What is the value of your painting contractor business? You may think it’s worth whatever someone is willing to pay. Unfortunately, the price one person is willing to spend is not necessarily the value. In reality, the value of your business is determined by a calculation that is based on multiple characteristics and factors of your business. Additionally, your business may have more than one value, depending on what the valuation is to be used for.
You may want a business valuation for many reasons, which I’ve grouped below into two sections: tax valuations and nontax valuations (see Exhibit 1).
Valuation for tax purposes can be more involved than for nontax purposes because stricter guidelines must be followed. For this article, let’s assume that the intended purpose of the valuation is to determine a benchmark value for the sale of a painting contractor business – a nontax valuation.
One type of value is fair market value (FMV). FMV is an excellent benchmark for valuations involving a painting business for sale. You need to have realistic expectations when selling your business, so understanding its FMV will help you successfully negotiate the price, terms and structure with a buyer. The Internal Revenue Service defines FMV as: The price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, and both parties have reasonable knowledge of relevant facts.
Is it possible for a buyer to offer more or less than the FMV? Absolutely. It happens all the time. Buyers acting with a compulsion or without the knowledge of relevant facts may pay more than FMV. For example, a buyer who is desperate to expand into your market may offer a price that exceeds FMV.
What Exactly Are We Valuing?
Business owners often misunderstand the differences between a valuation and an appraisal. An appraisal is used to determine the value of the tangible assets owned by and used in the business. A valuation, on the other hand, takes into consideration intangible assets and earnings potential. Therefore, it is important to understand the differences between tangible and intangible assets.
Tangible assets have a physical form and include fixed assets, such as service vehicles, equipment, sprayers, scaffolding, computers, buildings, warehouses, land and inventory.
Intangible assets are nonphysical assets, such as customer lists, patents, trademarks, copyrights, goodwill, brand recognition, service agreement programs, advertising slogans and operating history.
A business valuation is designed to determine the value of both tangible and intangible assets, of which the latter is more subjective.
The Steps in a Business Valuation
A business valuation involves several steps that must be performed in order, just like painting a building. You would not apply the final coat of paint before putting on the primer. The steps, in sequential order, are:
Determine the purpose of the valuation
Gather historical financial data
Adjust historical financial data for extraordinary and discretionary occurrences
Determine which valuation approach works best for the situation
Calculate the enterprise value
Apply balance sheet adjustments to the enterprise value
The Numbers (the First Coat)
The basis of any business valuation is the historical operating results. The financial results are important because all would-be buyers will be interested in the future returns (profits) of your business. The single most reliable method of predicting future returns is by analyzing past performance.
What about your business’s potential? So many contractors want to base the value of their business on its ability to generate additional revenue. Whose business could not be more profitable with a few more good crews of painters, expanded marketing efforts or a better economy? But don’t set your valuation expectations based upon potential, because buyers recognize it and plan to capitalize on it. Potential is typically a motivating force for a buyer, and the buyer does not expect to pay for unrealized potential.
Gather your financial statements (income statements and balance sheets) for the last three full years. If you have five years of operating history, even better. A valuation specialist will consider multiple years of historical data but will place a greater emphasis on the most recent information. For most scenarios, historical financial results beyond five years are not considered.
The Real Numbers (the Second Coat)
Chances are your historical financial statements will require adjustments before the true financial picture of the business can be understood. A common term for extraordinary and discretionary expenses on the historical income statements are “add backs.” Common add backs include, but are not limited to:
Excessive rent paid on real estate owned by the owner
Excessive officer compensation
Expenditures deemed to be “nonbusiness” in nature
Capital assets purchased and expensed
One-time expenditures associated with business disasters
Knowledgeable buyers are skeptical and will scrutinize all the add backs the seller offers. Add backs are subjective and can be overpromoted when a seller attempts to report higher profitability to the buyer. This can lead to a seller having unrealistic expectations for the business. On the other hand, a seller who omits legitimate add backs might undervalue their business. Add backs are a crucial step in determining the true profitability of any business, as very few have no adjustments required.
Selecting a Valuation Method (Choosing Your Color)
Business valuators use three generally accepted valuation methods to value a business. Each specific situation requires a certain method. The methods are:
Market Approach – If five very similar painting contractors, all operating within your market, each sold for $300,000 within the last year, one could draw the conclusion that the sixth similar painting contractor would also have a value of $300,000. This sounds simple enough, but is it? Gathering enough data to draw a sound conclusion can be difficult. Seldom are there enough relevant transactions within a reasonable time frame and of comparable size to offer a proper comparison. The market approach is used successfully in real estate but has limitations when valuing small businesses.
Asset Approach – The value of your tangible assets alone will not add up to an impressive final valuation. Sure, your fleet of vehicles and equipment have real value to a buyer, but when it comes to the overall FMV of your business, these assets are only a few pieces of the puzzle! The remaining pieces are the intangible assets, the most important being the ability of your business to return a profit.
If your adjusted historical financial statements indicate that the business is not capable of producing profits, or worse yet, its survivability is questionable, then the intangible assets have little or no value. In this case, the valuation specialist will use the asset approach. Valuing an unprofitable business based upon the tangible assets involves determining the market value of all the assets that are owned by the business. The asset approach commonly returns a low valuation when used to value contracting businesses with minimal tangible assets.
Earnings Approach – The opposite of the asset approach, the earnings approach is used to value a business that has demonstrated the ability to return profits and therefore has both tangible and intangible assets with value.
Several different methods are used to apply the earnings approach, and all have the same premise: The value of a business is based on a factor applied to an earnings indicator (earnings stream) of the business. The most common factor is known as the “multiplier.” A multiplier is applied to an earnings indicator such as adjusted earnings before interest, tax, depreciation and amortization (EBITA), pretax net income, or after-tax net income.
EBITDA represents the cash flows generated through the operations of your business. It is used as an earnings indicator, as buyers are commonly focused on generating enough cash flow to pay for the purchased business. When EBITDA is applied to a multiple, the result is the enterprise value (EV).
The EV of your business includes the tangible assets used in the business and the business’s intangible assets. Conversely, EV does not include the values of current assets and liabilities (referred to as working capital), such as:
The EV of your business is not the final FMV, because working capital as well as long-term debt must be considered.
Earnings Multiple – A multiple represents an expected rate of return on an investment. Valuation specialists obtain the earnings multiple from the adjusted historical financial statements. These multiples are less subjective than the earnings multiplier, but there are sound theories that go into formulating them. Naturally, the higher the risk associated with the investment, the higher should be the expected return.
One way to compare the multiple to an expected rate of return is to divide one by the multiple, as demonstrated in Exhibit 2.
Based on Exhibit 2, would a multiple of 10 be used to value a painting business? Most likely not, considering there are several safer alternative investments, such as stocks and bonds, that offer a 10% return with significantly less risk.
Expecting a 20% return, based on the risks of investing in any small service business, is as low of an expected return as a reasonable investor should expect. For this reason, earnings multiples exceeding five times the earnings indicator are uncommon. With an expected return of less than 20%, a knowledgeable would-be buyer has better choices on where to invest his money.
Multiple ranges do vary, however, and valuation professionals take the ranges into serious consideration when they are used to value a business. A slight increase or decrease in a multiple can significantly affect the overall EV of a business. Assuming that a business reports a historical EBITDA of $100,000, the EV utilizing a range of different multiples would be as shown in Exhibit 3.
In Exhibit 3, for every half point added to the earnings multiple, the EV of the business increases by $50,000. Determining the correct earnings multiple to use is subjective and involved. Therefore, consider seeking the advice of a professional business valuation firm with industry-specific knowledge.
Putting It All Together (the Final Coat)
Assume your business has an adjusted EBITDA of $200,000 and the correct range of earnings multiples is determined to be in the range of 3.0 to 3.5. Additionally, if the business maintains $20,000 in accounts receivable, $30,000 in accounts payable and $150,000 of vehicle debt, the actual range of FMV would be as shown in Exhibit 4.
The FMV range of your business would be $440,000 to $540,000 – a range that gives full credit to the current assets and liabilities in your business. Buyers often expect that some amount of working capital remains with the business and, therefore, the FMV is adjusted to reflect the expected level of working capital.
A common reason for a business valuation is to set expectations. Entering into the sales process with an understanding of the FMV of your business will enable you to better negotiate the sales price terms, and set a structure with a buyer. Follow the steps outlined in this article to ensure that the calculated value is accurate and reliable. An inaccurate business valuation is just as uninformative as no valuation at all.
Editor’s note: We will feature this article in an upcoming special report on value in paint contracting businesses, which we are publishing in collaboration with Business Valuation Resources, LLC, (www.bvresources.com) this fall. Look for more details about the special report soon.
Brandon Jacob, CPA, operates Contractors Financial Opportunity LLC, (www.Contractorscfo.com) a financial consulting firm specializing in guiding owners of privately held contracting businesses’ in the areas of businesses valuations, transactions and exit strategies. Brandon is recognized industry-wide for his experience and knowledge in valuations, mergers, acquisitions and ability to assist contractors in successful exit strategies. Brandon has recently published For What It’s Worth (www.Forwhatitsworthbook.com), a contracting industry-specific book that explains in detail how to value your contracting business. He can be reached at (713) 443-8311 or Brandon@Contractorscfo.com.