As published by Gary Anglebrandt in Crain’s Detroit Business 

If you’re the owner of a small business, or even one not so small, and don’t know the value of your business, don’t feel bad. It’s not a figure most business presidents can pull out of their pockets.

“Some business owners hear their friends at the country club say they sold their company at eight times EBITDA, so they think, ‘My company must be worth at least as much as that because my company is better,’ ” said Christopher Sheeren, partner at Huron Capital Partners LLC, a Detroit-based private equity firm.

Valuations are a necessary part of business acquisitions. Any business with plans to sell itself will want to stay on top of its value, as will businesses with visions of gobbling up competitors.

“It’s more common that most small businesses formally don’t know their value. It’s more of an understanding of their cash flow. They know what they’re taking out of the company and know what it needs to operate, but they’re not so sure they know the value,” said Daniel Minkus, an attorney at Clark Hill PLC’s Birmingham office who specializes in business counseling and mergers and acquisitions.

For businesses not looking to sell or buy, there are other reasons to become valuation-savvy.

Many variables beyond the basic numbers go into valuations, not all of them obvious, especially when someone is dangling millions of dollars before a company’s eyes.

“There are things that surprise (owners) that drive value that they normally wouldn’t think about,” said Patrick O’Keefe, CEO of O’Keefe & Associates Consulting LLC in Bloomfield Hills.

More small-business owners are acquainting themselves with the finer points of valuations, in part because of private equity’s rise to prominence, Sheeren said. But misconceptions abound.

It’s also not a set-in-stone process. It varies by purpose and from transaction to transaction, contingent on the interests of the parties involved.

“At the end of the day, it is what both sides agree it is. In most cases, it isn’t a perfect answer where a magic formula is used. Subjective factors go into that,” said Sara Kruse, an attorney at the Southfield office of Jaffe Raitt Heuer & Weiss.

Here are answers to five fundamental questions about the ins-and-outs of business valuations, from local professionals steeped in the process.

How are valuations measured?

Business valuations commonly are done in multiples of EBITDA — earnings before interest, taxes, depreciation and amortization — an indicator of cash flow. This allows outside parties to estimate how much cash the business will generate in the years ahead (typically five years).

There’s also adjusted EBITDA, popular among private equity firms, which removes expenses a future buyer wouldn’t necessarily have to pay. These could be things like expenses for the business owner’s car or country club membership — expenses added to get the greatest tax benefit but that detract from a valuation.

“A lot of these expenses wouldn’t exist under different ownership,” Sheeren said.

One-time expenses, such as those related to a weather disaster, also are removed in adjusted EBITDA, as are one-time gains, such as the sale of property or equipment.

Large capital expenses also should be considered in a valuation, especially if it’s a company with significant annual capital expenditures that consume free cash flow. This could be a trucking company that continually has to repair and replace trucks.

Ultimately, the valuation exercise is about developing a strong understanding of the company’s free cash flow — in other words, estimating how much money the business truly generates annually.

“Earnings growth is what drives valuations,” Sheeren said.

What this also says is that valuation is not just about revenue. “The profitability of the revenue is more important than the amount of the revenue,” O’Keefe said.

Nor is it about the hard assets a company owns, things like buildings, chairs and computers.

“Those things have market value, but that’s an appraisal more than a valuation. The desks are worth X, computer systems worth Y, the building is worth Z,” Minkus said.

So, revenue and hard assets are factors, but ones that often take a backseat to other characteristics of the business. It wouldn’t make sense to value a technology or health care company on its limited number of few hard assets, whereas with a manufacturing company, hard assets would be a more prominent factor.

Can’t I just go with the ‘5 times EBITDA’ rule of thumb?

Not all businesses are worth five times earnings, Minkus said. Some should be based on revenue stream, others on their intellectual property. The results can vary wildly, according to the nature of the business, its market and its industry.

This rule of thumb is at best a starting point, and not a very good one at that, Minkus said.

“You can’t be out there in the business world for any length of time and not hear that number. It’s a great insult to the valuation community and to the concept of valuation,” he said.

What other factors go into valuations?

A long list of tangible and intangible variables can be factored into a valuation: the company’s intellectual property, supply base, reputation, planned product launches, potential future developments, corporate entity type, uniqueness of product and protections against competition. Not to mention the market and industry.

Buyers also will look at the length of time managers have been around, telling evaluators if leaders are engaged with the business and its customers. A business’ value will take a hit if it’s dependent on one entrepreneur who holds the keys to all the important relationships.

“We’re looking for enterprise value as opposed to one or two people driving all the sales. No one is around forever,” Sheeren said.

Family-owned businesses are prone to transition issues, as well, Kruse said.

Because of all this, a business with less revenue than its competitor can have a higher multiple, and vice versa.

“I’d rather have $10 million (in revenue) and a margin of 20 percent resulting in $2 million in earnings than a $20 million company with 2 percent margin and only making $400,000 in earnings,” Minkus said.

What about customer lists?

The quality of a company’s customer base is what’s important here. Are they new customers? Do the customers keep changing from year to year? Are there long-term contracts in place? How old are these companies? Are they new, or distressed?

“Stability and predictability” are what buyers look for, Sheeren said.

And of course, diversification is as important as ever here. If the business relies on just one or two customers for the bulk of its revenue, that won’t help a valuation.

“It’s not merely as superficial as saying, ‘Do they have a good customer list?’ ” Minkus said. “If there’s a bunch of clients the company has done work for, for a long time, the risk is lower and the buyer doesn’t need the same return on investment. It’s worth paying a higher multiple.”

Is it necessary to know a company’s value at all times?

Some would argue “yes” — a strategic buyer could make an offer out of the blue. It’s best not to be caught unawares.

“A competitor comes knocking and says, ‘We’d like to give you X million dollars for your business,’ you’d like to be prepared to respond quickly to that,” Sheeren said.

Plus, a sudden health issue for an owner could lead to stepping down or passing on a stake to a family member.

Others would say “no” because it’s costly — a valuation is only good for about a year as market conditions change, necessitating continual spending to keep up.

“Valuations are only at a point in time. They become pretty stale pretty fast,” said Minkus, who wouldn’t bother having one on file at all times if it were his business.

Firms that do valuations, usually accounting firms, will charge at least $5,000 or $10,000, but probably much more. “Anybody worth his salt is going to charge $20,000 to $30,000 for the first year,” O’Keefe said.

However, subsequent update valuations will cost around $5,000 and might be worth it, said O’Keefe.

Valuations are good for knowing how an owner’s net worth has changed relative to the business, and they provide information on transactions of comparable companies within the past year — critical insight for anyone thinking about a sale.

Considering the prep work for value improvements can take a long time, novices of the process would be well-advised to at least begin thinking about it now. A less costly method is to stay in touch with knowledgeable contacts who can speak to market conditions and transactions.

“Prudent business people stay in touch with attorneys, accountants, bankers, industry groups to get a continuing sense of the value of their company and companies in their space,” Minkus said.