11.1: Why are Businesses Bought and Sold?

Valuing the Business

Everyone is interested in how much a business is worth. The entrepreneur and the entrepreneur’s family are interested because they hope to use some of the income from the business to live on or because they are interested in how much they might sell the business for someday. Then, there is a simple curiosity factor: “I wonder what I could get for this?” If the entrepreneur seeks outside funding from friends, banks, angels, and venture capitalists (VCs), they will be very interested in the potential value of the firm. When a public company is being sold, its current trading price establishes a starting point—usually a minimum transaction price—but the acquiring company must still decide on the maximum bid consistent with a profitable acquisition. But when selling a nonpublic company, even that starting point does not exist. The field of business valuation has developed techniques designed to estimate the value of a business.This chapter is adapted from material originally appearing in Huefner, Largay, and Hamlen (2005 and 2007, Thomson Custom Publishing; used by permission of the copyright holders).

One author gives this thorough definition of business valuation:

A business valuation determines the estimated market value of a business entity. A thorough, robust valuation consists of an in-depth analysis by a qualified independent professional who combines (a) proven techniques; (b) analysis and understanding of a specific company and its associated industry; (c) research and analysis of industry, association, and other publications; academic studies; the national and local economy; and online databases with (d) judgment honed by education, training, and experience; and (e) intuition. A valuation estimates the complex economic benefits that arise from combining a group of physical assets with the intangible assets of the business enterprise as a going concern. The resulting valuation, part science and part art, is a well-founded estimate that represents the price that hypothetical informed buyers and sellers would negotiate at arms length for an entire business or for a partial equity interest.Jones and Van Dyke (1998).

A major reason why businesses are bought is that parties interested in beginning or expanding business activity often prefer acquiring an existing business rather than starting a new one. Existing businesses are “up and running,” and have in place a product or service line, a work force, customers, suppliers, the necessary physical resources, and various intangibles—technology and “know-how,” systems and procedures, location, reputation, and the like.

From a seller’s perspective, business owners need to have an exit strategy, a means of extracting value from their investments of time and resources in the business. A sale may be occasioned by the death or intended retirement of the owner, or by a desire to “cash out” the investment at a time when its value is perceived to be high. Or, an owner may wish to expand the business by taking on new partners, selling a portion of ownership to new parties. Sometimes this is done to reward and retain key personnel by offering them an ownership interest in the business.

Even when no transfer of ownership is involved, a business valuation may be done when seeking major new financing. A valuation provides the prospective lender with an indication of the safety of a loan secured by the business.