Understanding Valuation

One of the biggest challenges that you will have is coming up with a valuation that you and the seller can agree upon. Sellers are typically non-scientific in their approach valuation and will come up with various ways to value their business. On the other hand you will have to deal with information quality and availability, lack of proper control systems, and the sustainability of earnings once the seller exits. Other things that may affect valuation are one-time events such as the sale of part of the business, competitiveness, required future investment in CapEx or R&D, and other peculiarities that were found during due diligence.

Other items that may affect valuation are lack of comparable businesses that have recently sold, or competition for the deal that might drive up price. There are some general rules of thumb for valuation, but every company and situation is unique in some way. Therefore, you should know what you are willing to pay and at what price you are willing to walk away.

Technical Steps to Valuation

1. Obtain detailed historical financials from the seller and validate their accuracy
2. Obtain any future projections from the seller
3. Scrub the numbers - validate, adjust for seller's discretionary items, look for overvalued/undervalued assets, restate the numbers
4. Create a common size statement analysis
5. Create your own pro forma financials from the above analysis - estimate cash flow, levels of debt, growth

Valuation Methodologies

The most commonly used valuation method is the multiple of earnings expressed as a multiple of EBIT or EBITDA. For example, microcap businesses of all types typically sell for somewhere between 3 - 8 times Adjusted EBITDA.

Book Value, Adjusted Book Value, and Liquidation Value are sometimes used to set a floor what the business is worth.

Discounted Cash Flow (DCF) is a commonly used tool to value a business. Oftentimes you will see a combination of both the DCF and Multiples Methods used. DCFs are useful, but very complex and prone to errors in how the assumptions are determined. That said, learning how to build your own pro forma model and use DCF to determine a valuation is a very useful skill.

Valuations can be affected by a number of things - QofE, Customer risk, management and employee retention risk, state of business systems, fair market value of assets, age of products, industry status, competition, etc. etc. etc. It is important to understand what you are buying and what are the risks. If you can mitigate the risks and secure the most important assets of the company at an acceptable price you are half way to success. This is what makes valuation more art than science. If it were just science we would let the numbers speak for themselves, but different buyers and sellers will see the future of the business with a different lens.