There are a number of solid reasons to value your business – even on annual basis. First, if your spouse will inherit the business upon your death, your company should have enough term insurance on your life to be able to buy back the stock from your spouse. That action assumes, of course, that you would like (a) to see your company be perpetuated for the benefit of your staff and your clients and (b) your spouse has neither the interest nor the skill to operate it.
Second, an annual business valuation is important to fund a buy-sell agreement that may exist with a partner, family member in the operation, or some other key manager with designs on owning the firm at some point in the future. Because the value of the business may change from year to year, the amount of the funding through term insurance should vary as well.
Finally, you will want a business valuation in preparation for selling the company – the most obvious rationale. By doing the valuation on an annual basis, however, owners can focus on strengthening those factors in the coming years that are currently depressing a sale price. Such remedial action could have a major impact on securing a premium price for the business.
Variety of Valuation Formulas
Accountants have a whole host of business valuation formulas that can be applied to your firm. They most frequently used are the income approach (where a future earnings stream is taken into consideration), the market approach, and the asset approach. As you can imagine, the best formula for a seller may be entirely different than that for a buyer.
In spite of all these valuation formulas, the one most often used by sellers comes from the business brokers they typically employ to market their businesses at a premium price. And that’s the methodology that I would recommend kitchen/bath owners use when valuing their own operations on an annual basis. This valuation formula is based upon several parts: (1) owner’s recast compensation, (2) intangible asset value, and (3) tangible asset value.
Part 1 - Owner’s Recast Compensation
The rationale behind this portion of the business valuation assumes that once the business is sold, a competent manager will cost a lot less in total compensation than what the current owner is taking out of the business. Using the latest annual financial statements of a hypothetical operation, here are the steps involved in recasting the owner’s compensation:
1. Enter Total Income (last year; accrual accounting) $1,750,000
2. Enter Operating Expenses $1,670,000
3. Enter Owner’s Compensation (including all Perks) $253,000
4. Recast Operating Expenses (Step 2 minus Step 3) $1,417,000
5. Enter New Manager’s Salary $100,000
6. Enter Cash Reserve (for emergencies) $100,000
7. Calculate Adjusted Earnings (Step 1 minus Steps 4-6) $133,000
8. Subtract Financing Expense (Annual Interest on Note) $47,000
9. Enter EXCESS EARNINGS (Step 7 minus Step 8) $86,000
Part 2 - Intangible Asset Value
To develop an Intangible Asset Value for the business, one has to measure six different elements in as an objective fashion as possible. Using a rating of 0-6, with 0 conveying the greatest negative value and 6 bearing the greatest positive value, the purpose of Step 10 will be to generate the proper multiplier for our hypothetical kitchen/bath design business.
10. Develop Multiplier for Intangible Asset Value:
- Risk 4
- Competition 2
- Industry Growth Rating 5
- Company Earnings Rating 5
- Company Growth Rating 3
- Desirability 4
Average Multiplier 3.83
Once this Intangible Asset Value Multiplier is determined, Step 11 establishes the Going Concern Value. The simple calculation for this step multiplies 3.83 times the $86,000 Excess Earnings number from Step 9, delivering a Going Concern Value of $329,380.
Part 3 – Tangible Asset Value
The final phase of the business valuation is the easiest because it involves identifying a couple of numbers off the company Balance Sheet. Step 12 creates the Tangible Asset Value by adding the sum of all Fixed Assets (minus depreciation) plus Inventory. Of course, the only inventory that a kitchen/bath firm possesses is its displays.
Unfortunately, if these displays were expensed in the year they were bought rather than capitalized as they should have been, their value will not positively impact the sale price of your business. Likewise, if the displays were indeed capitalized, but allowed to depreciate like other Fixed Assets contrary to the NKBA position paper on display accounting rendered in 1978, they too will not improve your sale price. The official industry position on display accounting is that displays should posted as Current Assets not to be depreciated; this position was advanced because displays are generally given substantially deeper discounts than those for resale to customers, making it possible for kitchen/bath dealers to earn a profit on them even 5-7 years later.
To arrive at a final business value for our hypothetical operation, Step 13 adds the Going Concern Value of Step 11 ($329,380) to the Tangible Asset Value of Step 12 ($539,000). The resultant is $868,380. So, if your intent is to sell the sell business, then your asking price should be $865,000. The same figure should be used to fund a company purchase of stock from your beneficiary or to fund a buy-sell agreement. If you wanted to get a bigger price for this hypothetical business, then improving the firm’s growth rating, building its brand compared to the competition through an effective advertising campaign, increasing its gross profit margin, and streamlining operating expenses would all make favorable contributions towards this end.