Business Valuation

You are your reviewing your personal situation and you need to value your business, for estate planning purposes or in case you are planning to sell the business. You see ten different valuators and everyone comes up with a different value of your business and everyone has a disclaimer saying that the actual selling price could be different. The true value of the business is what someone is willing to pay.

Until you find that person, you never know what the final price will be. When you sell your house, if you live in a subdivision, many houses are either identical or very similar, the lot is the same, the front elevation may look different but the house is very similar. One house may have a few more upgrades and you can factor that into differentiating the two houses. It is much easier to value a house because you can compare it to the house that sold in the same neighbourhood.

When if comes to a business, no two businesses are identical. You have have a franchise with identical name, price of products etc but no two locations have the same value – why? Each location is unique, the traffic count could be different, the product mix could be different, the average purchase price and average sales per customer can be different. What is the same between these two businesses – the name and nothing else. One location could be making money and another could be losing money, they cannot be valued the same.

Many years ago I saw a fast food franchise, it was in an office building. Two main tenants of the building moved out but were still paying the rent because they were unable to sublet the space. As far as the landlord was concerned, the building was fully occupied however the head count in the building was down by 50% because of so many vacant floors in the building. As a result of the lack of people in the building, the fast food restaurant was struggling and ultimately went bankrupt.

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If you sales are dropping and costs or rising, owners unfortunately will end up having to reduce or eliminate their salary. Fluctuating the owners’s salary should have no impact on the valuation on the sale of a business. Most investors will look at normalized earnings to value a business.

Normalized earnings are usually calculated backwards, starting with the net income reported on the financial statements. Add back all personal expenses and I typically add back the owners salary.

Then I reflect a salary for what you would have to pay to replace that owner. if the owner is taking only $20,000 in salary but you determine that you would have to pay say $65,000 for an independent person to replace the owner, then you would reduce normalized earnings by $45,000. If there were no other adjustments except for the salary adjustment, you would drop the reported income by $45,000 in my example above ($65,000 which you consider normal less $20,000 actually taken out by the owner).

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