by Brandon Jacob
What's the value of your HVAC business? I'll bet more than one reader is thinking, " Whatever someone is willing to pay for it." This common notion is both right and wrong, as I'll explain.
In reality, the value of your business is a calculation based on several characteristics and factors that together make your business unique. Furthermore, your business may have more than one value, depending on the end use of the valuation.
One type is a "fair market value." For estate planning purposes, the IRS generally accepts a fair market value, which it defines 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."
Fair market value is also an excellent benchmark when valuing your business for purposes of a transaction such as a sale. Understanding the fair market value of your business will help you successfully negotiate the price, terms, and structure of the sale of your business.
What's Being Valued?
Business owners often confuse a valuation and an appraisal. An appraisal is used to determine the value of the tangible assets owned by a business. It doesn't take into consideration intangible assets or earnings potential. Certain assets, such as real estate, may be appraised separately or as part of an overall business valuation.
Tangible and intangible assets are divided up as follows:
Tangible: Vehicles, tools, sheet metal brakes, office furniture, computers, gauges, tools and forklifts.
Intangible: Telephone numbers, customer lists, operating history, company name, files, records, computer files, computer databases, customer names, customer lists, and company records
As you can see, tangible assets are those assets that can be touched or felt, whereas intangible assets typically are non-physical. A business valuation is designed to determine the value of both tangible and intangible assets.
Steps in Valuation
The steps required to value an HVAC business are as follows:
- Determine the purpose of the valuation
- Gather historical financial data
- Adjust the historical financial data
- Determine which valuation approach works best for the situation
- Calculate the enterprise value
- Understand the balance sheet and how it affects the final valuation.
There are several reasons why a business valuation may be required, and they're typically separated into two groups: tax valuations, and non-tax valuations. Examples are shown in Table 1.
A valuation for tax purposes can be more involved, must follow stricter guidelines, and can be more costly than a non-tax valuation. For this article, we'll assume that the intended purpose of the valuation is to determine a benchmark for the sale of an HVAC business, which is a non-tax valuation.
|Tax valuations||Non-tax valuations|
|Charitable contributions||Litigation support (divorce, etc.)|
What are My Numbers?
Any business valuation is going to focus on the historical earnings of the business. Why? Because a buyer is interested in future returns (profits) of the business, and the single most reliable method of predicting future returns is by analyzing past performance.
What about potential? When I was purchasing HVAC, plumbing, and electrical businesses for a publicly traded contractor from 1996 through 2002, many owners wanted value based on their business' potential ("If only I had more techs," they would say). The fact is that every contracting business has greater potential than what it's currently producing, and every buyer is aware of that. Furthermore, the buyer intends to put forth every effort to achieve the business' maximum potential. Ask yourself, who should be rewarded for successfully capturing that potential, the seller or the buyer?
Gather your financial statements from the past three to five years. A current value will consider historical data, but will place the greatest emphasis on the most recent information. Beyond five years, the data becomes irrelevant to the current valuation.
Time for an Adjustment
There's a good chance your financial statements will require adjustments before the true financial picture of the business can be understood. A common term for these adjustments is " addbacks." Common add-backs include, but are not limited to:
- Excessive rent paid on real estate owned by the owner
- Excessive officer compensation
- Non-reoccurring expenditures
- Expenditures deemed to be " nonbusiness" in nature
- Capital assets purchased and expensed.
Shrewd buyers skeptically scrutinize all add-backs suggested by sellers. Add-backs can be an area of abuse when the seller, trying to report higher profitability to the buyer, adds back actual operating costs as non business expenditures. Nevertheless, adjusting for add-backs is a crucial step in determining the true profitability of any privately held business.
Methods to the Madness
There are three generally accepted methods used to value a business, and there are specific situations where one method may be preferable to the others. The methods are the market approach, the asset approach, and the earnings approach
Remember what I said about the value of your business being "whatever someone-is willing to pay for it?"
Let's say that five HVAC shops sold in your town this year Each was performing $1 million/year in residential service. Each sold for $500,000. One could draw the conclusion that a sixth $1 million/year residential service business-in your town would have a value of $500,000, right? Maybe, maybe not.
The answer lies in gathering enough data to draw a sound conclusion. Every business — even those with very similar numbers — is different. During the height of the consolidation period (1996-1999), the market approach was applied fairly regularly, as a significant amount of data existed in regard to privately held businesses that sold to public companies.
However, applying the market approach today isn't as easy, as historical comparables aren't as readily available and/or accurate.
The big dollars of any business aren't in the tangible assets. Don't get me wrong, your fleet of service trucks cost real dollars, and has value to a buyer. Regarding the overall business value, however, these assets are only a few pieces of the puzzle.
The other pieces are the intangible assets. 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, a buyer will wish to use the asset approach. Valuing an unprofitable business based upon assets simply involves determining the market value of all of the tangible assets that are owned by the business.
While the asset approach is used to value an unprofitable or failing business, the earnings-approach is used to value a business-that has demonstrated the ability to return profits. This business has intangible assets with value.
There are several different methods 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 of the business. The most common factor is known as the "multiplier." A multiplier is applied to an earnings indicator such as adjusted EBITDA (earnings before interest, tax, depreciation and amortization), pre-tax net income, or after-tax net income.
EBITDA represents the cash flows generated from your business. EBITDA is used as an earnings indicator because buyers are typically concerned with generating enough cash flow to pay for the purchased business. When EBITDA is applied to a multiple, the result is the enterprise value.
The enterprise value includes the tangible assets used in the business, and the intangible assets of the business. It does NOT include cash, accounts receivable, accounts payable, or debt.
The Earnings Multiple
A business' earnings indicator is obtained from its adjusted historical financial statements. The earnings multiple is more subjective.
A multiple represents an expected rate of return for an investment. The higher the risk associated with the investment, the higher should be the expected return. A simplistic way to compare the multiple to an expected rate of return is to divide one (1) by the multiple, as demonstrated in Table 2.
Based on the information in Table 2, would anyone ever use a multiple of 10 to purchase an HVAC business? Probably not, considering there are several safer alternative investments (stocks and bonds) that offer a potential 10% return with less risk.
Expecting a 20% return, based on the risks of investing in any small business, is probably as low of an expected return as one would accept. That's why multiples used to value contracting businesses exceeding five times EBITDA are uncommon.
Multiple ranges vary, and should be taken into serious consideration when used to value a business. A slight increase or decrease in a multiple can significantly affect the overall value of a business.
Assuming that a business reports a historical EBITDA of $100,000, the enterprise value would be as shown in Table 3. For every half point added to the multiple, the enterprise value of the business increases by $50,000.
Determining the right earnings multiple is subjective and complicated. It's also a crucial element to make sure you're not under-or over-valuing your business. Therefore, if you're considering valuing your business based on this approach, seek the advice of someone who has professional business valuation experience, and preferably HVAC industry-specific knowledge.
Putting It All Together
Let's look at an example of a business that has an EBITDA of $200,000 and an earnings multiple of 3.5. The business maintains $20,000 in accounts receivable, $30,000 in accounts payable, and $150,000 of vehicle debt. The actual fair market value of this business would be as follows:
|Fair Market Value||$540,000|
Of course, one must consider that a buyer may desire a certain amount of working capital to remain within the business. Also, the quality of accounts receivable is always a concern.
Watch Your Steps
A common reason a business owner would need to know the value of his or her business is in preparation of a sale. Entering into the sale with an understanding of the value of your business will enable you to better negotiate the sales price, terms, and structure with a buyer. Because a business valuation is not something a business owner calculates every day, the steps outlined in these two articles should be carefully followed in order to ensure that the calculated value is accurate and reliable.
Brandon Jacob, CPA, CVA (certified valuation analyst) operates Contractors Financial Opportunity. He has 10 years of HVAC industry expertise as a valuation analyst and acquisition specialist. He can be reached at 713/426-4041, e-mail [email protected]. For more information about Contractors Financial Opportunity, visit www.Contractorscfo.com.