Copyright C&S Associates, July 20070 How to Value a Small Business Pete Smith C&S Associates Professional Development Seminar South Carolina Small Business

Copyright C&S Associates, July 2007

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How to Value aHow to Value aSmall BusinessSmall Business

Pete SmithPete Smith

C&S AssociatesC&S Associates

Professional Development SeminarSouth Carolina Small Business Development Center


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IntroductionIntroduction

Business Valuation: Estimating the Business Valuation: Estimating the Fair Market ValueFair Market Value of a business entity of a business entity

Principles are consistentPrinciples are consistent Application of principles is diverseApplication of principles is diverse Objectives of a Business ValuationObjectives of a Business Valuation

Accuracy Accuracy Fairness - ObjectivityFairness - Objectivity Defend-abilityDefend-ability


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Seminar ObjectivesSeminar Objectives

Understanding of the basic PrinciplesUnderstanding of the basic Principles Understanding of the basic Terms Understanding of the basic Terms

usedused Understanding of the basic Methods Understanding of the basic Methods

usedused With a hands-on example, gain the:With a hands-on example, gain the:

Ability to apply to appropriate client Ability to apply to appropriate client situationssituations

Ability to know when not to apply!!!Ability to know when not to apply!!!


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Fair Market ValueFair Market Value

““Fair Market Value is defined as the valueFair Market Value is defined as the value

that a that a willingwilling seller and a seller and a willingwilling buyer, both buyer, both

being being informedinformed of the of the relevantrelevant facts about facts about

the company, could reasonably conduct athe company, could reasonably conduct a

buy-sell transaction, neither party under anybuy-sell transaction, neither party under any

compulsioncompulsion to do so.” to do so.”


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PURPOSESPURPOSES

Business SaleBusiness Sale Business PurchaseBusiness Purchase Bank FinancingBank Financing Estate PlanningEstate Planning Estate TaxesEstate Taxes GiftingGifting

DivorceDivorce Partner Buy In/OutPartner Buy In/Out Report CardReport Card ESOP ESOP Inter-GenerationInter-Generation OtherOther

Always dealing with two sides – someone wants a Always dealing with two sides – someone wants a higher valuation, someone wants a lower valuation. higher valuation, someone wants a lower valuation.

One side is frequently the IRS.One side is frequently the IRS.


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SMALL BUSINESS SMALL BUSINESS CHARACTERISTICSCHARACTERISTICS

Size & Business ModelSize & Business Model

MarketsMarkets

PeoplePeople


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Market EvaluationMarket Evaluation

Size of Market in Size of Market in areaarea

Growth in areaGrowth in area Company’s PositionCompany’s Position Top CustomersTop Customers

ConcentrationConcentration Company GrowthCompany Growth Desire-ability of Desire-ability of

product/serviceproduct/service Location, Location, Location, Location,

LocationLocation


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Business Valuation Steps - 1Business Valuation Steps - 1

Define PurposeDefine Purpose Understand size & characteristics of Understand size & characteristics of

ClientClient Assessment of People and MarketsAssessment of People and Markets -------------------------------------------------------------------------------------------- Gather Additional DataGather Additional Data Recast Financial StatementsRecast Financial Statements Ratio Analysis / Industry ComparisonRatio Analysis / Industry Comparison


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Business Valuation Steps - 2Business Valuation Steps - 2

Application of Valuation MethodsApplication of Valuation Methods ReconciliationReconciliation AdjustmentsAdjustments Valuation ReportValuation Report


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GLOSSARY -1GLOSSARY -1

Pro Forma AdjustmentsPro Forma Adjustments Reflect Reflect Nature of DealNature of Deal Adjust for Real EstateAdjust for Real Estate Adjust for discretionary and one-time Adjust for discretionary and one-time

itemsitems Book Value of Stockholder’s EquityBook Value of Stockholder’s Equity Book Value of Total CapitalBook Value of Total Capital GoodwillGoodwill


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GLOSSARY – 2GLOSSARY – 2Income MeasuresIncome Measures

SalesSales Contribution ValueContribution Value Prime Gross ProfitPrime Gross Profit Gross ProfitGross Profit SDE – Seller’s SDE – Seller’s

Discretionary Discretionary EarningsEarnings

PBITDA, EBITDA, PBITDA, EBITDA, IBITDAIBITDA

PBIT, EBIT, IBITPBIT, EBIT, IBIT PBT, EBT, IBTPBT, EBT, IBT PAT, EAT, IATPAT, EAT, IAT


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Glossary - 3Glossary - 3

Arm’s LengthArm’s Length Date of ValuationDate of Valuation Discretionary ExpensesDiscretionary Expenses MaterialityMateriality One-time eventsOne-time events ControlControl / Minority Interest / Minority Interest Ranges of ValuesRanges of Values


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Discretionary Expenses Discretionary Expenses

Owner’s BonusOwner’s Bonus Management’s Management’s

BonusBonus Country/Golf ClubCountry/Golf Club AirplaneAirplane Director’s FeesDirector’s Fees Guaranty FeesGuaranty Fees Family SalariesFamily Salaries

Car ExpensesCar Expenses Life InsuranceLife Insurance Interest EarnedInterest Earned NASCAR ticketsNASCAR tickets London TravelLondon Travel Trade ShowTrade Show Training ClassTraining Class


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Valuation Methods - 1Valuation Methods - 1

IncomeIncome Methods Methods

CostCost Methods Methods

Comparable ValueComparable Value Methods Methods


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Valuation Methods - 2Valuation Methods - 2 Income Methods*Income Methods*

ROIROI Cash FlowCash Flow Excess Income (IRS)Excess Income (IRS) SDESDE DCF – Ugly!DCF – Ugly! Other MultiplesOther Multiples OthersOthers

* Can’t use many income * Can’t use many income methods if there is no methods if there is no incomeincome!!

Cost MethodsCost Methods BookBook Depreciation add Depreciation add

backback Replacement – newReplacement – new Replacement – usedReplacement – used Cost plus 1x GPCost plus 1x GP Multiple of BookMultiple of Book OthersOthers


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Valuation Methods - 3Valuation Methods - 3

Comparable Value MethodsComparable Value Methods

Deals Done – tough finding sources – Deals Done – tough finding sources – privately held businesses, definition of privately held businesses, definition of price.price.

Publicly held – minority vs. majority, Publicly held – minority vs. majority, liquidity?liquidity?

Industry Rules-of-ThumbIndustry Rules-of-Thumb


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BUSINESS VALUATION BUSINESS VALUATION EZ ELECTRICEZ ELECTRIC

Purpose:Purpose:

Joe would like to retire sometime in his Joe would like to retire sometime in his mid-50’s. mid-50’s.

Wants to get an idea of the value of the Wants to get an idea of the value of the business to plan ahead.business to plan ahead.

Make sure he has enough life insurance Make sure he has enough life insurance to cover the value, knowing that much to cover the value, knowing that much of the value is gone in the event of his of the value is gone in the event of his death.death.


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EZ ELECTRIC – Size /OtherEZ ELECTRIC – Size /Other

20 Employees 20 Employees including Joeincluding Joe

Sales $3mSales $3m 100% owned by Joe100% owned by Joe Founded, Dad 1970Founded, Dad 1970 Joe took over 1997Joe took over 1997 Dad passed 2000Dad passed 2000 Key Man Life Insur.Key Man Life Insur.

Joe’s Mom in Joe’s Mom in Florida Comes to Florida Comes to annual meeting at annual meeting at Xmas.Xmas.

She owns buildingShe owns building Lease to EZLease to EZ Son and Daughter Son and Daughter

work at EZwork at EZ


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MarketsMarkets

Apparatus service market in area Apparatus service market in area $10m$10m

1 competitor same size, 3 smaller1 competitor same size, 3 smaller Industry Growth: FlatIndustry Growth: Flat Top Four CustomersTop Four Customers

Mining Mining 15%15% AutomotiveAutomotive 10%10% ManufacturingManufacturing 10%10% Health CareHealth Care 10%10%


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Adjustments - 1 Adjustments - 1 Joe bought out Mom’s stock at the Joe bought out Mom’s stock at the

then fair market value, balance is part then fair market value, balance is part of Long Term Debt. Payments of $3k of Long Term Debt. Payments of $3k per month for principal and interest on per month for principal and interest on 8% note. Pays her an additional $10k 8% note. Pays her an additional $10k at year end to for attending board at year end to for attending board meeting to supplement her income.meeting to supplement her income.

Any discretionary? Any one time?Any discretionary? Any one time?


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Adjustments - 2 Adjustments - 2

Joe’s only sister is an attorney. Keeps Joe’s only sister is an attorney. Keeps track of the corporate records, track of the corporate records, member of the board of directors, member of the board of directors, handles collection letters and other handles collection letters and other minor legal matters. Joe pays her $1k minor legal matters. Joe pays her $1k per month.per month.

Any discretionary? Any one time?Any discretionary? Any one time?


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Method/Calculate Method/Calculate Lower Lower Higher Notes Higher Notes1.1. 4 to 6 x 1604 to 6 x 160 640 960 Total Equity* 640 960 Total Equity*

2.2. 3 to 5 x 2503 to 5 x 250 750 750 1250 Total Capital 1250 Total Capitalless debtless debt (375)(375) (375)(375)

375375 875 875 Total Total Equity*Equity*

3.3. 40% to 60%40% to 60% 180 270 Acc. Depre. 180 270 Acc. Depre.Book EquityBook Equity 375375 375375

555555 645 645 Total Equity* Total Equity*

4.4. No Information No Information* Valuation of Total Equity is the objective* Valuation of Total Equity is the objective

Apply Methods 1-4Apply Methods 1-4


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Method/Calculate Method/Calculate Lower Lower Higher Notes Higher Notes5. 1.5 to 2.5 SDE5. 1.5 to 2.5 SDE 600 1,000 600 1,000

FA+GW+Inv** FA+GW+Inv** Cash, A/R, OCACash, A/R, OCA 310 310 310 310 Total Liab.Total Liab. (525)(525) (525)(525)

385 785 Total Equity* 385 785 Total Equity*

6. 25% to 40%6. 25% to 40% 525 525 840 FA+ GW only 840 FA+ GW onlyAll Tot. CAAll Tot. CA 550 550 550 Current Assets 550 Current AssetsTotal Liab.Total Liab. (525)(525) (525)(525)

550550 865 Total Equity* 865 Total Equity*

*Valuation of total equity is the objective*Valuation of total equity is the objective** Typical Small Business Sale** Typical Small Business Sale

Apply Methods 5-6Apply Methods 5-6


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EZ Electric - Reconciliation

0

200

400

600

800

1000

1200

ROI CashFlow

Cost SDE Rule ofThumb

Lower

Higher


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Copyright C&S Associates, July 20070 How to Value a Small Business Pete Smith C&S Associates Professional Development Seminar South Carolina Small Business