Business Valuation

Business valuations are done for a variety of reasons including sale to an outside party, sale to a family member, IRS gift taxes, buy-sell agreements divorce and other reasons. Valuations will be done differently for different reasons and each method and use case will come up with different results. The valuation of a business for divorce purposes is different than the value for the purpose of selling to an ESOP. In this article, we will be discussing a brokers opinion of value used for the purpose of selling a business to an outsider. For some other purposes, such as IRS gift taxes or divorce a qualified appraiser will be necessary.

The question of valuation is one of the most important elements in the sale of your business. If you advertise the business for too little, you are leaving money on the table; price it too high and buyers may not even look at your listing and it may never sell. Remember that value and price are different - value is what something is worth and the price is what the market is willing to pay. Value is an opinion - price is a fact.

Most businesses that sell for under $2 Million are priced based on a multiple of owners discretionary earnings. Very small businesses are priced based on the cash flow that the owner/employee needs to make plus a return on the amount invested. The price may be discounted based on the risk that the prior performance results may not be realized in the future. If real estate is included in the sale, another complex variable is added to the equation.

Other valuation methods that may be relevant include discounted cash flow, capitalization rate, and liquidation value. For the purpose of selling a small business, these methods can be used to measure the reasonableness of the final valuation but are not usually as relevant to a buyer (and hence, to the seller).

Calculating the "Profit" or "Sellers Discretionary Earnings"

The first task in valuing a business is to compute the owners' discretionary income - a version of the business profit. The calculation usually begins by taking the net earnings and adding back any non-cash expenses such as amortization and depreciation. In addition, interest paid on company debt not used for business operations - such as debt used for acquisitions is added back, as are the taxes. This gives us EBITDA - Earnings Before Interest Taxes Depreciation and Amortization; a standard measure of business earnings.
Most of the time we use the company tax returns as a base for these calculations since that is what the owner has represented to the IRS and most buyers will want to start with the tax return figures as a verifiable beginning point for financial due diligence.

In a small business, where the new owner will be taking the place of the exiting owner we then add back the owner compensation, benefits and certain owner "perks" that are verifiable. Typically these include amounts for the owners' vehicle, cell phone expenses, and other expenses that were paid by the company but may not be spent by a new owner; such as charitable expenses, business travel, and compensation for family members. If the real estate is owned by the business owner and the lease is not at a market rate we may need to make an adjustment to the rent to reflect this situation.

The Market Multiple

The market sets the multiples that are paid for companies at any particular time. Some factors that affect the market multiples are:

• General economic conditions
• Interest Rates
• Industry
• Market appetite for risk

These market multiples are published in several industry-related databases such as DealStats, the Business Reference Guide, and BizComps. Each of the publications has their own twist to how they calculate the numbers which may be somewhat confusing to someone not familiar with using these services.

In all cases, we have a range of multiples for each industry and business type. Main street and lower middle market business with values between $100,000 to $2mm generally sell for between .5x - 3.5X the sellers discretionary earnings. Where in that range a particular business falls is determined by the quality of the business. Some industries are usually at the higher end and some at the lower.

The Ugly Baby

A small business is the owners baby and no baby is ugly. To a buyer, the business may not resemble a baby but may look more like a remodelling project. And so, the buyer and seller may have very different views of the value of a business even if they both agree on the income numbers. In order to figure out where on the spectrum a business lies, we need to look at factors that affect the business quality such as:

• Dependence on the owner
• Clean financials
• Defined business transition strategy
• Strategic plan (past, current, future)
• Testimonials, awards, community recognition
• Key customer analytics (or lack thereof)
• Marketing systems (if any)
• HR strategy, development or succession program (if any)
• Employee documentation
• Written contracts: customer or supplier (if any)
• Business systems documentation
• Expense analytics
• Financial forecasts or support for history
• Lawsuits
• Ease of transferring licenses

These and other factors can point to whether a company should be priced as best-in-class or needing work. Obviously, a best-in-class company will sell at a much higher valuation multiple than a company that needs work. Also, in general, larger companies command higher valuation multiples than smaller companies.

Exit Planning

If an owner has time to prepare for the sale they can engage an exit planner to help boost their companies' position in the range of multiples to increase value. For instance, the owner might want to reduce the level of perks he/she is taking out of the business. Getting key customers under a signed contract, and getting non-compete and non-disclosure agreements from key employees reduces risk to a buyer. Putting key procedures, sales and marketing systems, and reducing customer concentration can dramatically increase the amount a buyer is willing to pay.

In the end, the amount a buyer is willing to pay for a company comes down to math: Profit X Multiple = Price. In order to maximize the price a buyer is willing to pay an owner needs to increase the profit and increase the quality of the company so the multiple used will be higher.