Valuation Basics

When discussing valuation for a small business or professional practice, the first important concept to know and appreciate is that cash is king. Small businesses are purchased as investments and the buyer will want a return on their investment.

There are other factors that influence price but at the end of the day the cash flow that a business produces will be the main component in determining its fair market value. The reason that cash flow is so important is that it is cash flow that will service the debt on the business purchase, provide an income for the new owner, provide a return on the owner's investment, fuel expansion plans and justify the initial debt in the first place.

The major basis of the valuation is the discretionary cash flow since most "main street" businesses are bought and sold on a multiple of cash flow.

The multiple of discretionary cash flow method is best suited to businesses where the salary and perks of an owner represent a significant portion of the total benefits generated by the business and/or the business is typically run by an owner/manager. Buyers of small closely held businesses tend to think in terms of income to replace their previous paycheck or income to support their family.

They look at total discretionary cash flow to see if it is sufficient to pay all operating expenses of the business, carry the debt structure necessary to buy and/or operate the endeavor, and provide an adequate income.

The appraisal focuses on individual sales of comparable businesses in order to determine appropriate multiples of discretionary cash flows to be applied to the subject company. It includes a full trend analysis and adjustment of historical financial performance to determine the real available cash flow to a new owner. In determining the value of the business, all appropriate appraisal methods are considered. However, in most cases, the market comparable method is used as it is generally considered to be the most appropriate for valuing privately-held small business entities.

Most owners of small closely held companies work hard to minimize the profit they report in order to decrease their tax liability. On top of this, many owners tend to mix personal expenses with business expenses.

The end result is a bottom line profit that is usually significantly lower than the actual value of the benefits an owner gains from a business. In the world of business appraisal, greater discretionary cash flow translates directly into higher fair market value. Consequently, one of the main activities involved in business valuation is the adjusting of earnings or net income to accurately reflect the owner's real economic benefit.

To calculate the owner's discretionary cash flow, an appraiser takes net pre-tax profit and adds back a number of expenses. The most common of these include: