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OPERATING PROCEDURE Page 1 of 10 IPA PROJECT # SUBJECT: BUSINESS VALUATION 1.0 INTRODUCTION 1.1 The purpose of this Standard Procedure is to introduce the ownership of your company to a method of determining the value of your business. With few exceptions, the business is the most valuable asset you have. Most business people who own a small business want to know how much the business is worth even if it is not for sale at the present time. It is wise to start planning for succession long before you need to transfer ownership, whether to the next generation, to another company or owner. 1.2 The basic approach of this evaluation method is similar to that used by some professional appraisers of small businesses. It assumes that a business is worth the value of its assets, plus a premium for goodwill when the earnings are sufficiently high. What is unique about this method, is that it establishes a precise format for the redefinition of earnings as well as a discipline, through the use of a detailed form, so that the method can be followed by anyone familiar with basic business accounting. 2.0 THE SEVEN BASIC STEPS 2.1 The seven steps involved are as follows: 2.1.1 Determine the Business’ real “Earning Power;” 2.2.2 Determine the tangible “Asset Value;” 2.2.3 Determine the “Cost of Money;” 2.2.4 Determine “Excess Earnings” of the business; 2.2.5 Calculate a “Multiple” for excess earnings; 2.2.6 Calculate the “Value” of the excess earnings; to 2.2.7 Determine the “Total Business Value.” OPERATING PROCEDURE Page 2 of 10 IPA PROJECT # SUBJECT: BUSINESS VALUATION 3.0 CALCULATION OF THE BUSINESS VALUE: 3.1 Real Earning Power - Calculate the “real earning power” of the business by preparing a stabilized (real earning power of the business over a 12-month period beginning on the date of valuation) income statement. 3.1.1 Real earning power is defined as what you think earnings will be over a twelve-month period beginning on the date of valuation. Do not simply estimate your entries that may have been distorted by such factors as accounting techniques used or the non-recurring circumstances that have affected earnings. 3.1.2 This stabilized or adjusted earnings figure cannot be based on wishful thinking or used to disguise basic problems in a business. 3.1.3 This statement of real earnings power must be scrutinized carefully in the event of an actual sale or transfer, and is best if all the assumptions used to adjust income and expenses are stated in writing in the evaluation. 3.1.4 Chart B-100-1 shows a summary of reported earnings for a fictional company along side the stabilized earnings. 188.8.131.52 At the bottom of the chart are notes that explain why adjustments were made (these may at times be supported by other documentation for clarification when necessary). 184.108.40.206 Adjustments include: 1) Replacing owner’s salary, with an owner’s salary based on what it would cost to hire a manager to replace them; 2) Depreciation expense, an item that is often misleading, is replaced with an expense called “replacement fund.” (Think of this as a sinking fund to build savings to provide for normal replacement as equipment wears out.); 3) The stabilized earnings, do not reflect interest expense, since interest expense can fluctuate according to the loan structure and special circumstances of the owner. Instead, at a later stage, the term “cost of money” will be defined and used. OPERATING PROCEDURE Page 3 of 10 IPA PROJECT # SUBJECT: BUSINESS VALUATION 3.2 Asset Valuation - To calculate the value of tangible assets properly, a well-qualified appraiser may be needed. 3.2.1 This appraisal will cover the value of land, buildings, inventory, furnishings and equipment of all types needed to conduct business. 3.2.2 Chart B-100-2 summarizes the value of tangible assets of your fictional company. 3.3 Cost of Money - The term, as used here, is a specialized term defining the annual investment cost of owning tangible assets of the business. It is a substitute for interest expense. 3.3.1 The rate used may differ from the current prime rate to the actual rate paid depending on the circumstances. If you were to base the valuation on the prime rate, it would lead to a situation where business values went up and down as wildly as the prime rate does, and the business “market value” just does not work that way. 3.3.2 Therefore, use a figure that is more stable and somewhat lower than the prevailing interest rates. This is the underlying interest rate. 3.3.3 To keep it simple, a rate about four points above the inflation rate is generally used in these instances. In the illustration, 12% is being used. ***NOTE: The cost of money only applies to the tangible assets of the business, as calculated in Step 2. (Chart B-100-3 shows this calculation for the fictitious company.) 3.4 Excess Earnings Calculation - The excess earnings represents how much the business can be expected to earn after the cost of money is deducted from the stabilized earnings. 3.4.1 Excess Earnings is a simple calculation shown on Chart B-100-4. 3.5 Excess Earnings Multiple - The excess earnings multiple must be appropriate for the business. 3.5.1 Excess Earnings Multiple will be used in the following step to determine the value to place on the excess earnings calculated above. OPERATING PROCEDURE Page 4 of 10 IPA PROJECT # SUBJECT: BUSINESS VALUATION 3.5.2 This multiple reflects the risk, stability, and other factors inherent in the business. 3.5.3 Chart B-100-5 is the tool to be used to arrive at the correct “Excess Earnings Multiple” for the business. 3.5.4 Chart B-100-6 shows the use of the “Excess Earnings Multiple.” 3.6 Total Business Value - The total business value is determined by adding the “Value” assets to “excess” earnings. 3.6.1 Chart B-100-7 shows the calculation for “Total Business Value.” 4.0 CONCLUSION 4.1 The steps above, if followed carefully, offer a common sense approach to determining the value of any business. 4.2 Estimating the business value quantitatively determines that a business may be worth the market value of the assets that are necessary to conduct business, plus a premium if the business is profitable. 4.3 Upon closer examination it may be observed the methodology used to determine the premium to be paid for earnings is quite conservatively calculated. 4.3.1 In the example used, a multiple of 3.9 was calculated. This means that if the business sold at the same price as the valuation suggests, the purchaser will receive a return on investment of 25.6% on the portion of the purchase price not backed up by tangible assets (payback in 3.9 years equals an annual return of 25.6%, $121,680 divided by 3.9 = 31,200, 31,200 divided by 121,680 = 25.6%). 4.3.2 There may be a situation that a current business has no excess earnings. In such a case, the business is only worth the value of the tangible assets. 4.3.3 In fact, some businesses have negative earnings, which means they are not even worth the value of the assets. OPERATING PROCEDURE Page 5 of 10 IPA PROJECT # SUBJECT: BUSINESS VALUATION TABLE OF CHARTS Chart B-100-1 Stabilized Income Statement Actual % Stabilized (12 months) % 1996 1996 Sales of (1) $650,000 100.0 $700,000 100.0 Cost of Goods (2) <197,600> 30.4 <212,800> 30.4 Direct Labor (2) <187,000> 28.8 <201,600> 28.8 Gross Profit 265,400 40.8 285,600 40.8 Sales Expense* < 86,750> 13.3 <92,400> 13.2 Admin Expense* < 52,650> 8.1 <42,000> 6.0 Executive Salaries (3) < 40,000> 6.2 <49,000> 7.0 Replacement (Deprec) (4) < 11,700> 1.8 <21,000> 3.0 Maintenance & Repair* < 5,200> 0.8 < 7,000> 1.0 Misc.* < 5,200> 0.8 < 7,000> 1.0 Total Overhead Exp. <201,500> 31.0 <218,400> 31.2 Assumptions: 1 - Sales will increase at inflation rate of 7.7% 2 - Cost of Goods and direct labor will remain at constant % 3 - Executive salary should be increased by $9,000 to reflect current salaries offered in comparable businesses. 4 - Replacement fund of $21,000 will be submitted for depreciation expense. This is ample to replace assets as they wear out. * - Minor adjustments were made through a detailed analysis of each line item or expense and reflect best estimates. OPERATING PROCEDURE Page 6 of 10 IPA PROJECT # SUBJECT: BUSINESS VALUATION Chart B-100-2 Value of Tangible Assets Land $ 20,000 Buildings 120,000 Inventory 60,000 Equipment 60,000 Working Capital 40,000 Total Tangible Assets $ 300,000 Chart B-100-3 Cost of Money Value of Tangible Assets $300,000 “Underlying” Interest Rate 12% Cost of Money $ 36,000 Chart B-100-4 Excess Earnings Stabilized Earnings (from Chart B-100-1) $ 67,200 Cost of Money (from Chart B-100-3) <36,000> Excess Earnings $ 31,200 OPERATING PROCEDURE Page 7 of 10 IPA PROJECT # SUBJECT: BUSINESS VALUATION Chart B-100-5 Rating Formula (showing values for the example - see Chart B-100-8 for details) Risk 4.0 Competitive Situation 3.0 The Industry 3.5 The Company 5.0 Company growth 4.0 Desirability 4.0 Total 23.5 Excess Earnings Multiple (Total/6) = 3.9 Chart B-100-6 Valuing Excess Earnings Gross Earnings (from Chart B-100-4) $31,200 Multiple (from Chart B-100-5) 3.9 Value of Excess Earnings $ 121,680 Chart B-100-7 Total Business Value Value of Assets (from Chart B-100-2)* $ 264,000 Value of Excess Earnings (from Chart B-100-6) 121,680 Total Business Value = $ 391,920 *Note that the $40,000 used in chart B-100-2 for required working capital has not been included here. A new owner will have this amount available in addition to the purchase price. OPERATING PROCEDURE Page 8 of 10 IPA PROJECT # SUBJECT: BUSINESS VALUATION Chart B-100-8 Calculating the Multiple (key to rating scale) RISK RATING: 0-6 0 = Continuity of income at risk 3 = Steady income likely 6 = Growing income assured COMPETITIVE RATING: 0-6 0 = High competitive in unstable market 3 = Normal competitive conditions 6 = Little competition in market, high cost of entry for new competition INDUSTRY RATING: 0-6 0 = Declining industry 3 = Industry growing somewhat faster than inflation 6 = Dynamic industry, rapid growth likely COMPANY RATING: 0-6 0 = Recent startup, not established 3 = Well established with satisfactory environment 6 = Long record of sound operation with outstanding reputation COMPANY GROWTH RATE: 0-6 0 = Business has been declining 3 = Steady growth, slightly faster than inflation rate 6 = Dynamic growth rate DESIRABILITY RATING: 0-6 0 = No status, rough or dirty work 3 = Respected business in satisfactory environment 6 = Challenging business in attractive environment OPERATING PROCEDURE Page 9 of 10 IPA PROJECT # SUBJECT: BUSINESS VALUATION RATING FORMULA Risk + Competitive Situation + The Industry + The Company + Company Growth + Desirability = Excess Earnings Multiple is the "Total"/6 FICTITIOUS COMPANY BUSINESS VALUE ESTIMATION A - Sales for the Next 12 Months $ B - Operating Expenses Including Cost of Sales and Direct Labor: C - Administrative Expenses (do not include owner's salary, depreciation or interest) D - Owner's Salary (what it would take to hire someone) E - Replacement Fund F - Stabilized Earnings G - Value of Assets Plus Necessary Working Capital 1 -Land 2 -Building 3 -Inventory 4 -Equipment 5 -Furnishings & Fixtures 6 -Other Tangible Assets 7 -Working Capital Required H - Total Assets & Working Capital I - Underlying Interest (current inflation rate + 4%) J - Cost of Money OPERATING PROCEDURE Page 10 of 10 IPA PROJECT # SUBJECT: BUSINESS VALUATION K - Excess Earnings (Stabilized Earnings - Cost of Money) L - Multiple (from Chart M-408) M - Value of excess Earnings: 1 -Reenter Excess Earnings 2 -Reenter Multiple 3 -Value (Line M1)(Line M2) N - Total Business Value : 1 -Reenter Asset Value 2 -Reenter Excess Earnings 3 - Business Value (N1 + N2) Note: If this figure is used by purchasers, they will have to provide any extra working capital to operate the business. The total business value as shown here includes inventory. This figure does not apply to stock purchase. The stock purchase value will be this figure (N-3) less total liabilities to be assumed. In addition, other adjustments may need to be made in the event of a stock sale if tax benefits are lost as a result by the buyer.
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