Have you ever gotten one of those certificates from the jewelry store that says the jewelry you just bought is worth more than you paid?  How smart you are to have made such a wise purchase!  But don't try to sell it back because the jewelry store won't be buying at that price.  The purpose of the certificate is to make you feel good about your purchase or, perhaps, to give you a high value for insurance purposes.  Just don't expect that certificate to tell you what you would actually receive if you sold the jewelry.

Business valuations are not altogether different from those jewelry appraisals.  Business valuations are prepared for all sorts of reasons—estate and gift planning, domestic disputes, and buy-sells, to name a few—but when it comes to actually selling a business, many of those valuation reports are about as helpful as that jewelry certificate.  What an owner really wants to know is what can he or she expect to receive if the business is sold—what I call a "Real World Business Valuation."

In the real world we know that value is in the eye of the beholder.  A knowledgeable business buyer values a company based upon expected return on investment, commonly called "ROI."  Typically, a buyer of a small to medium-size business expects to get a 20-35% annual return on the equity investment in the business.  Whether to require a 20% return or a 35% return depends on the buyer's perception of risk.  For example, an investor might demand a 20% return for a company with a long history of growth, stable net income, seasoned management, and loyal customers but a 35% return for a relatively new company with erratic earnings, thin management, and fair-weather customers.  Higher rates of return are required for riskier investments.

Adjusting the rate of return for the perceived risk is standard procedure in valuing businesses.  In fact, the primary tasks of a business appraiser are determining the appropriate rate of return and estimating the future operating cash flow and balance sheet needs of the business.  But a typical business valuation ignores several factors that significantly affect a buyer's ROI—deal structure, financing and tax consequences.  Simply put, you can't calculate true cash flow without knowing the structure of the transaction (asset or stock purchase), the financing arrangements, and available tax deductions.  And if you don't know your true cash flow, you can't calculate true ROI or the price you can justify for the business. 

Let me give you a few specifics on how these factors affect true cash flow and ROI.  Purchasing assets rather than stock can significantly improve a buyer's cash flow because depreciation and amortization tax deductions are typically greater in an asset purchase than a stock purchase.  And greater tax deductions means lower taxes and improved cash flow.  Financing can also dramatically alter the buyer's ROI not only because the interest payments are tax deductible but also because ROI is based on the equity contributed to the business, not the total funds committed to the transaction.  If the business is successful, the smaller the equity investment, the greater is the return on the equity investment. 

Said another way, before you can determine what your business is worth to you, you need to know what it is worth to a buyer.  And a buyer cannot determine what a business is worth to him until he knows the structure of the deal.  For instance, if we know that the sale is structured as an asset purchase, the relative value of the "hard assets" with a short depreciable life, and the financing arrangement—whether seller financed or asset-based lending from an outside lender—we can then determine true cash flow.  Once we determine the appropriate ROI for the particular business, we are ready to put a fair price on the business—a price that reflects true cash flow and true ROI, not hypothetical ROI for a hypothetical buyer.

In a Real World Valuation, deal structure is as important as determining the appropriate rate of return or estimating the future operating cash flow and balance sheet needs of the business.  The missing step in most business valuations, which is the real key, is determining the optimal deal structure for a given situation.  The optimal deal structure reflects the most appropriate mix of equity and debt that will not only cash flow for the buyer but also produce the required ROI.  For a buyer, the less cash or equity invested in a business the higher will be the ROI if the business is successful.  Debt is not always the answer though.  The more debt taken on by a buyer, the less likely the buyer will be able to cash flow the purchase—unless the financing terms are very favorable.

Standard business valuations have their place and are clearly preferred if you need a valuation for tax purposes, equitable distribution, or some other purpose that requires a conventional valuation.  But if you want to know what you should expect to get if you sell your business, a Real World Valuation will give you a much better answer.

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