What You Need to Know Before Transferring Ownership: Business Valuation Basics

Over the next 30 to 40 years, recent studies estimate that as much as $30 trillion in wealth will transfer to the next generation. Much of this wealth will come in the form of private business interests.

How much is your business worth? That’s important information when deciding whether to transfer ownership to the next generation — or whether it makes more sense to sell the business to a third party and give the next generation the sales proceeds (or alternative investments purchased from those proceeds). Here’s a closer look at business valuation methods and the current state of the merger and acquisition (M&A) market.

A well-known rule of thumb for valuing manufacturers is five times earnings before interest, taxes, depreciation and amortization (EBITDA). But many businesses sell for more (or less) than this average.

This oversimplified formula can serve as a useful sanity check for a purchase offer. But you shouldn’t rely on it alone when selling your business because it’s arguably the most important business decision you’ll ever face.

Instead, valuation professionals generally consider three tried-and-true valuation approaches to value manufacturers: the cost, income and market approaches.

Manufacturers rely heavily on tangible assets, so the balance sheet is a logical starting point. Some items are worth more (or less) than book value.

For example, real estate usually is reported at historic cost, but it often appreciates in value over time. Receivables also may need to be adjusted for bad debts. Inventory may include obsolete or unsalable items. And contingent liabilities — such as pending lawsuits, environmental obligations and warranties — also must be accounted for.

Another significant adjustment to the balance sheet is needed for intangible assets, such as internally developed patents, brands and goodwill. The cost approach generally omits an intangible value, but it can serve as a useful “floor” for a company’s value. Appraisers typically use another technique to arrive at an appraisal that’s inclusive of these intangibles.

Expected future cash flows can be converted to present value to determine how much investors will pay for a business interest. Reported earnings may need to be adjusted for a variety of items, such as accelerated depreciation rates, market-rate rents, and discretionary spending, such as below-market owners’ compensation or nonessential travel expenses.

A key ingredient under the income approach is the discount rate used to convert future cash flows to their net present value. Discount rates vary depending on an investment’s perceived risk in the marketplace.

Sales of comparable public stocks or private companies may be used to value your business. Finding comparables can be tricky, however. Many small, private manufacturers tend to be “pure players,” whereas public companies tend to be conglomerates, making meaningful public stock comparisons difficult.

When researching transaction databases, it’s essential to filter deals using relevant criteria, such as industrial classification codes, size and location. Adjustments may be required to account for differences in financial performance and to arrive at a cash-equivalent value if comparable transactions include noncash terms and future payouts, such as earnouts or installment payments.

2016 was a strong year for M&A activity, and the conditions are right for the upward trend to continue. Many companies are sitting on large cash reserves, banks are offering relatively inexpensive financing options, and the U.S. political uncertainty is expected to calm down after November’s elections.

With many potential buyers possessing the financial wherewithal to purchase your business, it could be easier to sell — and you could bring a premium if multiple buyers are interested in your business.

Owners contemplating family business transfers face a tough choice. Should you sell now and take advantage of today’s hot M&A market? Or should you transfer ownership to the next generation and keep the business in the family?

Answering these questions will help you start valuing your business and examining current market data. When you’re ready to discuss future transfers with the next generation, a valuation professional can bring much-needed objectivity and experience to the planning process.