As we’ve said before, buyers’ and sellers’ perspectives of the value of a business differ greatly. Both seek a good deal, the buyer wanting to pay as little as possible and the seller wanting maximum profit for the business he built with sweat and tears. Both perspectives have validity and are understandable. Therefore, using a sound method for determining actual value makes good sense.

Creating Value

The following factors create value in a business:

• A good recent profit history
• Good condition of company facilities, accuracy of books, employee morale, goodwill in the community.
• Demand for a specific type of business
• Current economy – the more investment capital available, the better the demand for purchasing good businesses
• Transferability of company assets. If intangible assets make up the bulk of the business’ assets, buyers question the viability since the asset may not transfer well to new owners
• Future profit potential – where is this business in the marketing cycle? Is the market pretty well saturated? Will the products become obsolete? Or is the business relatively young?
• Special circumstances of buyer or seller. If either the buyer or seller needs the sale, the resulting price changes based on the need. If the seller needs to sell, the price decreases. If the buyer needs a business investment, the price probably increases.
• Special terms available. Buyers may pay more for a business with special financing terms such as: less cash down, seller financing, lower payments at the start of the loan, etc.
• Tax consequences. Sellers experiencing a huge tax debt based on a sale stick harder to their asking price.

Valuation Methods to Avoid

While a “rule of thumb” might give you the ballpark price of a certain type of business, avoid using it to actually determine price. There is no such thing as a “one size fits all” in business. Location, inventory, the current state of the economy and many other factors toss “rule of thumb” rules right out the window

Comparable Sales once again provides a bench mark for the value of a business, but by no means provides a good sales price. No business is like another even if they sell the same product. The condition of the business, both physical and internal structure, changes from business to business

Reliable Valuation Methods

The adjusted book value balance sheet method of valuation provides a good look at value. (Note: Three balance sheet methods exist in accounting, book value, adjusted book value and liquidation value. Book value varies depending on accounting methods used, liquidation value really looks at the value at disillusion of a business.) Adjusted book value takes into account possible allowable but deceptive accounting methods. It looks at valuating the business assets in their current condition less current liabilities. Adjustments might also be made for obsolete inventory or inventory in poor condition, old accounts receivable, current market value of real estate, age and condition of furniture and fixtures.

The income statement method of valuation provides the most meaningful approach of valuation to the buyer. The buyer wants not only value, but cash flow, in order to remain a viable business. The discounted cash flow method looks first as historical cash flows and then projects future cash flows. Future cash flows are discounted to current value with a calculation for the residual value of the business at the end of the future cash flow projection. However, even the balance sheet and income statement methods of valuation are not without error. Looking at both methods of valuation along with viewing comparables and “rule of thumb” figures may give the buyer the most accurate point in which to start negotiations.

A successful business plan doesn’t get written overnight. First and foremost comes the all important foundation: research. Without a good foundation the business plan probably isn’t worth putting on paper. Your research provides the very basis for your projection of costs, expenses, sales and profit.

Business Market Information

Before you accurately project potential sales, you need market information. Who buys your products or services and how do you reach them? What are the preferred styles and colors, what doesn’t sell and why? What are the price points? At what point do you lose money and at what point does the customer stop buying. If you lower the price, how does that affect sales? Do customers for your products and services exist in your area? Is there room for growth? Is the market already saturated? Are there new technologies that will cause your products or services to phase out?

Collection of this information takes time, understanding and the wherewithal to extrapolate that which pertains to your specific market. No entrepreneur can plan for everything, but a detailed business plan exposes a lot of possible pitfalls. Researching and extrapolating data accounts for about 80% of the time involved in writing the business plan.

Business Plan Organization

Writing the business plan requires discipline and organization. Your plan should flow from the beginning to the end with continuity from one section to another.

Start with a title page which includes the name and address of your company. If your company doesn’t exist yet, use your contact address. Also include a telephone number and possibly an email address for quick contact.

Use the executive summary format for the first page. An executive summary provides a broad overview but includes sufficient data and statistical information so the reader knows the rest of the document supports the summary and its conclusions.

A table of contents makes the plan user friendly. It directs readers to the various broken down sections of the document in a quick easy method.

Follow up with the administrative details of the business. Who serves in what role and what are their responsibilities, educational background, expertise, etc. Include details as to how the company operates day to day, who makes the decisions and how these decisions are made. What are the policies and procedures for hiring and firing employees, their benefits, pay scale, and promotional opportunities and how will they be trained?

A marketing plan is a vital part of your business plan. Detail how you plan to increase sales and reach new markets. Demonstrate that your marketing plan is viable and will produce increased sales.

The financial end of the business comes next. Include data tables, charts and graphics depicting cash flow and sales projections. Back up these pictorial efforts with solid data references.

The final section of a winning business plan provides support documentation such as contracts, leases, resumes of principles, bank statements and other financial documents, letters of reference, demographics, articles and trend projections.

It’s time to write a business plan. Why? Equate a good business plan with a good house plan. Building a house without a plan means catastrophe and probably a hodgepodge of rooms. With little or no planning, costs skyrocket because no one plans economically placing the utilities or even laying the appropriate foundation for the expected dream house.

Strong Foundations

A business plan represents the foundation of your business. If the foundation fails, the business can’t survive. The foundation must be strong and able to withstand bad times along with good. A business plan forces consideration of where the business starts as a going concern and how it grows over time. It incorporates your eventual hopes for your business with realistic plans for today’s budget. It makes good use of money, carefully ensuring that the money available stretches as far as possible. Your business plan lays out the exact business you start, the products and service offered, the costs and expenses associated with those products and services and a realistic look at potential profit. Remember, define your markets – those currently buying, potential buyers and how you plan to attract both.

If you finance your business start-up, those helping you with financing expect a detailed business plan incorporating a section showing judicial use of their capital. The plan shows investors that you seriously researched your market and your projected profit depends on realistic sales and costs.

Next, we discuss actually writing the business plan.

When valuing a business an intangible asset exists: goodwill. While you don’t see or touch goodwill, it exists in many businesses, especially businesses with longevity. Goodwill may incorporate the customer loyalty built by the business, but in today’s world, goodwill also includes valuable properties such as favorable government contracts, copyrights, patents and even domain names of considerable value. All these things increase the potential earning power of the business and must be accounted for when setting the value of a business.

Of course sellers want payment for the goodwill built into their business. Unusual or lucrative copyrights and patents which make the business unique or simplify processes certainly offer value to the buyer. Sellers should carefully explain the value of these intangible assets since buyers tend to place value only on tangible assets. The buyer considers the cost of starting his own business when valuing an existing business. So if a good portion of the price of an existing business involves goodwill, the buyer must understand why the existing business provides a better opportunity.

The bottom line: Both sellers and buyers should be aware of goodwill. The buyer should understand the value of these intangible assets. The seller should carefully value goodwill so that it offers a realistic value for the price.

Considering Liability, Ownership and Taxation (LOT), business owners choose the legal form of their business entity. Choices for typical business entities are: Sole Proprietorship, Partnership, Limited Liability Company (LLC), S Corporation, and C Corporation.

Sole Proprietorship

As the name implies sole proprietorships mean one owner. A sole proprietorship requires no legal documentation; setting it up is sweet and simple. The owner reports business revenue and expenses on Federal Income Tax Form Schedule C with all net income being passed to and taxed on the sole proprietor’s personal tax return.

Note that simplicity comes at the cost of shelter from personal liability. The owner receives no protection of personal assets in this form of legal business entity. If a customer of the business decides to sue, they sue the sole proprietor. This puts the owner’s personal assets at risk.

Partnership

Two or more people are the business owners and take an active role in daily management of the business. Each partner may split the profits in equal or unequal shares depending on the partnership agreement. All profits pass through to partners each year. Partners should ensure a legal document exists outlining the details of the partnership.

All partners’ personal assets risk exposure to law suits for the actions of any one or more of the partners. If you want a risky form of business, this is it!

Limited Liability Company (LLC)

The LLC provides small businesses protection for owners’ personal assets while also allowing a simple legal entity. Limited Liability Companies do require legal documentation best drawn up by a lawyer practicing corporate law. Many states require the filing of the LLC documentation, annual meeting minutes and an small annual filing fee.

Profits pass through the LLC to owners of the company and can be in equal or unequal shares, depending on agreement of the owners. Check your states rules for exact terms of an LLC since LLC rules differ by the state in which you operate. The number of owners and the citizenship of owners may change based on your state.

S Corporation

The S Corporation is another favorite legal of entity of small businesses as it also allows for personal asset protection for all owners. S Corporation business form existed much longer than LLCs (relatively new to the legal entity form) but have some advantages for larger small businesses. Not all profits have to be distributed to owners every year.

The documentation and income tax rules for an S Corporation are more complicated but allow for the existence of the business for a short period of time if the owners die. As with Limited Liability Company’s, S Corporations must file annual reports. Use both an experienced attorney and CPA if you choose this business form as the requirements are rather strict.

C Corporation

Publicly traded companies usually take this legal form. Owners and investors receive personal asset protection and the corporation can choose how much if any of the profits to be distributed to owners.

As with LLC’s and S Corporation annual filings and annual meetings are required. Each state determines rules for C Corporations incorporated in their state. A C Corporation may form in any state but is required to have a registered agent (for receiving legal notices) in each state in which they operate.

Regardless of the entity you form, giving those with whom you do business is necessary for asset protection. So if you choose an LLC, S Corporation or C Corporation, make sure your business discloses its legal form and meets all state requirements.

Check with the Professionals

Remember the information presented here should not be taken as legal or tax advice. Check with your attorney and accountant for how these forms of legal entities may affect your business situation.