31 Oct Business Valuation Fundamentals
Business valuation fundamentals include knowing about your business and its true value. Today our guests discussed the fundamentals important when calculating business value.
In this week’s Exit Your Way Roundtable Episode, our guest speakers were Andrew Cross and Damon Pistulka. Andrew is the Founder of Cross NW-Business Advisory and the Co-Founder of Exit Your Way. Damon is also the Co-Founder of Exit Your Way. Andrew and Damon help business owners create & sell valuable businesses. They discuss the key fundamental of business valuation.
The conversation of this episode started with Damon asking Andrew about how important it is to know your business’s key value. Responding to this, Andrew said that when people first start their business, they think about the cash flow, their own income, and all the things that give value.
However, what they don’t understand is that this value is not the price of their business. In fact, most people don’t even realize that they are sitting on a great asset as their business.
Further, into the conversation, Damon and Andrew talked about business valuation fundamentals. For this, Damon shared a slide with the audience and they discussed it thoroughly. Talking more about the business valuation fundamentals, Andrew shared his insight on it. Moreover, he also said that at times even the rule of thumb doesn’t apply thoroughly.
Additionally, he also elaborated on this with an example saying that when we talk about the rule of thumb, everyone has a different thumb, so one can never be sure about it. Damon added to this saying that when it comes to business valuation fundamentals, there are several things through which you can test your business.
Moving on, Damon also said that when you are at the point of selling your business, you have to make sure you’re in the right ballpark. This means that wherever you’re selling you have to stay rest assured that you are doing it at the correct place.
By the end of the conversation, Damon and Andrew further shared the valuations that they think people should do before getting into the sales of their business.
The conversation ended with them thanking the audience for their presence.
Andrew Cross is the Founder of Cross NW-Business Advisory and the Co-Founder of Exit Your Way. The purpose of his company Exit Your Way is to help and teach business owners about selling an ecommerce business.
Apart from this, he has worked with The Executive Network of Seattle as a Treasurer and Fiber Dyne Advanced Compositions as Business Advisor. Moreover, he also worked with Seattle United FC as Board of Director and Treasurer.
As for Andrew’s education, he has an MBA Degree from Eastern Michigan University.
Damon Pistulka is the Co-founder of Exit Your Way and the show host of the roundtable at exit your way. Currently, Damon is also a Managing Partner at Sell a Business. The purpose of Damon’s business is to help other businesses that are about to sell, get out in a good value.
In terms of education, Damon has a Bachelor’s Degree in MS Industrial Management from South Dakota State University. He also has a degree in Mechanical Engineering from the same university.
His skills include strategy developer, Business broker, and leader.
About Exit Your Way®
Exit Your Way® provides a structured process and skilled resources to grow business value and allow business owners to leave with 2X+ more money when they are ready.
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Business Valuation Fundamentals
business, valuation, buyer, selling, people, company, asset, evaluation, andrew, most probable, transactions, approach, owner, pay, talk, profitability, employees, numbers, years, worth
Damon Pistulka, Andrew Cross
Damon Pistulka 00:02
All right, Andrew, how are things today?
Andrew Cross 00:05
Damon Pistulka 00:06
Yeah, yeah. Yeah, gotta get that blood for Mark. I was up early today doing some other work. And I did a little workout too, and just had to get it going again. So exciting times today, we are just happy to be able to talk today about business valuation fundamentals man, because you know what we we, this is something we How much do we talk about this stuff, Kurt Meyer knows he’s on here.
He doesn’t help people sell businesses. And he knows, you know, this is what we talk about day in and day out is valuation. So we’re really looking forward to this. I’m gonna get us going live on LinkedIn here. And then we are going to get the presentation started. So here we go. The going live, and boom. All right, everyone, Welcome once again, do the exit.
Andrew Cross 01:11
You got to work on that music.
Damon Pistulka 01:14
The music they see I could hear it, but I don’t think everybody else can so. So everyone, if you’re listening on LinkedIn, go ahead and drop rap where you’re listening from ask us questions, go ahead and do it. If you’re in the room, drop the chat in if someone on LinkedIn wants to know how to get into Remo, and interact with us, just go ahead and look under my posts. And you can find it or just go ahead and DM me or something like that. And I’ll get you the link to drop in. But today I’m really excited because we’re going to talk about business valuation fundamentals. We’re gonna ask some questions, if you want to ask some questions as we go along.
And we’ll get this done. So if you’re not familiar with the format, we do this roundtable twice a month, we do it in the first Thursday of the month, we’re going to talk about a subject, not necessarily us all the time. And then on the second Thursday of the month, or the third Thursday of the month, excuse me, first and third had remember that the third Thursday of the month, we’re going to talk about some practical applications of what we talked about. So in this case, we’re going to talk about, we’re going to go over some valuation situations that we’ve come into, and some other things like that.
And we’re going to get a panel of people that are going to be able to talk about it. So that’s going to be pretty exciting for us when we do the next one here. So without further ado, I want to first of all, a if I hadn’t done it already, I just start right in, I want to thank everyone for coming and listening to us today. We enjoy sharing this information. And Andrew and I have have just really want to want to let you know that. Yeah. And the The other thing we want to do is just get started.
So the the one thing that that I just don’t know any business owner, other than an investment business owner, that starts their business or gets into businesses goes, What’s my value? What’s the value of the business? Or what kind of value to business do I want to build? Right? And that’s what we really thought about this. So Andrew, before we get started, what do you think some are the real benefits of knowing the keys? Have your business value? If you get in your business and get started? What are some of the benefits? You can see if you start knowing that early?
Andrew Cross 03:45
Sure. I think um, well, I don’t I don’t think people think about that. First, when they open their doors and start business they’re thinking, you know, really, they’re thinking of the off the income statement, the cash flow, how much money is coming in? How much money is going out? How much can I put keep and put in my pocket in that that really, that’s value, right? That certainly is value, but it isn’t what the business is worth as an asset.
And I’m surprised you know, even to this day, I have people come to me, you know, thinking about retirement, think about selling their business, you know, it’s kind of the clock’s come coming around. They don’t know how to do it, but they don’t even realize that they’re sitting on an asset that has value doesn’t even occur to them. And it happens I swear to God and don’t realize there’s a market out there to to buy their business. And it’s a big market.
Damon Pistulka 04:44
Yeah. Yep. And it really is and i think you know, when you look at this, if you in terms of what we see helping clients as they in the last few years owning their business, getting them ready getting the to where they want, we really begin to understand if there the importance of knowing this, and what it really allows you to do. Because if you know that this factor can adversely affect or positively affect your business value or your ability to achieve the value that you want, those things can get changed. And they don’t take, you know, 20 years, they take a year, maybe at the worst.
Andrew Cross 05:27
Yeah, certainly can. And you know, I think everybody kind of has a concept of value and business value, because most of us have invested in the stock market. Yeah, right. I mean, ultimately, you know, you know, you’re, you’re, you’re buying the stock, you’re part of the deal, yet, you have very little control over it, and that kind of stuff. And in a publicly traded company, you know, you’re watching that value.
And they keep that scorecard every day. Yeah. And that’s the thing that really you have to translate back down to your own business value, is it that’s a moving target it today, this is we can tell you, you know, you may be I don’t want to get we’re gonna get into how, you know, valuation works. And those basic fundamentals for a business owner. Yeah, it might be worth this today. But it by the end of next week, it could be worth something completely different. Yeah. Yeah.
Damon Pistulka 06:22
That’s a that’s a great example. And we’ve talked about it before, but we’ve had clients and helping them towards the end of there, and they make decisions that adversely or positively affect the value considerably. And it really can. And great points Anders. So what we’re gonna do here is, we’re gonna we’ve got some slides, we’re going to share, we want you to go ahead and drop Andrew, a year and a half to check the chat. Because I guess the chat will work. I got to the technical thing, how am I going to get this going here? And we’ll make sure that we can see the presentation and share appropriately. So
Andrew Cross 06:58
yeah, I’m seeing the chat, too. So good morning, Jeffrey Graham, good to see you. Yep. See you. Yeah, but
Damon Pistulka 07:05
I got a, I got a swap that and do this. And now I can share my screen, I believe. Now, what am I sharing? Let me try, oh, I want to do it. No, no, it’s still working. I just want to make sure that I apologize people, I need to check one thing on LinkedIn here while we’re doing it to make sure I’m sharing the right screen there.
Andrew Cross 07:29
So I can get out the book on valuations and read it. pretty dry subject that we can get started. So I won’t give you the Reader’s Digest version. But this is a good one here. This is the Bible. And what’s key about this is valuing professional practice. This is this is really I mean, because valuing large businesses is a lot of the same fundamentals and principles. But anyways, we’re not going to do that today. We’re not
Damon Pistulka 08:03
doing that day. We’re not doing that today. So
Andrew Cross 08:08
I’m a junkie on, you know, cut sign of a kind of a valuation geek anyways, on that kind of
Damon Pistulka 08:14
stuff. Yep, yep. So so we’re gonna share this right here. And we’re going to talk about business valuation fundamentals. And really, what what we want to do is explain some of the key things that, that that affect your business value the most, so that you can use that going forward. So
Andrew Cross 08:35
then we’re gonna go through to kind of how, you know, valuation works, or how we come to these numbers as well. Yeah, yeah, to understanding that, you know, at least that least at the fundamental level, will allow you to make good decisions. Yeah. In your business. Yep.
Damon Pistulka 08:53
That’s for sure. All right. So without further ado, let’s get rolling. So our goal today is to give you some actionable information and and as as we go through this, you’re gonna see that I’m not the technical guy here, and who knows what’s going on.
So I’m the like, the play by play announcer, and he is the one that’s good, or vice versa, whatever. I’m the color commentary here. So but what we want to do today is give you some actionable information that you can use in your business to really affect the value so we’re going to get started and get rolling through here. So Andrew, let’s just talk about some valuation facts. Because you know, as people look at valuation, they often think it’s just a simple multiple of the profitability.
Andrew Cross 09:39
Yeah, but you know, and I think a lot of people may be familiar with the rules of thumb, you know, and they can, they can go you know, my business is, you know, worth, you know, I want to get one time x revenue, or as a rule of thumb, so it’s worth that or two times revenue or two times EBIT, and they talk about these rules of thumb and You know, those are great, you know, those are, you know, rules of thumb are very useful, and it is a good way to kind of understand where you are. But at the end of the day, what it you know, going through an actual valuation and using rules of thumb can be extremely different.
Damon Pistulka 10:18
Yes, yes. Because in a real world valuation, now you can go to a million websites and plug in your your industry and profitability, and it’ll spit out a number. And that’s about what it’s worth, because in a real valuation, you’re talking about things like, what is the health of your industry? What is the industry risk and stability? And then you also look at things like, how do you compare to others in your industry? And how do you compare to others that have just completed current transactions.
So there’s a lot of different things that you need to figure in, and your own individual business risk. And that’s one of the things that that a lot of people won’t address in a very simple valuation, where they’re just trying to give you a rule of thumb, as Andrew said, and when we were on last time, we kind of kind of looked at the rule of thumb, right? If you have 100 people in a room and they all stick up their thumb, how different is that? So how good is the based on rule of thumb so
Andrew Cross 11:20
rule of thumbs will generally get you in a ballpark? Yeah, you know, they can be used and so they are useful but yeah, but yeah, but the facts as to what what is most important about business valuation is data is the is the information you read, and that’s the challenge. Yeah, small businesses is that you know, in, in for publicly traded companies, but half our economy is all tied into small businesses, they’re just the data is not very accessible. Yeah, people don’t talk about it, there’s confidentiality issues, they don’t have to disclose they don’t have the regulations that you do in public companies. And there’s benefits to that but there’s also negatives when it comes around to kind of knowing
Damon Pistulka 12:08
where you’re at. Yeah, yeah. And the the interesting thing and this is why I wanted to bring it up first is that the reason you’re doing evaluation will affect the outcome of the valuation right? And we’re gonna look at some of the reasons and and it will be a different number. So there there are a lot of things what are the reasons why people doing most people think of the common ones and we’re going to run through those real quick
Andrew Cross 12:35
Yeah, there’s more than them and then you would think Yeah,
Damon Pistulka 12:39
yeah, there are there are there are a lot if we went through the whole list of them that’s actually over probably 10 or 12 at least. So the most common one that people talk about is most probable selling price. So Andrew talk a little bit about the most probable selling price.
Andrew Cross 12:54
Well we sell businesses, that’s what we do and we have business owners come to us and you know, hey, I want to sell this business you know, the next question is I’m not I don’t know what what is it worth? Yeah, you know, and we need we need we got pretty good at this over the years but you know, we need to be able to provide the most probable selling price is you know, you know, I look into my crystal ball here and say you know, look at the information that they can provide and this is what I think your most probable selling price is doesn’t mean this is what you’re getting out of this transaction.
But that’s the selling price at least it’s a good starting point or a basis to work in and so this is our common you know, your most used valuation at least for our standards and and also useful for any any business owner just to kind of get a gauge of where they’re at at this time. Yeah. And you know, it’ll use
Damon Pistulka 13:51
several of the several of the valuation methods but it won’t go into the more intensive valuation methods. And but it is it is that gauge that gauge that you want to have to make sure that you’re in the right ballpark, and this is where buyers and sellers I think this we’ve had buyers come to us and do them and and and come to find out that the value that the the the seller wanted was double or more when then they are just significantly more than what they really should have been in and help them get the price to where it should be or stop you know, not make a bad decision.
And then also on the sale price of it. If you’re leaving money on the table, you don’t want to leave money on the table. And, and with with valuation. The other thing is there’s a bit of valuation that’s subjective. So if you’re getting ready to sell a business, one of the things that we do is we test market, we test markets, our businesses with a small group of buyers that we know and, and that that allows us to really test market what’s going on sometimes to validate that our numbers are close.
Andrew Cross 15:00
What comes around a good point to his valuation is really it’s based on who’s the decider, okay, so in this case, the designer is the is the buyer, you know, and and we can, we can give you the most probable selling price, even a bracket of value and this is where you’re at today. But it doesn’t mean anything until somebody who’s willing to come up and pay that price. And then, you know, the company’s worth that they could offer. So and then, you know, in other kinds which will go on to the next slide. You know, legal proceedings, tax plantings, different decider, this might be IRS court of law, the judge. Yeah, so in this case, you use different
Damon Pistulka 15:44
approaches, you do different approaches, and obviously, you you there are different ways that you can value the business within the IRS guidelines to, to to value it appropriately. But it may not come out the same as if you were trying to sell a business, that’s all.
Andrew Cross 16:02
Yeah, and tax planning, estate planning, these are for different purposes, like I said, the judges the decider, but you can see very, very different values based on the market, you know, the most probable selling price and, and what the tax or estate planning situation is, because, and these are gray areas, you know, so, you know, this is much more of a legal side of it. And, you know, you have to be able to get by the judge in cases, or the audit. Yep, looking at a tax related stuff, why not?
Damon Pistulka 16:36
This is a good point to Andrew to talk about, if you’re going to get evaluation for IRS or estate planning, or even one of the other ones that we have here that require IRS type involvement, don’t screw around and go for the cheap price, get somebody that the certified valuation person that’s got the got the designation and the and the insurance and everything else, that if you get taken to task on that valuation with by the IRS, that you can defend it in court, and they’re going to be able to stand up to the numbers.
Andrew Cross 17:09
Well, that’s really what it’s for. I mean, you’re there to back up and validate, you know, I, you know, obviously in these situations, too, you’re looking for less value.
Damon Pistulka 17:19
Yeah. And Mark, Mark brings up a good point, he said, Yes, divorce is a situation where you’re going to do valuations, and we’re gonna
Andrew Cross 17:27
we’re gonna get there. Yeah, we’re gonna get there as well. That’s That’s it. That’s for disputes, you know, the legal side. Yeah. And your valuations, then this one, were a little out of order. But for all one, you know, stock options. This is, so there’s legal requirements. Yeah, this is one of them. stock options, you know, if you give your employees instead of you give them stock for incentives and stuff like that, this is just a legal requirement every year, you know, evaluation needs to be done that so that, you know, that’s really to protect the employees,
Damon Pistulka 18:03
yeah. employees and make sure that you’re doing what you should be because you’ve designated that, again, this is an IRS kind of thing. They’re, they’re requiring that. The other thing, you got to pay tax on it. Yeah, yeah, pay tax on and stuff. So it’s got it, it’s got to be in there, right. And the eighth up is, is another example of where valuation is used extensively. And it requires not only valuation at the beginning, so when these buys a company, they’re buying it for the appropriate price, but doesn’t it isn’t it required annually, then beyond that
Andrew Cross 18:36
to it is I mean, basically, these are, these are sort of regulations that are coming in, that are big companies do this all every day, every quarter, they have to, they have to do their submissions, they have to go through audits and that kind of stuff, but it’s to protect their shareholders. And so this is now trickling down into the small businesses were using Aesop’s because, you know, you got 100 employees were now the owners of the company.
They’re vulnerable. So yeah, the government wants to know, if you’re selling them a company for that amount of, you know, money. And basically you’re not, you know, in an Aesop situation, you’re not getting paid by their employees, they earn that out over years. They want to know they do a valuation every year to make sure that that your shareholders aren’t getting screwed. Yep, yep.
Damon Pistulka 19:22
Yeah, good stuff. And Jeff Graham brought up the triple D. Death delusion and what’s the last of divorce? Yeah, yeah.
Andrew Cross 19:32
afford these death divorce. declining sales and dissolution. There you go. So that’s four ways to get out of a business.
Damon Pistulka 19:41
Yeah, and I did I did have these out of order. We talked about legal proceedings, two divorces, the divorces man that is one that I’ve there’s actually people that believe it or not have that’s what their valuation practices revolve around is divorce valuation. So kind of
Andrew Cross 19:57
in those those situations, both sides are going to have valuations coming. Yeah, yeah, nice already know what you did on the solid, your evaluator that has to come and stand up and back up, you know, through their experience and their resume. And we do valuations, you know, because you know, and I always go back, you can you can get people, you can get CPA firms and those kind of stuff to do valuations and such, too.
But I really think, you know, our benefit to that is we actually are involved in the transactions, and it goes back to, you really don’t know what a company’s worth until, you know, it changes hands. Yeah. And a lot of experience doing that, in doing evaluations is just a critical path. But, but you know, you’re going to go in here and one side is going to be high and one side is going to be low. And, and then, you know, it’s all back to the decider. Yeah,
Damon Pistulka 20:48
and this is where, again, in legal proceedings, you’re you brought up a great point, there will be two valuations. And listen, if it’s worse than nificant money, if you lose, it’s well worth it to put the time in and get a more thorough evaluation from someone that’s going to be able to stand up in court. And, you know, you win that way.
Andrew Cross 21:10
And let’s, let’s go back to most probable selling price, we’re probably and when I do that we use probably for three or four different methodologies. And I will evaluate them based on the information received from the seller and about the business and everything we do, we kind of weigh those methodologies appropriately. Some of them can be weighed actually, equally, but some of them are heavily weighed towards one methodology. But in evaluation for a legal proceeding like this that’s fully certified, we’re probably using up to 25 different valuation methodologies. Yeah, and I’ll go through that a little bit. Yeah,
Damon Pistulka 21:45
we’re gonna go through some of those. So we got a couple questions here that I do want to address. Because Khan brought up a really great question. And, and first of all, hello, Khan, great to hear from you, and everyone else, but he said, How does evaluation differ for a business like a consulting or training practice? That has few physical assets? Where the owner is the brand compared to what’s mucking about?
Andrew Cross 22:10
That’s a great question. Yeah, it’s a great question. And, you know, yes, there again, you see, I think this is somebody who’s got a consulting business and doesn’t really understand that there is value there. Right. So consulting business practices, you know, you know, these are cash flowing businesses, though. Yep.
And, you know, the historical cashflow, you know, is the basis for the value and then, you know, obviously, you buy you buy a company because you want to come in because it’s been cash flowing and making money for the last 10 years. And I expect that to continue. And I’m going to I’m going to participate in at help pay for that business when I when I pay for it, and pay for the debt service on it and then I’m going to own that asset at the end within a reasonable amount of time. That’s where you kind of get into that value.
You don’t need physical assets and Yeah, well, physical assets is I think a common misconception is that people think I have a factory with you know, $10 million worth of equipment, the best machines a state of the art, my company must be very valuable. But when we look at the income statement, they’ve been, you know, losing money for the last year. So guess what, guess what the company’s worth does this but it is worth the assets Yeah, it’s worth the asset, worth 50 cents on the dollar you know, but you know, a, you know, these are goodwill kind of businesses and when the owner is the brand, you know, we’re going to talk about that,
because that is a common thing that we have to deal with, when we’re selling that and it’s, it’s things that people should really think ahead when they go and starting a business, slapping your name on the business, you know, can cause some difficulties. When you get down to that it’s time to move the business and stuff like that, it’s not impossible to sell it but you you know, if you are the brand, or you are heavily involved in the business, there’s a lot of tribal knowledge, you can come to us and talk about how we can help you extract yourself from it. And you know, and you can significantly increase your value but it’s definitely a negative and it’s a risk when the owner is involved
Damon Pistulka 24:29
it what it does is it makes it more difficult to get the actual value. So the and we’re going to talk about Mark just asked a question when the owner is the brand How do you determine what To what extent cash flow is dependent on the owner? Well, we’re going to talk about that in a little bit. So we’re gonna go,
Andrew Cross 24:47
you know what I can give a great example for this. I like to use this because you know, when you’re involved with dental practices, and practices, there’s really a lot of assets that probably lease a building and other than equipment but they’re all goodwill Many people go to their dentist because they no longer they’ve been going to them for years so when you do that transaction you know the only value you’re getting from the company is all those people that come and get their teeth done but when they are in the banks to our you know,
will they fund this but when you know a new guy comes in and you add 100 you know clients before they just switched dentists I don’t want to be with this guy you know how many are we going to lose you know that’s the whole thing and so you know, there’s techniques you can use doesn’t make the business devalue but it makes it trickier to exit and typically how they do that is they bring in their buyers in you know, as partners and then you know, eventually there’s a transition out and also you know, a good portion of the price and the value is held until there’s a time has passed in which we can see how much the customer attrition there is. Yeah, just a good example
Damon Pistulka 26:01
a great example because it does typically draw out the time that you’re going to get paid the total amount for your business if you’re involved in it heavily or it makes it more difficult to sell. Now Kahn asked the question how can existing contracts mshs and client lists impact value?
I’ll answer that real real briefly the existing contracts if you got contracts that someone can step into and continue on that is the the gold standard for that kind of stuff if you’ve got longer term two year contract with somebody and you know what you’re going to get paid for that that is awesome if you’ve got Msh and and you can you can show that hey, every year this MSA is produced this I’ve got it for three more years. That’s another great example of what you can do
for it so recurring revenue is
Damon Pistulka 26:52
great there you go recurring revenue, that’s why adder is good, the recurring
Andrew Cross 26:56
that is you know, that’s very valuable. buyers are looking for that and evaluators are looking at however one of the challenges of selling a business and one of the major contingencies that will buyer is that are they transferable and so again that’s another thing you can do understanding it value is you know, but when you negotiate those contracts and that kind of stuff to just you know last question when when you’re when your customer said say hey what if I What if I had to transfer this business or what if I sell you know i’m not saying that you are and I’m not saying I am but it’s good to know and maybe even you can negotiate in a clause there that those are assumable contracts to a buyer
Damon Pistulka 27:37
that’s a great point because we’ve got bitten in transactions before where were you you know like big company here like with us with aerospace companies you really have to do look at that because the big companies like Boeing will make you get approval to sell your company to in that contract they’ll say you can’t do it without getting that approval so that’s a great point Andrew and con on those kinds of things if you can if you can build those in where they’re assumable by the new owners without approval that’s the best so we’re going to continue on so there there’s a lot of other special valuation uses So Andrew just this off the top of your head name a few of the other ones that are that you run into?
Andrew Cross 28:18
Um, well uh let’s see where where are we going here
Damon Pistulka 28:22
about your uses of evaluations because so there’s like, there there’s like the ones and I don’t have the the details of this page but they’re, they’re just a litany of, of the different kinds of valuations that you’re going to need when you have when you have a management buy outs so you got two partners partner dissolutions where you’ve got to have two partners want to get out there it really those situations we’ve really seen that’s that’s very unique, because if you’re doing an inside sale only to other people in the company, there’s a discount that’s associated with the value because you can’t sell it outside there.
There’s just a lot of different ones where you run into them where someone like Andrew that’s doing the valuation or other valuators they really need to consider that because just like whether I’m looking at it for taxes or selling a business, they’re different, it’ll be different in those situations as well.
Andrew Cross 29:15
It may sort of fall into that legal entity, but you know, the other uses are, you know, playing you know, loans, yes, loans applying even even for personal loans funding your business. Obviously the banks are in a lot of cases are requiring these SBA loans require Yeah, they’re not very detailed loans. But yeah,
Damon Pistulka 29:36
I had that. Yep. You know, and, and then just the fair market value opinion and those kinds of things are used for a myriad of things like we talked about as well. So So this is where this is where I really gets interesting now because people talked about this and the fair market value of the business IRS actually has a definition for this, Andrew, it talks about the premise of value. It’s the first statement of evaluation. I don’t think anybody really reads it.
Andrew Cross 30:07
If you do have it there. I mean, I know it, but I don’t have it memorized.
Damon Pistulka 30:11
I don’t I can’t see the notes in this, but it’s the one that talks about the willing buyer and seller.
Andrew Cross 30:17
Yeah, I should, I should memorize it. But yeah, it’s a win a, a, a with business premise, fair market value, the definition of it is the legal definition of is when is a business’s willing to change hands between a buyer and seller when the buyer is not compelled to do so? I think that’s sort of a Yep, recreated version of that, too. And that’s very carefully worded legally, but it is very true. I mean, you don’t have to buy the business. That’s where the market, that’s the supply and demand factors, but it is an awfully strange market, rather than supply and demand where you could kind of get an A sort of an auction type of thing and a typical economic cycle.
But you know, at a certain point, you know, business transactions have to make, they have to make economic sense. Yeah. Which they do. But they also, you know, so you, but you can also get irrational pricing options all the time, especially in the tech space. Yeah. You know, and that’s probably the one everybody understands is most common. Or in startups, yeah, we’re, you know, we’re, they’re really focused the value and the transactions based on future value. Yeah. So as we go through, we go through some of the assumptions on the premise of value here. And what I think we’ll just go through a bit, yeah, we’ll
Damon Pistulka 31:38
go through some of those. Right, so one thing that I wanted to bring up with this slide is, just because your valuation says your business is worth $100 million, it doesn’t mean that you can find someone that will pay 100 million. That’s exactly the only reason why I put this slide in here, because you can have a tremendously profitable business that no one will give you near the value for B got a lot of other things,
Andrew Cross 32:07
said I think too, I mean it you know, people can look at that, too. So I mean, Amazon is one of the, you know, most valuable companies in the world. And but they aren’t making near the cash that some of their peers are making in the fortune 500, you know, and it’s been like that for years, they, you know, they’re not a cash cow. But everybody understands their value. There is more in the future, and it’s dominating that market. And they London, basically unlimited potential. So yeah, that’s an interesting aspect of value, though. So yep,
Damon Pistulka 32:40
it is just because it’s worth something doesn’t mean you’ll get it. And that’s, that’s why we did that. So when we look at the valuation methods in themselves, and you know, a valuation is typically a combination of methods that come up with different numbers that are blended correct, Andrew?
Andrew Cross 32:56
Correct. Yeah, we talked about those methodologies, right. So when we’re doing most probable selling price, like I might use four or five of the ones that are most relevant. And they all fall under three different categories, the asset approach, the income approach? Well, I’ve been under two major, the asset approach and the income approach and all the other methodologies kind of fall either into one of the other. Yeah,
Damon Pistulka 33:21
so explain the asset approach and why we do the asset approach, method use that acid approach method in a valuation Andrew?
Andrew Cross 33:30
Well, um, the asset approach, you know, as it suggests, you know, is looking at the, the assets of the business, including the goodwill and that kind of stuff, whereas the income approach is, you know, looking at, you know, that it’s really about the numbers, the gender, the The, the, you know, the ability in the historical revenue stream that’s created, which is basically the underlying value of the business. And then the real kicker is the future. potential revenue of the company.
Damon Pistulka 34:03
Yeah. So the acid approach to is that’s you use that in a valuation, though, is basically just set the liquidation value, correct?
Andrew Cross 34:12
Yeah. That way is always a starting point. Yeah. liquidation value orderly liquidation value is something we need to do in a business valuation. You know, even though we may not weigh it in the value, because yes, you know, liquidation value is just a if I shut down today and sold it off, it’s not being sold on the market. And what would it be worth in, in the case of what Kahn was talking about, that’s going to be very low, because you’re just selling off physical assets. And if you don’t have them, that’s fine. But you know, and the reason we need to do this too, because the business may be worth more being liquidated than it is on the market.
To sell it the market size, the revenue stream or the profitability, or the potential profitability of the company. And in a good really good example of this is that people see it all the time is furniture, retailers, who have a lot of assets, they may have warehouses full of furniture that you can put a number on. And in this, we know, that’s a tough, that’s a highly competitive business, they have, they have a lot of overhead, they have facilities all over the place, and now you’re losing money.
So they’re losing money on the market value, they’re worth, you know, they’re only making you know, if they’re doing 20 million in sales and making 100,000 a year. And so that’s a 7x, they may be only worth a million dollars, but they have 15 million in inventory. So there that’s, that’s where that trigger switches. And it’s a we don’t say that, in that case, it makes more sense to liquidate. And that’s when you have liquidation sales that’s how that’s how you exit those businesses or orderly liquidation. So no,
Damon Pistulka 36:00
that’s awesome. That’s an awesome example Andrew, because that’s a that’s a great thing where the asset, the asset approach gives you a better the value really should use because and we’re going to talk about the income approach and some of the things there there’s there’s a bunch of different methods under the income approach, but generally give us the idea of, of what we’re going to use with the income approach.
Andrew Cross 36:24
So um, you know, they’re looking at it, historical income, and over the years, usually on an annual basis, and you know, you’re going to, you’re going to develop multiples of this, and that’s where your value comes from. So in most probable selling price, I’m looking at that as a basis from the buyer, you know, what perspective he has you go into that business that, yeah, it’s been making, you know, it’s been making four or 500,000 a year consistently over the last five years, and then we’re gonna come to a multiple of that make that assumption.
Yeah. And what’s different here is, this is a numbers, you know, approach as opposed to the market approach the market, you know, it’s going to look here, at the market approach, they’re going to look at your business and how it’s done up into this point. Yeah, the income approach is going to look forward. Okay.
So, you know, you’re going to get more value off of it, if you have been growing on a consistent basis, you know, save 20% year over year, because then you can project that future income into the future. And then you would say, Okay, what will I pay for this? It’s growing at 20%? If we assume that happens for five more years, what do I pay for it today? And then we discount that back? Yeah, for the buyers will do that, which will give you sometimes a higher number than just where it is today, based on what it’s done in the past.
Damon Pistulka 37:49
Yeah, that’s a great point. And that whole discount rate calculation takes it it takes someone that’s done the valuations as understands, can can figure in the risk of your industry, your business and everything else to do that, but it is valuable, because if your your company is growing, you can actually you value will, will typically value higher. So great point. So you just talked about it a bit, too. So and we’ve got two slides on the market approach, because this is such a great indicator. So Andrew, talk a bit about the market approach to valuing the business.
Andrew Cross 38:26
Well, what a buyer would be willing to pay, you know, and this is the one that’s most relevant to us. You know, it’s we’re involved in a transaction and healthier client. And the best way we can do this is really understand what the market will bear. And with that, what you need data. Right here,
Damon Pistulka 38:45
this is an example of the kind of data that we get is, is you get market comps you’re looking at, you’re looking at the sizes, and this is detailed data that you can get as a as evaluation person, you can pay the subscription rates and get the detailed data. It’s not it’s not waving a wand. I mean, they’re this look at how they’ve used statistics to give you the percentiles the medians, all the kind of stuff on this data on private transactions. Yeah, go ahead.
Andrew Cross 39:18
And this is this is hard to get this is the hard part. I mean, you can get these it’s the the formulas and the numbers that they’re generating and all that kind of stuff are, are coming on are the same ones that they use for publicly traded companies and everything else. But where where do you get this information from? Well, every time I do a transaction, I belong to these organizations. So brokers investment bankers have been submitting this data for years and they go out and do the research.
But as you can see in here, we’ve we’ve narrowed this down into a certain type of business. And we do zeroed in on the certain size range of the business. When and so there was nine comps here nine transactions that we can look at a very similar we can go into even more detail than this.
But you know, by entering in the balance sheets and the terms of the deal at closing, you know we can analyze this is just valuable, you know really clutch information for really understanding because I mean I think everybody to understands I’m selling my house because my neighbor’s house last year sold for that, and that one up the street sold for that, and we’re about the same size and same shape. So it does sort of help us, you know, get in that ballpark. Although you will see that you have to really look at this closely. Because this is an apples and oranges. Business is
Damon Pistulka 40:40
a different it is and you have to look at it carefully. But this really allows you to see what the markets doing on a business. And that’s where a rule of thumb approach just does not give you enough detail to really go, okay, because this is where I always say if someone walks into your business today, and you get two numbers, and they get two numbers from you, they say, okay, you’re about this big in revenue and this much in profitability, and they tell you with certainty, that’s what your business is worth, they haven’t looked into it.
Andrew Cross 41:08
yet. This happens. Also, this happens all the time. I mean, when I see this with clients, my competitor, or I’ve been, you know, Jim, up the road, you know, we’re both in manufacturing, we’re both doing about 20 million a year, he just sold his company for $50 million. Therefore, my company must be worth about $50 million. But if we looked at Jim’s company, he was $50 million, with 5 million in profit and own the real estate, then was leasing it back to you know, himself and the other guy down the street and go Come to me go I want 50 million for my company, but he’s making 500,000 rents his space bed still as top line of $50 million. So what do we think it’s worth, right?
Damon Pistulka 41:59
Yeah, there’s not as much not as much You know, there could be technology, there could be IP, there’s all kinds of things that that affects us to beyond the numbers here as well. So let’s let’s quick roll into this because we’re getting or, again, we’re getting near the end, but these business risk adjustments so this is something that contact about earlier, we know if the owners the business and other things like this Now, when you’re doing a an in depth valuation, the business risk adjustment, talks, to talks to many things.
And yeah, I did put this in there on purpose mark, because it will literally blow up a deal like this or or sabotage your your chances to get that value. Like we said, you can have $100 million company. And and we have an example we have somebody a couple years ago, their business was worth, you know, 30 40 million, they were getting offers at 1512 to 15. And it was because of these risks. So in real world things that will affect your value. And and the first one is is management depth. So talk about this a little bit, Andrew and and how you can adjust this or how this affects the evaluation.
Andrew Cross 43:12
I think to this, this goes back to cons question as well, when the owner is heavily involved in the business. I mean, it’s one thing to be branding it with your name. But if you’re there and you know you’re working, you’re still you know, even at 65 years old, you’re near retirement, you’re still working 70 hours a week, you know, that’s a risk management depth, you know, professional management, think about the buyer, the buyers coming in, they’re really investors.
And a lot of the better buyers, the ones who paid more money are our investor buyers, not necessarily they’re, they’re not buying a job, they’re not coming to buy into working 80 hours a week because nobody wants to do that. They want to use their money because they’re paying investing and they want to see that money work. And that personnel, the key personnel are, these are not risk factors. They can be risk factors, but they can also be assets.
Damon Pistulka 44:07
Now are too important to the success of the business. If you have one person, that’s the reason why and this is an owner or an employee. If you have one person, that’s the key, and they hold some knowledge that you just can’t find someplace else, this will this will negatively affect your business. If
Andrew Cross 44:25
these are all factors that are you know, these are common in small business, small medium businesses, tribal knowledge, things not written down, no set processes, it’s in the owners head or it’s in the key employees heads. You know, those are the things that will drive value down or datas book, they spook buyers. So you know that you know that’s that’s where you’re at with that. Yeah,
Damon Pistulka 44:50
and and we talked about this before and I’m gonna address the question mark as well. I hit the wrong button. Oh, well, we’re gonna have to get off at nine the The How do you assess it it is it is a matter of doing the in depth in interviews with the businesses to understand how they run, that’s how you do this mark. And there’s a whole matrix that you use to be able to do this. So again, what
Andrew Cross 45:15
you do is how do you assess it is the same way a buyer would, yep, burning so I’m going to make an offer on your company, that’s all good because we we set all this, we said you had a great management team. You know, we said, you know, nice, all these great assets that you’re buying with the business, they make an offer, but then you get into diligence. So that’s, you know, we did this aspect the same way the buyer does they go, they have their legal review, they Financial Review, they interview all the employees, you know, that you got to get by that all those landmines in order to get a deal done. So we do it the same way. And then we put value
Damon Pistulka 45:51
on it. Yep, that’s where the industry its ability obviously plays in like we talked about customer supplier product diversity, if you’re too concentrated in one product, one customer one supplier that’s going to help help or hurt you, depending on what you’re doing, you want to diverse on those things. And then really, as it showed up there in our in our market approaches, what’s your net profit ratio compared to others in the industry, that’s going to be another big if you’re lower or higher, it’s going to really negatively or positively affect you from the others in the industry.
Andrew Cross 46:27
A big portion of that, too, is benchmarking, ya know, another, you know, factor that we do in and I think that, that’s, that’s right there, you can do this, you can benchmark your business against the industry. And why do you want to do that? Because the buyers are going to do it valuators do it all the time.
Hey, you know, uh, you know, you know, what is our net income, revenue, percentage margins benchmarking is you can look at your peers, companies similar size, you can get a whole bunch of metrics to see where you’re out of line with the industry or you’re ahead of the industry, which we would emphasize those and selling the business the most cases and, and it will help you make decisions to on how you need to restructure your business and your strategy to, to get back within the benchmarks. Because if they identify something that’s out of whack in a benchmark study, that’s a risk, ya know, that buyers gonna, that’s gonna spook a buyer as well.
Damon Pistulka 47:27
Yep. And it’s great benchmarking is a great thing. And that was that was the end of our slides. And what I’m gonna do is I’m gonna quit sharing my screen right now. And I want to talk about a couple things real quickly here that, that I think that we might shut this down real quick, and chatter presentation down so I can actually see what’s going on live, then I want to thank First of all, that thanks for for Jennifer Gordon, for commenting on LinkedIn.
But a couple things Andrew that I wanted to cover, before we finish, I want to at 855, I want us to stop presenting go back to the tables for at least a few minutes. But it’s really important if if you talk about benchmarking, if someone gets gets a good value of their business early, and they track this, like the financials, like their monthly financials, this is one thing that we’ve really seen is beneficial for, for our clients in what we do. And actually when you’re going, Hey, I want I’m at 5 million, I want to be worth 10 million. Explain how you’ve seen that help companies just the use of the proactive use of valuation? Hmm,
Andrew Cross 48:41
yeah, um, you know, I mean, benchmarking is an aspect of it too, and everything else but you know, it’s gonna, if you’re running if your labor and I think we just went through a company that did this, too, that paid a lot of bonus out to their employees really, really good to their employees. But when it when you circle back and looked at their profitability, percentage over their peers was way lower. This is a technical engineering company.
You know, solving one problem was labor problem. I mean, they kept labor and they had long tenured employees and loyal employees, but their you know, their percentage margin is way down identifies a problem in the costs and, you know, buyer, would you be willing to take that on, you know, if he’s paying 20% over market, on his labor, those are the but that’s the thought process they have, right? So you gotta, you got to think about that. When you make those business decisions, right? It’s all good to want to share your company, but at the end of the day, it affects your asset. retirement.
Damon Pistulka 49:47
I think you said one thing there that that I’ve really seen it help business owners with is when you’re looking at your monthly financials, and you go, Okay, I made 100,000 1,000,010 million this month, whatever the Income numbers and you look at the line below it and when we help them and that’s the value, what am I value do this month, based on my last 12 months, this is where we really get, your mindset begins to change.
And I see Troy’s on here today, which is awesome, because Troy gets, just gets to help owners after they, they’ve exited and managed as well. And you really that number, if that number is not big enough to make the owner happy, and Troy says, hey, you’re going to be good after this, that really helps him to, to to get from, I’m enamored with the fact that I’m making a million dollars a month to, I know this is going to be given me the value I need or not. And the long term,
Andrew Cross 50:41
I think that number if you’re looking at that value, and that’s sort of a point in time, but if they if you really start to understand that number and see how it moves, you can have a big impact on it. And Troy will tell you to and when it’s time to cash out that most probable So likewise, how, how we’re going to use that money in a different way so that you’re not living off of business anymore. Yep.
Damon Pistulka 51:06
Yep, good stuff. Well, it’s getting close to the top of the hour. And you know, as we said before, we are stopping this thing at 9am our time because we want everyone to be able to get back to work. So we’re dropping off LinkedIn live here right now. And then we are going to go back to the tables for a couple minutes a conversation, and then everybody’s back out to kick it for the day.