Getting to the valuation before the negotiation
While facts are irrefutible, there are subjective judgements to be made by you about your required return on investment, and external market factors that are open to interpretation, that may ultimately determine your valuation outcome. It’s best in fact to come up with a range of valuations – good value, OK, and Oh that hurt’s.Once you’ve learned a few small business valuation principles computing your own valuation based on some subjective assumptions is not as difficult as you might believe.
If you’re seriously considering buying a business, some of the wisest words I’ve heard were, “Before you enter into any negotation, write down the maximum price you are prepared to pay, and if you can’t get below it, walk away.”
Once you’re happy with your small business valuation(s), the trick is in convincing the other side of the transaction to see eye to eye with you on your decisions about those assumptions, and that’s where good negotiating skills, and creativity come into play.
This is where the money is to be made or lost in a business transaction, and why it pays to take good advice from a qualified small business valuation professional in your area of the world
So what about some key business valuation principles?
Related post: Small Business Software
Going Concern Principle
Before you start applying any business valuation method, you need to consider whether the transaction is going to be treated as a going concern or not. But, what is going concern I hear you ask?
An analagy would be to think of the business as a car. A car that is a going concern, will continue to provide many years of reliable service, and happy journeys, providing that it’s looked after and serviced appropriately.
A car that is not a going concern is a wrecker. What it’s worth to you, is what it can be broken down and sold for. It may be worth patching up, but unless you’re an expert, this could also mean throwing good money after bad.
Instinctively you know which car is worth more. The one with the road mileage left in it. A business is no different. A going concern business is worth more than a going/gone bust business.
Thinking about a business that cannot continue to trade though brings us around to the second principle of small business valuation:
Assets Based Approach
As soon as you start to think about the break up value of a car, you’re thinking about taking it to pieces and independently assessing the most valuable components on an individual basis, who they could be sold to, and the used value they might fetch in the classifieds.
There is absolutely nothing wrong with this approach in business. To identify each of the assets of the business, and appropriately value them.
This is where it becomes subjective. Not to mention that assets being sold in a distress situation are always worth less than when you can take your time and find the right buyer.
The Concept of Goodwill
In finance and accounting terms, goodwill is defined as the excess of price paid less the assets of the business at fair value (the value they can fetch in an open market).
Hmm. Back to the car analagy. When you buy a car you can drive away in, you place some kind of value on the freedom it will give you, that it has been serviced regularly by a dealer, that the owner was a little old man who only used it three times a week, and washed it every weekend. That’s goodwill.
In a business, you have to think differently about goodwill that will be recognised when the transaction happens, and the economic goodwill that the business has in terms of it’s customer relationships, intellectual capital such as patents, brands and their value etc.
They’re pretty intangible things, and difficult to value without subjectivity. Each of the different small business valuation techniques has goodwill within it somewhere even if not explicitly recognised.