I digress. I read something today from a respected author that echoed an age-old question on how to value a business. Many financial academicians will endeavor to value a business in a variety of ways, each more complicated than the last. It blows my mind how sophisticated it can get. In fact I once became an expert on valuation, years ago in my infancy. I ran probably six or seven different valuation methodologies for every deal I looked at. Then averaged them. Then ran sensitivity analysis. Then, when we had just started to ramp our merchant bank, I produced printout valuations to present to our target companies. Not huge companies, maybe $4-$5mm in sales. Oh, they were impressed. In many cases they even agreed with our assessments.

Did doing sophisticated valuations ever lead to anything like an agreement, signed or otherwise, on price? Never. Why? Well, for one thing it usually just served to inflate the value of the business and made the seller ever more difficult to deal with. Another thing is it complicates an an otherwise easily understood concept. Sellers are by and large uncomplicated people. They know one thing well and that is their business. If deals get too complicated that scares them.

Books from the biggest accounting firms are published on the subject of valuation. Maybe they have some relevance when buying General Motors, but in our mini market there is only what the buyer will pay and what the seller will sell for. Now, before we say that is over-simplified hogwash, I will also say that there are a few simple real world ways I value each business without trying to score them like a credit history or put them in equations with hurdle rates and variables that don’t mean anything.

Thus I gave up the rather excruciating process of valuing companies using conventional valuation techniques in favor of rule-of thumb metrics which are simple to deploy even on an at-a-glance look at the financial statements. I will often use the same multiple of earnings approach that every business broker uses for starters and come away with a decent valuation in 1 minute or less. BUT. Accurate valuation is not a static process, so you can throw away all the books that put it in one time frame. The valuation must be adjusted for a number of key factors which the books never describe. And here some of them are:

  1. Adjust the earnings according to the salary, bonus and perks the owner takes out. What will be the compensation package after you buy the business? Figure to adjust the earnings picture to reflect what a market salary would be, and not all the other bonuses. Adjust the earnings to reflect a true picture of what the company should currently earn if the managers were just all earnings normal salaries.
  2. Look for extraordinary items and non-recurring items and areas where expenses can and will be cut back after closing. Factor them into the earnings picture.
  3. Look closely at the asset package. Is it strong or is it weak? If the company is overloaded with assets it should increase the valuation. Will YOU increase the valuation? No. Underestimating the value of the asset package is one tactic the buyer can use to get a better price – and  there is no downside. The assets often have disputable value. There is no reason to give the seller the benefit of this unless he makes a very good case.

So start the valuation process with the simplest method and only get more complicate when forced to. I start out with a 3x multiple on a lot of deals and I am quite conservative on the earnings. Prepare to be challenged but if you are that means you are doing your job.