The Art and Science of Valuation for SMBs

A good friend of mine who owns a successful franchise territory in lawn care products and services, called the other day to discuss business valuations.  He wanted purchase additional territories to expand his empire.  Basically, there are two ways to grow a business – organically or through a transaction, e.g. acquisition, partnerships, carve-out, etc…  He chose the latter route and wanted to make sure he did not overpay for future growth opportunities.

There is an old saying among bankers – “price is what you pay, value is what you get.”  You want to make sure that value is built into the price you pay for.  Business valuation is as much art as science.  The numbers alone do not tell the entire story, as the risks inherent in any business situation are not static.  While there are countless methods, the three generally accepted approaches to business valuation are: asset, market and income.

Regardless of the method chosen, sound valuation depends on the clear identification of cash flow, future growth potential and inherent risks.  For bigger firms, like public companies, fair market value also takes into consideration marketplace perception, investment value, and investor’s intrinsic value.  However, for smaller, privately-owned firms identification of relevant, often idiosyncratic variables that go into valuation calculations becomes even more crucial.

After a lengthy discussion over a couple of cups of coffee, we identified the following variables as the most relevant for valuation for his scenario: historical revenue trend; type and duration of customer contracts; gross and net margins; EBITDA vs. OIBA metric; number of competing businesses in the area; short- and long-term and potential liabilities on B/S; and other critical drivers of future revenue and growth.  Art is in the identification of these variables, proper weighing of each and understanding how they fit into the big picture.  Science is in the application of the formulae and metrics to arrive at a tangible figure, and also includes the creation of a forecast to predict the future.

I may be a geek, but these are fun projects.  Business valuation is a strategic exercise, and there’s nothing like war-gaming potential scenarios for optimal results.

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About Richard Lee
Experienced finance and operations professional. Currently partner in five companies, adjunct professor of economics at Columbia College and executive contributor to a small business blog (www.SMBmatters.com); following corporate finance, M&A and management consulting tenures with Orbitz and Diamond Technology Partners; and six years of service with the United States Army.

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