Business Valuation For Dummies®
Table of Contents
Introduction
About This Book
Conventions Used in This Book
What You’re Not to Read
Foolish Assumptions
How This Book Is Organized
Part I: What Business Valuation Means
Part II: Getting Familiar with Valuation Tools, Principles, and Resources
Part III: If You’re Selling a Business . . .
Part IV: If You’re Buying a Business . . .
Part V: Don’t Try This at Home! Turning Things Over to the Valuation Experts
Part VI: The Part of Tens
Icons Used in This Book
Where to Go from Here
Part I: What Business Valuation Means
Chapter 1: The Value of Understanding Business Valuation
Basic Tenets and the Importance of Valuation for Businesspeople
Value differs from price
Planning drives value
No two valuations are exactly alike
Valuation isn’t a one-time deal
The Basic Building Blocks for Calculating Value
Discount and capitalization rates: The numbers that really matter
Doing your homework: Due diligence
How rule of thumb enters into business valuation
Getting Expert Help
The Move toward Intangible Asset Valuation
Family Businesses: Important Valuation Targets
Chapter 2: What Triggers a Business Valuation?
Exploring Reasons for Wanting a Business
It’s time for a new career
You’re fulfilling a dream
You’re taking advantage of a strategic opportunity
You’re buying a business to pass on to your heirs
Shaking the Money Tree: How Lenders Make Thorough Valuation a Necessity
Borrowing to buy a business: What lenders want to see
Preparing for mergers and other big-money deals
Seeking new or continued funding for an existing business
Attracting public or private investors
What If You Want — or Need — to Sell a Business?
Doing some smart estate planning
Reaching retirement
Letting the kids take over
Facing threats from market forces
Separating from a co-founder or partner
Dealing with divorce
Exit Plans: Writing the Ending
Who benefits from an exit plan?
When should an exit valuation be done?
Chapter 3: Understanding the Tangibles and Intangibles of Business Valuation
Examining Your Reasons for Valuing This Business
Introducing Standards of Value
The mother of all standards: Fair market value
Perceptions of investment value
The fundamentals of intrinsic value
Going over going-concern value
Liquidation value
Adjusting or Normalizing a Financial Statement
Other Considerations: Science Meets Art
Adding business and economic news
Folding in tangible assets
Drawing valuation conclusions with intangible assets
Chapter 4: Approaches and Methods — Basic Theories of the Valuation Process
A Step-by-Step Overview of the Valuation Process
Risky Business: Gauging Circumstances for the Best Results
Understanding the different approaches
Calculating risk and its relationship to present value
Using discount and capitalization rates and income valuation methods
Chapter 5: The Challenge of Valuation in a Knowledge Economy
Moving from a Hard-Asset to an Intangible-Asset Economy
Reviewing types of assets
Recognizing the increasing value of intellectual property
Determining the Value of a Company Based on Ideas
The importance of real, documented income
What strategic buyers and lenders want to see
Reaching Intangible Value
Taking a stab at brand valuation
Recognizing customers as valuation drivers
Preserving Your Knowledge Business for the Future
Shaky times: When the founder’s brain leaves the building
What owners need to do: Planning ahead
Part II: Getting Familiar with Valuation Tools, Principles, and Resources
Chapter 6: Getting Familiar with a Typical Valuation Report
What a Valuation Report Is Supposed to Do
Outlining a Typical Valuation Report
Cover
Valuation summary
Valuation assignment
Economic outlook
Industry outlook
Business overview
Conclusion of value
Appendixes
Chapter 7: Meeting the Supporting Players in the Valuation Process
Getting Help in Valuing Your Business
Recognizing situations that call for valuation experts
Finding the experts you need
Seeking the qualities your experts should have
Appraising What Appraisers Do
How appraisers are trained and certified
What appraisers cost
How to examine a business appraiser’s work process
What to ask a prospective business appraiser
Taking Account of Accountants
How accountants are trained
How accountants are certified
What accountants cost
How to examine an accountant’s work process
What to ask a prospective accountant
Hiring Advocacy: Attorneys
How attorneys are trained and certified
What attorneys cost
How to examine an attorney’s work process
What to ask a prospective attorney
Brokers: One-Stop Valuation and Sale Services
How business brokers are trained and certified
What business brokers cost
How to examine a broker’s work process
What to ask a prospective business broker
Chapter 8: Understanding Financial Statements
Gathering the Financial Data You Need
Looking into Support Data
External data
Internal data
Taking a Look at Financial Statements
The balance sheet
The income statement
Statement of retained earnings
Cash-flow statement
Ratios and formulas for valuation
Chapter 9: Using Rule-of-Thumb Valuations for Mom-and-Pop Businesses
What Rules of Thumb Do in Business Valuation
2008 Rules of Thumb from the Business Reference Guide
Full-service restaurants
Bars
Gift shops
Medical practices
Auto repair shops
Day-care centers for children
Dry cleaning
Coin laundries
Bookstores
Bed-and-breakfasts
Part III: If You’re Selling a Business . . .
Chapter 10: Making Sure You’re Ready to Sell
Understanding Why Timing Is Important
Examining the Motivations behind a Potential Business Sale
Anticipating the owner’s retirement
The kids are taking over!
Weighing the possibility of a merger or acquisition from a friendly suitor
Changing market conditions are threatening a company’s future
Bringing Valuation into the Picture before You Bring In the Buyers
Providing a reality check
Transparency: Preparing for a sale
Heading off problems to increase value
Determining the Kind of Transaction You Want
Outright sale
Employee stock ownership plan (ESOP)
Ownership transfer to key family members
Chapter 11: Deciding What to Do about the Family Company
Planning for the Worst Possible Scenario
Examining the State of the Family Business
Specific characteristics of family companies
How families hurt the value of their businesses
Why “equal” in a family business isn’t always fair
Getting Your Family Down to Business
Following a phased-in approach
Addressing the fairness question head-on
Setting up the best plan for the generations
Chapter 12: Due Diligence on the Sell Side
Looking at Why a Seller Has to Do Due Diligence
Understanding the Three Stages of Due Diligence
Tricks of the Trade: Collecting and Exchanging Information
Gathering your own company data
Protecting your company with a confidentiality agreement
Chapter 13: Case Study: Valuation on the Sell Side
Heading Off Common Valuation Disasters
Writing down your wishes
Making sure that your records are adequate
Taking time to plan
Considering confidentiality
Setting Up Your Prevaluation Plan
Finding the problems
Analyzing the prevaluation
Performing the Valuation
Taking valuation from fantasy to reality
Checking the structure of the deal
Looking at an example of a deal in progress
Part IV: If You’re Buying a Business . . .
Chapter 14: How Do You Know Whether You’re Ready to Buy?
Knowing What Typically Drives a Business Purchase
Getting Ready to Buy
Tackling challenges unique to buyers
Looking at whether the business is right for you
Evaluating a failing business
Understanding how the mating process (typically) works
Restarting the Value Process
Chapter 15: Moving from Valuation to Negotiation
Knowing What Valuation Does for the Dealmaking Process
Identifying potential pitfalls and opportunities
Timing the purchase well
Minimizing emotional shocks
Getting Ready to Meet the Seller
Recognizing window dressing
Remembering motives
Knowing what sellers want
Let’s Make a Deal: Negotiating
Deciding whether to handle negotiations yourself
Getting ready to negotiate
Understanding what you should do in negotiation
Working with someone who’s negotiating for you
Chapter 16: Due Diligence on the Buy Side
Seeing What Due Diligence Means in Practice
Looking at the Unofficial First Stages of Due Diligence
Researching the company
Consulting your family and the pros
The Informational Game Plan: Cracking the Books (and the Internet)
Gathering the Company’s Data
Knowing which questions to ask about the target company
Checking with the company’s departments
Collecting Outside Data about Your Industry and the Economy
Chapter 17: Forensic Accounting and the Due Diligence Process
Understanding Forensic Accountants
Characterizing a qualified forensic accountant
Recognizing situations that link forensic accounting and valuation
Comparing Basic and Forensic Accounting
Recognizing Business Situations That Trigger Forensic Accounting
Doing a Forensic Accounting Test
Looking at Forensic Accounting Case Studies
Chapter 18: Case Study: Valuation on the Buy Side
Being Frank: Selecting an Industry
Doing Research in Advance
Contacting the Target
Negotiating the quick-and-dirty valuation stage
Knowing when to talk . . . and when to hang up
Moving on to Company Number Two
Seeing How Failing to Consult an Advisor Can Cost You
Knowing when to involve advisors
Encountering problems
Seeing what could’ve been done
Checking Benchmarking Data
Understanding Deal Structure
Part V: Don’t Try This at Home! Turning Things Over to the Valuation Experts
Chapter 19: Divorce
Doing Estate Planning Regardless of Marital Status
Planning Prenuptial and Postnuptial Agreements
Breaking down a prenuptial agreement
Creating a postnuptial agreement
Seeking the Correct Professionals
Looking at What Happens to a Family Business in Divorce
State laws on splitting property
The marital balance of power
Determining the Business Value in a Divorce
Keeping Valuation Dates in Mind
Chapter 20: Estate Planning and Gifting
Succession Planning: A Critical Part of Business Planning
Considering Family Matters
Anticipating problems
Considering blended and nontraditional families
Creating contingency plans for relatives who renege
Creating a Succession Plan
Creating an Estate Plan
Finding the Experts You Need for Estate Planning
Fitting Buy/Sell Agreements into Estate Planning and Valuation
Taking Gifting into Consideration
Gifting strategies
Gifting techniques
Chapter 21: Attracting Outside Investors to Your Startup
Exploring Your Startup Resources
Creating the Starting Point: The Business Plan
Working with Investors
Angel investors
Venture capitalists
IPO investors
Part VI: The Part of Tens
Chapter 22: Ten Reasons to Consider a Prenup
It Gets You to Talk Honestly about Money at the Start of a Marriage
Your Life’s Work Shouldn’t Go down the Drain
If Both Spouses Have Sacrificed to Build the Business, They Need to Share
The Working Spouse Shouldn’t Lose the Business Entirely
Kids from Earlier Marriages Need Protection
Kids from Your Next Marriage Need Protection, Too
Planning for Worst-Case Scenarios Is a Good Habit
Your Business and Personal Finances Really Are Connected
Family Legacies Need Protection
When a Marriage Ends, a Prenup (Or Postnup) Can Save You Both Money
Chapter 23: Ten Questions to Answer Before Considering a Partnership Agreement
Who Will Be in the Partnership?
How Much Capital Does Each Partner Have to Kick In at the Start?
How Will Decisions Be Made?
Do You Have a Plan for Resolving Disputes?
How Will the Firm Admit New Partners?
How and When Will Profits — or Losses — Be Shared?
What Happens If a Partner Leaves or Dies?
How Will the Partnership Be Sold or Dissolved?
How Will Legal Disputes inside and outside the Partnership Be Handled?
Will Noncompete Issues Be Covered?
Chapter 24: Ten Things to Consider Before Transforming Your Company Into an ESOP
Research How ESOPs Are Created
Understand Why ESOPs Are Attractive in Certain Situations
Know How the Tax Advantages Work
Examine How Valuation Comes In
Get a Handle on Your Launch Steps
Prepare for Preparation Costs
Get Ready to Train Next-Generation Leadership
Plan Ongoing Training for Employees
Estimate ESOP Costs after Launch
Realize That ESOPs Can Fail
Glossary
Business Valuation For Dummies®
by Lisa Holton and Jim Bates, MBA
Business Valuation For Dummies®
Published by
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Copyright © 2009 by Wiley Publishing, Inc., Indianapolis, Indiana
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About the Authors
Lisa Holton: Lisa Holton heads The Lisa Co., an Evanston, Illinois–based writing, editing, and video consulting firm founded in 1998. She is a former business editor and reporter for the Chicago Sun-Times and a former editor for Thomson Corp. She is a busy writer for corporations, associations, and universities nationwide.
Holton has 26 years of experience writing about business, workplace, education, and investment topics and has written or co-written 14 books. Her titles include For Members Only: A History and Guide to Chicago’s Oldest Private Clubs (Lake Claremont Press), The Everything Guide to Mortgages (Adams Media), How to Be a Value Investor (McGraw-Hill), The Essential Dictionary of Real Estate (Barnes & Noble Books), and The Encyclopedia of Financial Planning (FPA Press). She also ghostwrites books for corporate professionals.
In 2005, she became a contributing writer for the Financial Planning Association on consumer finance and retirement planning issues. She also writes on corporate governance and business planning issues for a variety of publications, including Corporate Board Member magazine.
Since starting her company, Holton has written for national magazines and newspapers including the American Bar Association’s ABA Journal, Parents, American Demographics, Latina, Working Mother, The Boston Globe, and the Chicago Tribune.
She is a graduate of Northwestern University’s Medill School of Journalism and a former national board member of the Society of American Business Editors and Writers (SABEW). She is a current member of the Authors Guild, the International Association of Business Communicators, and the Society of Midland Authors.
Jim Bates, MBA: Jim Bates is vice president, Transaction Support, for the Christman Group, a middle-market investment banking firm based in Palatine, Illinois. He ran his own business valuation company after managing the business valuation division of a national consulting firm.
Bates’s responsibilities include providing the managing directors of Christman’s regional offices with complete transaction support, including but not limited to preparing business valuations, writing offering memoranda, doing industry research, identifying and contacting buyers, and helping with virtually every other aspect of serving clients. He has been involved in more than 30 sell-side engagements and has prepared more than 500 business valuations.
In his spare time, Bates is a competitive tennis player at the national level and serves the Professional Tennis Registry as its representative for Illinois. Currently, he is five-time defending champion of the Midwest Hardcourt, 35 and over, doubles championship. He has been playing and/or coaching tennis competitively for more than 25 years and is certified by the Professional Tennis Registry at the highest of its three levels.
He holds a bachelor of business/economics degree and an MBA with concentrations in finance and marketing from Western Illinois University.
Acknowledgments
Many of the people who contribute to the process of writing a book are unsung, so we’ll do the singing here.
We’d like to start by thanking Tom West of the Wilmington, North Carolina–based Business Brokerage Press for graciously allowing us to reprint excerpts from his rule-of-thumb industry bible, the Business Reference Guide.
Darrell Dorrell of Lake Oswego, Oregon–based Financial Forensics was a font of information on the forensic accounting field and a great storyteller regarding the criminal side of valuation and finance. Justin Cherfoli, managing director of the Dispute Advisory and Forensic Services Group of the Chicago-based financial advisory firm, Stout Risius Ross, provided great guidance and harrowing commentary on what some families go through in the valuation process.
Above all, Mike Adhikari of Business ValueXpress and the Kellogg School of Management at Northwestern University was a great conduit to basic valuation knowledge and many of the sources within this book.
We couldn’t have done this book without substantial help and support on the For Dummies side of the street. Natalie Harris, Chrissy Guthrie, and Stacy Kennedy worked tireless hours to make this book a reality.
Lisa would also like to thank her agent, Marilyn Allen of the Allen O’Shea Literary Agency in Stamford, Connecticut.
Jim would like to thank his family: Brad Bates, Mary Ann Bates, Mary Agnes Bates, and Meredith Spiering. Without their love and support, his career would not have been possible. In addition, he would like to thank his colleagues at the Christman Group: Pete Christman, Rich Jackim, Jack Emmons, and Anneke Chamy. Their feedback, experience, and friendship are invaluable.
Publisher’s Acknowledgments
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Introduction
No two businesses are exactly alike — even those that are part of a national chain with exactly the same sign on every door. Each business or outlet of a business has its own complexities that determine whether it’s worth a little . . . or a lot.
That’s why business valuation is actually a pretty complex affair for someone who’s never taken a finance class. If you go online or into a bookstore looking for books on business valuation, you’re likely to find volumes that are written more for people who’ve already been exposed to business finance, accounting, or management training. If you’re considering buying a business or have operated one for years without a lot of that training, we’re pretty sure that a complicated textbook isn’t what you need.
We think that valuation should be the first thing you think about before you make a move into or out of any business. Consider this book to be a starting point for a bright, well-informed future in buying or selling a business, because the dream of owning or selling a business should always begin with dedication to understanding the true value of what you’re buying. If we can give you an understanding of the basics of business valuation and of the tools and expertise you require to get the right valuation for the job, we’ll have accomplished our purpose.
About This Book
This book is very cautious because we think it should be.
We’ll state this upfront: This book will not make you qualified to handle most business valuation tasks by yourself. Nor will you have a complete background in business accounting or business law when you get to the last page. The purpose of Business Valuation For Dummies is to give you an overview of all the critical skills, issues, and methods involved in small-business valuation without taking you through all the detailed theories and number crunching necessary to the process. Other, more-advanced resources are out there to show you those processes when you’re ready. But by the time you’re done with this book, you’ll know which basic processes, resources, experts, and tools you need so you can put together the fairest and most affordable valuation solution for the business in question.
We tell you what various professionals do in the valuation process, but we don’t tell you that you can do their job. We also tell you the many steps you can follow to educate yourself about valuation in general and your target business in particular, as well as how to make the right decisions to get an accurate valuation of a business. For instance, you can consult resources, free or nearly free of charge, to build a baseline of the business you’re considering and then move on to the basics of valuing that kind of company. We tell you about those resources in this book, discussing rule-of-thumb valuation and other resources you can consult early in the process to start building knowledge. We encourage you to do this basic research before you even think about buying or selling a company. (And yes, even if you’ve owned a business for decades, you need to do this research before you sell!)
If we’ve done our job, this book will give you a thorough summary of all the steps in effective valuation and show you how to plan and execute that process. We give only two detailed examples of valuation in this book: one for the sale of a business and the other for a purchase. This way, you get a close-up look at how an isolated example works, which we think makes a lot more sense than attempting to generalize for every possible situation, which might mislead you.
This book adopts a holistic approach that involves expertise not only for business valuation but also for your personal and family finances. Why? The decision to buy or sell a business is a major life step; it’s not just about the business. Ownership is tied to one’s personal finances and family goals, and business valuation needs to tie into all those things. Even if you have a small business and a small family, getting advice tailored specifically to your circumstances is usually smart.
Last thing: Because one of the authors of this book is a valuation professional, you may say, “Oh, that’s why they keep saying to use an expert.” Keep in mind that we don’t say which experts you need to use; you have a choice. But anyone who wants to be in business needs to know that tax, valuation, legal, and finance issues are interconnected, and you need people with excellent skills helping you manage these subjects if you don’t have the expertise yourself.
Conventions Used in This Book
When this book was printed, some Web addresses — which appear in monofont — may have needed to break across two lines of text. If that happened, rest assured that we haven’t put in any extra characters (such as hyphens) to indicate the break. When you use one of these Web addresses, just type exactly what you see in this book, pretending that the line break doesn’t exist.
We use italics to highlight new terms, and we follow them up with easy-to-understand definitions.
What You’re Not to Read
If you want to lighten your reading load or just simplify your understanding of the concepts, take a pass on any text preceded by the Technical Stuff icon. Also, although we encourage you to check the chapters that have a significant amount of formulas and math in them (which we haven’t overdone, by the way), you may want to take a break on those or just save them for last. Finally, you can skip the sidebars — gray boxes containing related but nonessential text — if you want to get straight to the good stuff.
Foolish Assumptions
This book is designed for two kinds of people: those who are thinking about buying a business and those who are considering selling one. We consider this book to be optimal for people who want to go into business for themselves for the first time, because it addresses the critical knowledge that all good businesspeople have: the ability to maximize value at all times. Yet if you’re planning to sell a business, we provide a planning outline to allow you to maximize the value of your business before the for-sale sign goes out front.
Here are a few assumptions we make about you, the reader, whether you want to buy or sell:
You’re probably looking at a company of less (sometimes significantly less) than $5 million in annual revenues. This book focuses mainly on the purchase and sale of private companies — that is, companies that don’t trade daily on a major exchange.
You have some experience with the business world. However, we don’t assume that you have a background in finance or valuation, which are frankly two different and very complex disciplines.
More than anything, we assume that you don’t want to be taken to the cleaners on your first foray into business or your last decision with the business you own. Perhaps you’ve watched other people go into business, and you just know that they don’t have any idea what their business is truly worth; they’ve negotiated up or down with a seller, but they haven’t fully kicked the tires. That move isn’t the kind you want to make. You realize you need industry, financial, and operational knowledge to make the best decision.
How This Book Is Organized
Like all other For Dummies books, this book is divided into parts, and each part is divided into chapters. What follows is a summary of what you can see in each part of the book.
Part I: What Business Valuation Means
We start by telling you what business valuation is and why we think it’s the first thing you should understand about being in business. We talk about why valuation is such a challenge, and we give you the basic accounting approaches that experts take to uncover value — or the lack of it — in an organization. Last, we talk about the greatest valuation challenge today: how experts evaluate what intellectual property means to an organization.
Part II: Getting Familiar with Valuation Tools, Principles, and Resources
This part is where we spend the most time talking about paperwork, process, and expertise. We talk about what a valuation report looks like and what various professionals do in the valuation process; we offer a primer on financial statements and how they’re used in the valuation process. We also offer an important chapter that talks about rule-of-thumb valuation information — where it can help and where it can mislead.
Part III: If You’re Selling a Business . . .
People sell businesses for lots of reasons. They’re sick of running the business, for example; or they’ve made the business a rousing success that’s ripe for a nice price from a new owner; or they’re ready to retire or to pass on what they’ve built to the next generation. The reasons can vary, but one thing is clear: Planning for the sale of a business is something that you don’t do just a few months in advance. The planning takes years and is best thought of as part of a founder’s overall estate strategy. If you build a business, you want to get the best value for it in a way that allows you to enjoy the full rewards of what you created.
So if you’re trying to figure out what to do with a family-owned company, this part is for you. Family businesses supply an incredible amount of drama in the valuation process. This part also introduces a detailed case study on the sale of a fictional business.
Part IV: If You’re Buying a Business . . .
Knowing about basic valuation issues is the key to making a deal. Buyers have to do their own planning for a transaction because they may be going into business for the first time or buying another company in a series of companies to complement existing business interests. And of course, buyers have their own succession and estate-planning issues to deal with. In this part, we discuss valuation issues for the buyer and feature another major detailed case study, this one on the purchase of a particular fictional business.
Part V: Don’t Try This at Home! Turning Things Over to the Valuation Experts
The purpose of this part is not to win business for valuation experts, even though we clearly believe that these chapters cover situations in which you need help. The idea is to communicate why the complexity of certain valuation situations should encourage you to seek help.
This part includes three chapters that discuss situations in which business owners definitely shouldn’t go it alone. Which situations did we choose? Divorce certainly qualifies because it endangers many family companies. Estate planning and gifting are tied in with the value of the family business; therefore, they need joint coordination. Finally, people need valuation advice when they’re preparing to attract outside investors to a business.
Part VI: The Part of Tens
These three chapters offer ten points of interest each on the following topics: reasons to consider a prenuptial agreement, elements to build into a partnership agreement, and things to consider before transforming a conventional business to an employee stock ownership plan (ESOP).
Icons Used in This Book
This book uses the following icons to highlight key information.
This icon calls your attention to particularly important points and offers useful advice on practical financial topics. This icon saves you the cost of a yellow highlighter pen.
This icon serves as a friendly reminder that the topic at hand is important enough for you to put a note about it in the front of your wallet. The icon marks material that a college professor would put on the board before class starts, noting the important points that students should retain at the end.
This icon warns you about speed bumps and potholes on the valuation highway. Taking special note of this material can help you steer around a financial road hazard and keep you from blowing a fiscal tire. In short — watch out!
This icon marks nonessential information, such as statistics and history lessons. The ideas here are interesting, but you can skip this text if you want to get back to the basics.
Where to Go from Here
We really enjoyed writing this book. We particularly like the idea that we can get small-business people thinking about the importance of valuation early in the life of a business.
If you know nothing about the business valuation process, we suggest you start with Part I. But this is a reference book, so feel free to jump around a bit. For example, you can see how specific situations are handled in Part V, and if you want to see detailed case studies on valuations, by all means, head to Chapters 13 and 18.
Part I
What Business Valuation Means
In this part . . .
Many people think that business valuation is all about getting to a price for a business, and that’s certainly a big part of it. But we think that valuation is the central concept of what makes a business a business — and that very few people really understand it. In this part, we discuss the reasons valuation happens in a business, and we introduce the accounting concepts in the process. Most importantly, we discuss valuing business ideas.