Art of Accounting: Telling a client the reality of their business’ value

A client told me that his business was worth $10 million and he wanted to know how much he would net if he sold it and how it could be invested to provide him with sufficient cash flow in his retirement.

I disagreed and gave him a “ballpark” number off the top of my head and got an angry retort telling me I did not know what I was talking about. Then the problems came.

My client started the business in his garage 27 years ago and now employs 35 people with annual sales of $10 million. He told me that his business is worth the amount of sales he has: “Don’t you know anything about how businesses are valued? Besides, it is growing and in a few years the business will be worth $12 million so it is a bargain at that price.”

There are many ways to value a business and many factors that go into determining the value. My job suddenly became trying to explain this to my client, and to do it in a way that did not upset him more than he already was, without lessening my credibility.

I tried to explain there are many different ways of valuing a private business but to simplify the discussion I would explain two basic ways. I told him that after we go over these, we can get further into values and then apply what we know to his specific company.

The first basic way is based on the earnings with a rate of return applied to the earnings to determine the value. An example is a business with earnings of $300,000 where the investor would want a 20% return. This would value the business at $1.5 million calculated like this: $300,000 ÷ 20%. If the investor wanted a 10% return, the business would be worth $3 million, and if he wanted a 25% return, it would be worth $1.2 million. Explaining this was not easy. Regardless of his or any owner’s attachment, the business is a business whose purpose is to provide an income either to an investor or someone who wants to work in the business and earn their living from it. An investor would want a greater investment return than someone who wants to create a job for themself. However, in either situation the basis for the value is its earnings. In most situations the value is not based on what it would cost to recreate the business, although that is usually the situation when someone starts a business from scratch.

I told the client to set this aside and to let me tell him the other way. And then we’ll get back to what we were talking about. 

The other method is when the buyer has their own motive for wanting to own the company, i.e., what it could do for their present business. That is called a strategic or synergistic buyer. An example is when Amazon.com acquired Pillpack for $1 billion. This instantly gave Amazon.com the ability to ship prescriptions to all 50 states. That $1 billion value was only the value to Amazon.com and likely not to anyone else since Pillpack’s sales were about $100 million with far less profits. Further Amazon.com’s market value increased $20 billion when the announcement was made. No one could consider what Amazon.com paid as a true measure of Pillpack’s value to anyone other than that single buyer. 

Getting back to my client, we discussed whether there might be any strategic value to a potential buyer and whether he could identify a potential situation that would make his company attractive to such a buyer. I also identified some of his business’s value drivers so he could see what might be done to increase its value. I told him to think about our conversation and we would discuss it at a later time.

I then explained that since income was a major factor, we needed to examine what that means. I explained the process of normalizing the earnings to what they would be if someone else owned and ran the business. One example I gave him was that if he had his brother-in-law working for him at a 50% higher salary than that position warranted, we would add that 50% amount back to the profits and get a higher earnings amount that we would work off of. We would do that with every expense item. 

I then suggested a starting capitalization rate, and we came up with a ballpark value for a future starting point for any discussions about the value. To further add salt to his wound, I then told him to expect to net about 60% of any selling price after paying selling costs and taxes. With these types of discussions, I find it much better to get all the negative things out of the way early on so the client knows what to expect.

At that point I was not sure he believed what I said, but it dampened his dream of untold wealth and cooled his thinking of an early retirement. He also became somewhat assured that I understood these situations. 

A takeaway for my colleagues is this is a typical situation and eventually occurs with most of our business clients. A better way of dealing with this is to work this type of discussion into a few regular meetings with your clients to 1) provide a feel or range of what the business might be worth, 2) what the net from a sale would be and the potential cash flow from those proceeds, 3) to identify value drivers, 4) to discuss the possibility of a strategic buyer, and 5) to have your client start thinking about operating the business in a way that could increase its value rather than only increase its earnings.

I co-authored a pretty thorough article on providing a client with a method of valuing their business. If you want a copy of it, email me at GoodiesFromEd@withum.com and just put Valuation Article as the subject. No messages are necessary.

Do not hesitate to contact me at emendlowitz@withum.com with your practice management questions or about engagements you might not be able to perform.