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Considerations For Valuing a Service Business
Written by: Keith HannaArticle Overview: A common problem occurs when an entrepreneur, who has been building a business for a period of time, decides to take on a new partner
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Free Download - Lag Time By Keith Hanna |
Considerations For Valuing a Service Business
A common problem occurs when an entrepreneur,
who has been building a business for a period of time, decides to take on a new
partner. What are the factors that determine the price that the new partner
buys into? What piece of the company is a fair piece?
In public companies, where the shares in the
company are traded on a stock exchange, the price of the shares reflects a
consensus value determined by the interest level of all parties aware of the
stock. If there are many shares trading hands on a frequent basis and the
company is publishing its progress and successes through the press and the
public is paying attention and the company is generating earnings, the price of
the shares is a multiple of these earnings (say a multiple of ten times
earnings). The public believes that the stream of earnings from the operations
of the company will likely increase through time and they collectively reward
the company with a high future value that it trades on.
In private companies, there are many
difficulties. First the shares are not as liquid: someone who buys shares
cannot easily sell them. Private companies pay back the investors only through
dividend income or when the company goes public itself or is bought by another
company in the space. With a growing company that is constantly cash-hungry,
income that could go to dividends has to go back into growing the company. The
other exit strategies of going public or merging with or selling to another
company is a risky and difficult proposition.
In the case of a founding entrepreneur
bringing on another partner, these issues are less of a consideration. Someone
who is considering entering a business as a partner is there to contribute
their talents and skills to the growth of the business and share ownership is a
way to acknowledge this investment and compensate a partner from drawing less than
their market value out of the business while it grows.
There is a natural conflict that exists
between the founding partner(s) and the new partner(s). The founders have
invested their time (sweat equity), cash and other assets to get the venture to
its current level of success. The rationale of bringing on a new partner is
this: the business will be more successful and will be worth more through the
combined efforts of the original and new partners.
Private companies are typically bought and
sold using a number of valuation methods:
1.
multiple (1 to 4 times) of cashflow or EBITDA (earnings before interest,
taxes, depreciation and amortization)
2. multiple of sales (50% to 150% of trailing
revenue, as a moving average for 1 to 5 years of history)
3. the book values of hard assets (goodwill,
intellectual property, machinery and realestate)
4. discounted value of future cashflow (the
sum of 1 to 5 years of estimated EBITDA discounted for risk and uncertainty)
When a private company has not yet broken out
and realized the escalating value that the original partners believed it had,
sales and earnings may be low or negative (particularly if the founders are
taking draws or salaries that are lower than the market rates for the roles
that they are performing). Many service-based companies have no assets or
goodwill or intellectual property that is unproven. Looking forward into the
future, there are many risks and factors that positively and negatively affect
sales and EBITDA. These factors make the value of the company ambiguous and
easily contested.
The original founders tend to over-value the
company based on the immense sacrifices and investments of time, energy and
money they have made to get the business to its current state.
New partners tend to under-value the company
based on the future value of their contributions and the amount of financial
value that has not and might not materialize. Additionally the value of future
cashflow is based in part to the assumption that they will succeed in contributing
to the company: the company is less likely to become financially valuable if
they do not join the partnership. If this was not true, they would not be good
partner candidates in the first place.
Other factors to consider are the salaries of
the new partners, how much of a discount these salaries are from market rates
for their roles and any human, intellectual and financial capital they might
bring.
The way ultimately to frame these
negotiations is to arrive at a deal that is fair and that everyone can live
with, remembering that great partnerships have great synergy and that a team of
people can create much greater value together than apart.
Lesson #3 Know The Game Part I
Lesson #3 Know The Game Part II.
Making a Logical Bid or No-Bid Decision
Steps on How to Start a Business from Home
Buying An Existing Business Part VIII of IX
Article Tags: entrepreneur, new partner, service business
Referred by: http://www.infinity-pr.com
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About the Author: Keith Hanna RSS for Keith's articles - Visit Keith's website  Click here to visit Keith's website   Purity of Heart is to Will One Thing Indirect Contribution What High Level Enrepreneurs Think Great Coaching is About What Ice Climbing Has to do With Business Value is What Value Does |
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