What About the Balance Sheet When Valuing Your Business?
By Victor Harding
The most common method of valuing small businesses is to use a multiple of earnings or EBITDA to arrive at a value. In short it is the income statement showing earnings that is key to arriving at such a valuation. Naturally owners then look at their balance sheet and ask what about the value contained there? And it is true that the balance sheet does sometimes hold extra value but the point of this article is to illustrate that that there is not as much extra value there as some owners think. Let me explain.
Not so long ago I got a call from an owner asking me to help him sell his integration business. It was quite a successful business. The owner told me what he thought he should get for the business. Here he was implicitly referring to his income statement and thinking about a multiple of his earnings. The owner then went on to tell me that he thought his balance sheet should hold another whack of value above and beyond the base purchase price. In fact even the company’s accountant was suggesting this as well. And on the surface his balance sheet looked pretty good. There appeared to be lots of working capital and a fleet of owned vans for the techs totaled $250,000 in fixed assets.
The truth is in most cases and with most buyers the balance sheet will not hold as much extra value as the owner might initially think. Let’s break the balance sheet down and look at each section- short and long term assets and liabilities- to see why.
Many owners don’t realize that buyers expect there to be a “normal” amount of working capital in the business when they buy it. Working capital deals with current assets and liabilities and is generally defined as cash + accounts receivable+ inventory – accounts payable and accrued liabilities. In most successful businesses this is very much a positive number. At the very least the ratio of current assets to current liabilities should be2 to 1. Anybody who has tried to run a business with lower or negative working capital knows how important this item is.
Having adequate working capital in the business at the time of sale is particularly true of “share” deals where the buyer is usually buying everything on the balance sheet. The last thing a buyer wants to have to do is pay for a business and then the first day he owns inject another sum of money into the business for working capital to keep it afloat. If there is inadequate working capital in the business at the time of sale, the purchase price will often be reduced.
If a buyer is doing an asset deal, the buyer can to some degree pick and chose what assets and liabilities they want to buy. Generally in deals for alarm companies the buyer will buy the alarm accounts, the good will attached to the business including the telephone number and company name and maybe the inventory and a couple of vans. So here working capital does not come into play so much. But in an asset deal where the buyer is keeping the target business in place and operating it as a separate business they will want working capital in the business when they buy. It is wrong to think that requiring working capital only goes with share deals.
“Normal” working capital required to run a business can vary enormously. Alarm companies that don’t get involved in big installation jobs and don’t need to carry large inventories usually require small amounts of working capital. However for integration companies that install large jobs & therefore carry a lot of work in process inventory and also have receivables that can easily stretch into 60 days or more the working capital requirements are a lot more. With one integration company I sold, the buyer reasoned that they needed $1.5 million of working capital and it was hard to argue with them.
So the moral here is don’t go into the sale of your business thinking that your working capital is going to land you a huge extra bonus of purchase price. It is true that some companies do have “excess” working capital (more than “normal”) at time of sale which should be feed back to the seller. Books have been written on what a “normal” amount of working capital should be.
Let’s move to the longer term or fixed assets & liabilities on your balance sheet. Most deal practitioners assume that when you value a business using a multiple of earnings, the fixed assets used to produce those earnings are included in the purchase price they offer. This seems inherently sensible to me. So the bottom line here for security dealers whose major fixed asset other than buildings are vans, you are not likely to get extra money for your vans when you sell.
Regarding longer term debt- debt below the current liabilities section on your balance sheet -generally any balance here is required to be paid off by the seller at time of sale or reduces the purchase price.
What I have laid out here are general guidelines as to what to expect in terms of value from your balance sheet at the time of sale. There are exceptions to these guidelines but generally if you are dealing with an informed buyer there will be less extra value on your balance sheet than you first might think.
Victor Harding