business valuation including asset based methods, earnings based methods and market based methods. Rule of thumb based valuation of a business is typically a multiple of SDE or EBIT. The multiplier for your business depends upon several factors including sector, industry, location, deal-size, deal structure, economic climate, financing, number of buyers and so on.

Please note / Disclaimer: Business owners must work with a business professional such as a business broker or chartered accountant (CA) to get an exact estimate for their business. The techniques described here is for business owners to conceptually understand Seller’s Discretionary Earnings (SDE), which plays a critical role in business valuation.

Introduction to Business Valuation

Non-Financial Due-DiligenceValuing a business should not be put off to the last minute when a business is looking for an exit. Most business and finance professionals agree keeping valuation numbers current is a good idea. Using valuation as a measurable key performance indicator (KPI) allows the owner to continuously make changes that maximize value. Valuing a business frequently provides the owner several additional insights such as whether selling the business will provide sufficient funds to retire or whether merging a business is a better option to selling the business.

Overall, there are several reasons to value a business where buying or selling a business is the most important one. Reasons to value a business can be summarized as:

  • Keeping score of value created
  • Making changes continuously to maximize value
  • Facilitate business merger or sale
  • Division of assets within a family and estate planning
  • Tax planning and other disputes
  • Litigation
  • Keep track of valuation for retirement

Valuating small businesses is tricky because there is no central database that keeps track of all transactions. Therefore, valuing a business requires a lot of work and information. Both business buyers and business sellers need to value businesses. The business seller usually has completed valuation and has a price. Regardless of the business seller’s price, the buyer must independently value the business as well. Usually the business buyer will value the business a price that is lower than the asking price. If the two valuations are in the zone of probable agreement (ZOPA) then there is room to negotiate and potentially close the deal.

Collecting this information for a business valuation starts from understanding the industry to conducting detailed financial analysis of the company’s financial statements. For industry analysis the evaluator must determine if the industry is growing or declining and how well the business is positioned within the industry. The evaluator must also complete competitive analysis using Porter’s five force analysis. Other elements of due – diligence includes quantifying the addressable market and current market share of the business.

There are several valuation methods one can use to determine the intrinsic value of a company. These valuation techniques are broadly classified as Asset value methods, Earnings value methods and Market Value based methods. The valuation methods listed above are based on discounting future cash flow, discounting future earnings and using industry specific multipliers. Corporate financial statements including the tax returns are the best source for intrinsic valuation and buyers should ask for at-least five years of data before valuing businesses.

Companies should enlist valuation experts for business valuation. Valuation experts can also help business owner’s benchmark against industry best practices and performance. Experts in business valuation fall in one of the following areas:

  • Business brokers
  • Certified appraisers and valuation experts
  • Forensic accountants
  • Attorneys and lawyers

Business owners tend to resist getting their business valued by a professional because of the cost involved. So, while it is important for business professionals to learn how to continuously value their business informally and they must also value their business formally.

Using Rules of Thumb for Business Valuation

Discounted free cash flow (DCF) and earnings excess based valuation techniques are the fundamental to correctly valuing businesses. That said businesses can also use rules of thumb to quickly value their businesses. Using rules of thumb is a great approach to get a quick and dirty estimate before conducting deeper financial analysis.

Rule-of-thumb valuation is a guideline that businesses owners and business brokers use for a particular industry or line of business to value a company. There are rules available for almost every type and size of business in existence. Most of these rules are based upon multiples of an economic benefit such as earnings, cash flow or annual revenue. Check with your industry associations for rule of thumb formulas for buying or selling a business.

Some examples of rules-of-thumb used to value businesses are:

  • Accounting firms are valued at 100-125% of annual revenue
  • Dry Cleaners are valued 2-3 times adjusted cash-flow or 70%-100% of annual revenue
  • Gourmet coffee shops are valued at  40% of annual sales + inventory
  • Food shops are valued at 30% of annual sales + inventory
  • Gas Stations (w/o C-Store) are valued at 15–20% of annual sales + inventory
  • Law Practices are valued at 90–100% of annuals revenues
  • Restaurants (Full-Serve) are valued at 30–35% of annuals sales + inventory
  • Insurance Agencies are valued at 125–150% of annual revenues
  • Grocery Store (Supermarket) are valued at 15% of annuals sales + inventory

Business for Sale Checklist

Gather Information for Business Valuation

Business brokers and sophisticated business buyers may use intrinsic valuation techniques for business valuation. They will project the free cash flow (FCF) from the business for the next few years and discount the cash flow projections to determine the intrinsic value. Additionally, business buyers will also try and estimate the value of a business by looking at values of similar businesses sold locally.

Selling a business is complex and the seller must take the time to plan and organize the exit. To assist with valuation and eventual sale, businesses need the following information.

  • Balance sheet, income statement and cash flow statement for 3 to 5 years
  • Corporate tax returns for 3 to 5 years
  • Value of inventory
  • List of capital expenses on fixtures and equipment
  • Customer and contact lists (Customer of Contact Management System)
  • List of employees
  • Copies of all leases, franchise agreements (if applicable)