The Art and Science of Valuing Your Business

In Uncategorized on June 14, 2011 at 1:41 am

By John Warrillow | March 10, 2011

When I sold my last business, I received a couple of written offers. Each revealed the price the acquirer was willing to pay for my company, but none included an explanation as to how the would-be buyers arrived at their offer price.

When I asked my advisers to help me, they threw out buzzwords like “discounted cash flow,” “risk-adjusted return” and “present value,” all of which they attempted to explain as only accountants can — in increasingly confusing terms.

I found this frustrating because as I was going into negotiations with potential acquirers, I wanted to be armed with an understanding of how they came up with their offer price.

Since then, I’ve learned a little bit about the techniques, tricks, and methodologies acquirers use to buy companies. A lot of it is math that you can program a spreadsheet to spit out, so I won’t bore you with too much technical theory, but I think you will find value in learning the questions acquirers are likely to ask themselves.

Question 1: How much money will your business make in the future?

The first thing a buyer needs to estimate is how much cash profit your business can be expected to generate in the years to come. Of course, this is a highly subjective question, so buyers come up with their best guesstimate by looking at a number of things including:

  • Contracts you have that guarantee revenue into the future
  • Recurring revenue that is likely to come in the future
  • The money and time it takes you to acquire a new customer
  • Your past profitability and growth rate
  • Your planned growth rate for the future
  • The possibility of selling your product or service to their current customers

The acquirer will likely have a number of people on staff analyzing this data. The more junior analysts will spend their time “modeling” your business plan, which means they will plug a number of assumptions into a spreadsheet and see how your business will perform under a variety of conditions.

The more seasoned representatives of an acquiring firm will spend less time monkeying with a spreadsheet and more time trying to validate the assumptions that go into the spreadsheets.

Question 2: How much am I willing to pay now for cash tomorrow?

Once potential acquirers have developed an assumption about how much profit your business will make in the years to come, they ask themselves what they are willing to pay today for money in the future. This is an equation we’ve all done before. For example, if you took $100 and knew that over the next year you could generate 5 percent interest, you know you’d have $105 at the end of the year. Therefore, the present value of $105 a year from now is $100 today. In this example, if you were looking for a 5 percent return on your money, you’d be willing to pay $100 today to make that investment.

Question #3: How risky is the stream of cash I will get in the future?

Once buyers have figured out how much money your company is likely to make them in the future, and what they would be prepared to pay today for that future cash, they then need to estimate how risky that future stream of profits is.

In the example above, if you knew you were guaranteed a 5 percent interest rate, it’s easy to know you would pay $100 today for $105 in the future. The tricky part about valuing a company — the art, not the science — is that the future is never guaranteed.

For example, if I felt really confident a certain baseball card would be worth $120 a year from now, I might buy the card today for $110 because I am near sure I will make $10, or 8 to 9 percent return on my money invested (with a better interest rate than the bank offers these days).

However, if I was less confident the baseball card would really be worth $120 one year from now, I may spend only $90 for it today.  In other words, I would want to make $30, or a 33 percent return on my money for taking the higher level of risk.

So, the level of risk and the buyers’ expectations are inversely proportional: The riskier the future value is estimated to be, the higher the buyers’ expectations of a return will be — and the lower the price they are willing to pay today for a shot at a payday down the road.

Here are your key takeaways:

  • Buyers pay for a future stream of profits (they don’t care much about the past unless it helps them predict the future).
  • If your future profits seem to be somewhat of a crapshoot, they will demand a higher return on their investment and offer a lower price for your business.

My suggestion is to ignore the equations and focus on what drives the math: how big a stream of profits your business will generate and just how sure the future looks.

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