The Value of an Informal Valuation When Deciding Whether to Sell Your Business

There will come a time when you need to know how much your business is worth. There are several reasons why you might be considering selling your business, including:

• Contemplating an estate planning strategy
• Separating and working through financial discussions to finalize a divorce
• Considering recapitalizing your stock into voting and non-voting shares or different classes
• Fielding unexpected purchase offers for your business from potential buyers

Knowing an approximate value of your business will help you to work through these situations.

Formal versus informal valuations

When you've committed to an ownership transfer, such as implementing gifting for estate planning purposes or engaging in a sale to a third party, a formal valuation is an imperative step. Formal valuations are conducted by a certified, independent expert, using several methods and spending considerable time examining company records to determine the value of the company. A certified valuation expert is someone with an Accredited Valuation Analyst (AVA®) or Certified Valuation Analyst (CVA®) designation given by the National Association of Certified Valuators and Analysts (NACVA®).

The process of getting a formal valuation is exhaustive and requires many records including inventory lists, audited financial statements, tax returns and more. Formal valuations are needed before reporting a transaction to the IRS to confirm the value wasn't too low or high, as well as to head off a possible dispute between partners or co-owners in the future.

The cost of a formal valuation can range from $7,000 to $20,000, so it's prudent not to request one on a whim, such as when you simply want an idea of how much your business is worth. Moreover, the valuation is tied to a point in time—from the point at which the valuation is completed, its future use or longevity has an expiration date.

On the other hand, an informal valuation can be a useful tool when you haven't committed to an ownership transfer transaction yet. Returning to the example of the unsolicited offer to buy your company—how do you know if the offer is in-line with its true value and the industry and market multiples? Before you go through the time and expense of a formal valuation, as well as the lengthy process of due diligence and negotiations for a sale, you may want to have an idea of if it's worth even opening the talks. That's where an informal valuation can help. Let's discuss how an informal valuation is created.

Using EBITDA for an informal valuation

Given the nature of an informal valuation, the measure of value can be based on a wide set of criteria from cash flow projections to net operating income. One widely used method for calculating informal valuations is Earnings Before Interest, Taxes, Depreciation and Amortization, or EBITDA.

EBITDA is a favored measure of company performance because it shows earnings or profitability before the effects of accounting or financial deductions and without considering capital structure.

EBITDA is also used as a tool by lenders to determine if a company can pay back short-term debt. Leveraged buyout bankers look at a company's EBITDA-to-interest coverage ratio to determine if a company can meet heavier interest payments needed after a restructuring.

Advantages of an EBITDA informal valuation

Apart from EBITDA being a favored measure of performance, there are a couple more advantages to using it. First, EBITDA is calculated from the information contained in a company's own financial statements which is particularly helpful for business owners trying to complete an informal valuation. Second, since EBITDA is such a common metric, it can be used to compare specific companies within an industry, or against an industry average.

Although the higher the EBITDA the better, an EBITDA evaluation by itself doesn't paint the full picture of a company's performance. To determine if you have a good EBITDA number, you'd need to compare it against similar companies or look at the same number over several periods to level out the data.

Do keep in mind that a straight comparison of EBIDTA between companies may leave questions unanswered. For example, a company that has lower net interest compared to the other could mean either that company is carrying less debt or the comparison company has a higher interest rate. Without digging into further documentation, you can't be certain.

Disadvantages of EBITDA

Using EBITDA does have its disadvantages. Because depreciation and amortization are added back, companies with large amounts of fixed assets—property, plants and equipment—may have disproportionate amounts of depreciation expenses removed, thus inflating their earnings. Adding back depreciation and amortization may even make some unprofitable businesses appear profitable, making their EBITDA misleading.

In addition, EBITDA isn't a Generally Accepted Accounting Principles, or GAAP, regulated measurement. Without an official regulation, less honorable owners could tweak the calculations to make their company appear more profitable. That's why looking at EBITDA over a series of tax years is important.

EBITDA also has some blind spots. It ignores the value of assets, as well as the cash required to fund working capital and replacement of old equipment.

Adjusted EBIDTA

EBITDA can also be adjusted or standardized by adding back some one-time or irregular items that cause a distortion to EBITDA. This standardization makes it easier and more meaningful to compare the measurement to peer companies. Adjusted EBITDA can normalize cash flows and income, as well as omit abnormalities and other quirks that may be unique to an individual company, thereby making it easier to compare across an industry.

Common adjustments include, but aren't limited to:

• Excess owner's salary
• Legal expenses
• One-time gain on the sale of an asset
• Restructuring or reorganization charges
• Special donations
• Repairs (capital expenditures)
• Product line start-up costs
• Insurance recoveries
• Discretionary retirement plan contributions
• Intellectual property expenses
• One-time windfalls
• Owner's personal expenses (cars, travel, restaurants, etc.)
• Compensation for additional headcount in an understaffed company

Earnings multiples

The other component to calculating the informal valuation is to complete an earnings multiple analysis. Multiples range from 1 to 12, with most companies falling somewhere between 3 and 8. Some sample multiples include:

• Growth prospects
• Company size
• Financial track record
• Earnings volatility
• Management succession plan
• Concentration of supplier and customer base
• Uniqueness of product or service

Once a multiple has been determined, a comparable analysis can be done by measuring the company against similar companies in an industry or same line of business using EBITDA as a baseline financial metric to determine if your company's value has a value gap.

Conclusion

There's a time and a place for a formal valuation. But if you're a business owner simply looking to understand how much your business is worth, an informal valuation can be a beneficial exercise to go through. With that informal valuation in hand, you can more easily know if an offer to purchase your business is even worth considering.

If you're interested in learning more about how business planning and informal valuations can help you manage your business, please contact your First Citizens Wealth Management partner about our Business Advisor Services.