Contents
1. Why You Should Use Estimate of Value
3. Income Adjustment Wizard: The Need To Adjust Revenue
4. Enabling the Income Adjustment Wizard and Algorithm
5. Walking Through the Income Adjustment Wizard
Why Should You Start Using Your Estimate of Value?
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You need to know where you are to know how to get there. There are many reasons and benefits to your business owners getting an Estimate of Value:
- Value gaps shown in scenario planning shows the actual value contribution of The Value Builder Score and how changing it can affect them.
- It shows the opportunity for incremental value (or the difference in their Estimate of Value) by improving their The Value Builder Score .
- It reinforces the need for improvements.
- They can pinpoint the levers that will maximize their value and by how much.
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Feeding on business desire to understand what they are worth.
- People want to know how much they are worth. This is the preliminary step to understanding what steps to take next.
- Think of this as the mortgage calculator at a banking site. Use it as a qualifier to sell future valuation improvements.
- If a business owner is considering options, this can be the first step before diving deep into a valuation.
- They’ll need a rough estimate of value whether for inheritance, tax, investment planning, partner buy-in/buyout, ESOP, recapitalization, and venture capital purposes.
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You can focus the conversation on value building.
- Having a business owner understand their value is the first step in recognizing the importance of working with you to make changes.
- Focus on metrics, not feelings. Make metrics-based decisions based on real numbers.
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We made the valuation algorithm significantly more accurate!
- 33% more accurate
- 6-digit NAICS code level accuracy
- New data sources
- Better experimental measurements
- Our Estimate of Value makes use of the first of two methods by comparing industry-standard data sources of over 65,000 market transactions along with rules of thumb for hundreds of NAICS codes to determine an average market price. This enables us to calculate the variation of price within most industries.
- The Value Builder Score is used to measure soft risks and, therefore, where one will likely land on the range of value typically found among similar businesses in your industry. We have used offer data from our 80,000 assessments to validate how our score correlates with the market value of a company. We can map this then to the market price to find an estimate of value. Companies that score 60 are roughly average and would command an average market price, whereas companies that score 80 or higher command premium prices at the top of the market range. Companies that score 30 or lower are typically sold at huge discounts or unsellable.
- While we always show an Estimate of Value, higher-scoring businesses can command strategic prices that may go significantly higher than estimated, while lower scores may indicate that the business is not sellable beyond its liquidation value.
- While a valuation may sometimes include inventory, usually the business is sold on a debt-free, cash-free basis, meaning the seller would assume any cash or debts as well as non-direct assets (i.e., real estate).
Income Adjustment Wizard: The Need to Adjust Revenue
For income, we attempt to calculate Seller’s Discretionary Earnings (SDE), which removes the effect of any tax or profit-taking strategies (such as salary or benefits) in order to compare companies.
SDE is directly tied to the value of an owner’s (your client’s) business.
• SDE is a standardized way of showing the potential profit for a buyer after selling.
• It represents the total pool of income available to a future owner.
Companies are most commonly valued as a multiple of income or profit. Your financial situation, profit-taking decisions, and taxation strategies can make profit widely different from one business to another.
This is dependent on an owner’s financial situation and choices:
• Leveraging a lot of debt or making larger purchases
• Taxation strategy – When a business owner makes it within their best interest to minimize income on their financial statements
• Profit that varies for smaller businesses
• Benefits and perks, especially in smaller businesses
Profit entered in question 34 can mean different things for different business owners. It can mean any of the following:
• Pre-tax – What you report on in taxes
• EBITDA – Standard for large companies (higher than pre-tax)
• Gross profit or net income – Bottom of profit and loss statement; probably what you care about internally
• Other – We have heard some unique things brought up.
There is another way of expressing profit called Adjusted EBITDA, which only adjusts the owner’s salary for a market replacement instead of adding it back in. This is usually more appropriate for larger companies ($5 million+) and is therefore not currently used in this algorithm. We use the Income Adjustment Wizard to find this value. If the business owner chooses not to use the wizard, the algorithm will use the values entered in question 34 and assume that it is SDE.
Enabling the Income Adjustment Wizard and Algorithm
Go to Settings > Value Builder Score Settings > Income Adjustment Wizard (Note: if you use the team functionality, you will have to change the setting under the Team Settings area.) “Enable Income Adjustment Wizard” is disabled by default; click Enable and Save.
Walking Through the Income Adjustment Wizard
The Income Adjustment Wizard is entirely optional for your business owners. Only after they get their score will they be prompted to “Get an Estimate of Value.” We have done this as we want to balance the need for more accurate data with the concern that a business owner may not get their score if they must enter a longer assessment, as well as the sensitive financial data the wizard requests.
The first thing in the wizard is to figure out what the contact entered in question #34 of the assessment and help the business owner calculate their EBITDA, if needed. EBITDA is an industry-standard way of expressing income that removes common accounting changes or management decisions that would be done when focusing purely on cash flow.
In Step 2, the contact is asked for their Salary or Compensation. This includes any bonuses and employer-paid taxes. Depending on the local tax situation, a business owner may take a large or small salary and take the rest in disbursements (which have been removed from consideration by using EBITDA). Note that the business owner is asked to figure out how much it would cost to replace themselves and to enter the difference. They are then asked to do this for additional business owners. While the additional business owner’s market adjustment is added back (or removed) from the income, the 2.3 is not used by our algorithm. However, we feel that this will enable you to calculate Adjusted EBITDA, as well as open the door to a conversation about how the owner could potentially step back from the business.
Next, the business owner is asked to record common benefits, Do note that we attempt to walk a tight line. While these benefits for tax purposes are business related, the new owner will have the freedom to decide whether these are necessary. It is common for the owner to take certain perks that they would not give to a replacement manager. These need to be added back in.
Also note that questions of rent are included. This is because ownership of any real estate is usually accounted for separately in the sale of a company, and owners either use rent as a profit-taking mechanism or subsidize the company by charging below-market rent. After a sale (where assets are not always sold), the seller would probably not continue this relationship but instead offer market rent.
Finally, any one-time expenses or changes are included. Most contacts should leave this blank, but it is possible that something extraordinary could have happened to suppress the profit that should be accounted for.
When you get to the table screen, it will show the calculation of SDE. You or the contact can now choose to exit and use one year’s data instead of a weighted average (would make sense if profit doesn’t change) or to click edit beside years two and three. They will be prompted if they want to start from scratch or copy over the values from the previous year. The weighted average can be important as it reflects three years of data, minimizing the chance that the recorded profit was a “good year.”