Buyer and Seller: Different Perspectives

Determining the value of a business is the part of the buy-sell transaction most fraught with potential for differences of opinion. Buyers and sellers usually do not share the same perspective. Each has a distinct rationale, and that rationale may be based on logic or emotion.

The buyer may believe that the purchase will create synergy or an economy of scale because of the way the business will be operated under new ownership. The buyer may also see the business as an especially good lifestyle fit. These factors are likely to increase the amount of money a buyer is willing to pay for a business. The seller may have a greater than normal desire to sell due to financial difficulties or the death or illness of the owner or a member of the owner's family.

For the transaction to come to conclusion, both parties must be satisfied with the price and be able to understand how it was determined.

Factors That Determine Value

The topic of business evaluation is so complex that any explanation short of an entire book does not do it justice. The process takes into account many, many variables and requires that a number of assumptions be made. Shannon Pratt, a noted business valuation expert, names six of the most important factors:

1. Recent profit history.

2. General condition of the company (such as condition of facilities, completeness and accuracy of books and records, morale and so on).

3. Market demand for the particular type of business.

4. Economic conditions (especially cost and availability of capital and any economic factors that directly affect the business).

5. Ability to transfer goodwill or other intangible values to a new owner.

6. Future profit potential.

The six factors named above determine the fair market value. However, businesses rarely change hands at fair market value. The reason is that three other factors often come into play in arriving at an agreed upon price. Pratt identifies them as follows:

• Special circumstances of the particular buyer and seller.

• Tradeoff between cash and terms.

• Relative tax consequences for the buyer and seller, which depend on how the transaction is structured.

The definition of fair market value is the price at which property would change hands between a willing buyer and a willing seller, both being adequately informed of all material facts and neither being compelled to buy or to sell. In the market place, buyer and seller are nearly always acting under different levels of compulsion.

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Rule-of-Thumb Formulas

The rule for using rule-of-thumb formulas for pricing a business is don't use them. The problem with rule-of thumb formulas is that they address few of the factors that impact a business's value. They rely on a "one size fits all" approach when, in fact, no two businesses are identical.

Rule-of-thumb formulas do, however, provide a quick means of establishing whether a price for a certain business is "in the ballpark." Formulas exist for many businesses. They are normally calculated as a percentage of either sales or asset values, or a combination of both.

Comparables

Using comparable sales as a means of valuing a business has the same inherent flaw as rule-of-thumb formulas. Rarely if ever are two businesses truly comparable. However, businesses in the same industry do have some characteristics in common, and a careful contrasting may allow a conclusion to be drawn about a range of value.

Balance Sheet Methods of Valuation

This approach calls for the assets of the business to be valued. It is most often used when the business being valued generates earnings primarily from its assets rather than the contributions of its employees or when the cost of starting a business and getting revenues past the break-even point doesn't greatly exceed the value of the business's assets.

There are a number of balance sheet methods of valuation including book value, adjusted book value, and liquidation value. Each has its proper application. The most useful balance sheet method is the adjusted book value method. This method calls for the adjustment of each asset's book value to equal the cost of replacing that asset in its current condition. The total of the adjusted asset values is then offset against the sum of the liabilities to arrive at the adjusted book value.

Adjustments are frequently made to the book values of the following items:

Accounts Receivable - often adjusted down to reflect the lack of collectability of some receivables.

Inventory - usually adjusted down since it may be difficult to sell off all of the inventory at cost.

Real Estate - frequently adjusted up since it has often appreciated in value since it was placed in service.

Furniture, Fixtures, and Equipment - adjusted up if those items in service (probably more than a few years) have been depreciated below their market value, or adjusted down if the items have become obsolete.

Income Statement Methods of Valuation

Although a balance sheet formula is sometimes the most accurate means to value a business, it is more common to use an income statement method. Income statement methods are most concerned with the profits or cash flow produced by the business's assets. One of the more frequently used methods is the discounted future cash flow method. This method calls for the future cash flows (before taxes and before debt service) of the business to be calculated using the 4-step formula.