Whether you’re thinking of selling your business or you’re looking for new investors, there may come a time where you need to evaluate the economic value of your business. Determining the value of a business isn’t simple. It requires accounting for a number of factors within your business finances. Because this process is so complex, I suggest you choose to work with an M&A certified CPA to receive an objective, thorough evaluation of what your business is worth. This being said, if you need to determine the value of your business, it’s worth understanding how this process.
There are different approaches to evaluating the value of a small business, but generally, each method will involve a full and objective assessment of every piece of your company. Business valuation calculations typically include the worth of your equipment, inventory, property, liquid assets, and anything else of economic value that your company owns. Other factors that might come into play are your management structure, projected earnings, share price, revenue, and more. Different small business valuation methods will be preferable in different scenarios (selling; buying; divorce; ownership percentage; etc). Generally, the best approach will depend on why the valuation is needed, the size of your business, your industry, and other factors.
Business valuation methods and approaches will arrive at different results, so the buyer or lender must have a baseline approach to deciding which bottom line is most applicable to their situation. Most valuation methods (some say as many as seven) can be broken into three basic approaches that focus on the assets or the market or the business earnings. Let’s look at each of these three general approaches.
The asset valuation method, as the name suggests, this type of approach considers your business’s total net asset value, minus the value of its total liabilities, according to your balance sheet. This method may not fit a company if there are not many assets, but this is where such intangibles as a client list can be included. The asset approach is similar to the replacement coverage agreement found in most insurance policies. It looks at what it would cost to replace the business if it had to start from scratch. The asset approach takes into consideration assets and liabilities. The trick is to find comparable market values for all assets and how to measure intangibles such as intellectual property, owner experience and proprietary licenses on patents. These are assets that typically are not recorded on company balance sheets.
The market approach is just that…instead of assets or financial data, this method derives your business’s value from other companies’ final selling prices in your industry and general location. This arguably makes the market method the most subjective option. It prevents you from overvaluing the company and coming up with an unrealistic figure. You cannot accurately apply the market method, however, without proper data on local competitors. Sole proprietors should probably choose another method because, unlike LLCs and corporations, they cannot access data on other sole proprietors simply by visiting an online database. The market method also doesn’t involve as many exact, indisputable numbers as other methods. Two people could have different opinions about what makes your business more or less valuable than your competitors. For example, an increase in monthly rent doesn’t always mean the neighborhood has officially become the new hot spot for small businesses. In other words, you might have to do some negotiating before both parties agree. Smart investors and buyers will not accept an initial offer based on your opinion or other indeterminable factors. For that reason, many entrepreneurs only use market valuation to compare it to the other two methods. If the other two results don’t even enter the same ballpark as the first, it’s time to reconsider their criteria.
The earnings method measures the buyer’s risk against the potential earnings of the company to arrive at a valued can be broken down into capitalization and discounting. Both sub-methods use a formula to figure out the value of the business based on future profits.
- Capitalization uses a formula based on past performance i.e. Multiples of Earnings Method: [ ( Multiple ) * Past Average EBIT ] + Stock At Valuation + Goodwill. Businesses with a history of solid performance are best measured with the capitalization method.
- Discounting takes into account the risk factors being taken by the buyer i.e. Discounted Cash Flow Method: Net Present Value(NPV) of Future Cash Flows + Net Assets. Newer, unproven businesses may be better valued using the discount method. The discounted cash flow valuation method, also known as the income approach, for example, values a business based on its projected cash flow, adjusted (or discounted) to its present value.
- Some people further break this method down into things like an ROI business valuation method that evaluates the value of your company based on your company’s profit and what kind of return on investment (ROI) an investor could potentially receive for buying into your business.
- Others use the seller’s discretionary earnings (SDE) to arrive at a business value. Similar to the capitalization of earnings valuation method, this small business valuation method calculates a business’s maximum worth by assigning a multiplier to its current earnings. Multipliers vary according to industry, economic climate, and other factors.
Let me give an example using the seller’s discretionary earnings (SDE) model to show why I recommend hiring a certified M&A CPA. In this approach, the equity value of a business is determined by multiplying its annual revenue or seller’s discretionary earnings (SDE) by the corresponding valuation multiple and adding or subtracting, as applicable, cash, accounts receivable, inventory, real estate, other tangible assets, and liabilities.
Standard Industry Classification (SIC) codes or North American Industrial Source Classification codes can be used to obtain multiples for comparable businesses. Below is an example using EBITDA where I will use SIC market data and multiples for a glass company I recently helped. The values below are for the sale of the entire company. Different applications have different values just as varying buyers or investors will look at value differently. For example, a strategic investor or buyer will likely see the value of your business differently–and, hopefully, higher–than a financial buyer or investor. Larger the business, the larger the multiple paid. This is tempered by the actual cash flow of the business, i.e. EBITDA (earnings before interest, taxes, depreciation, amortization). Now here is some of the information affecting the value of the example company:
- Companies with revenues of less than $5 million traded at price to EBITDA multiple of about 5.0 during the past five years.
- Companies that had revenues in the $20 million to $50 million range traded between 5.6 and 7.4 times EBITDA.
- Using the same companies in our sample, we found that the businesses traded at a wide range of values as a function of revenues, from 0.4 to 1.4. The higher end of this range is for companies with significant cash flow. We would expect the norm for glass companies to fall within a tighter range of 0.4 to 0.8 times revenue for companies with revenues of $1 million to $50 million.
- Using the multiples above as a rule of thumb, a company with $4 million in revenue that generates EBITDA of 11 percent or $440,000 would be valued at $2.2 million based on EBITDA and between $1.6 million and $3.2 million based on the tighter revenue multiple range.
Keep in mind that there is a lot more to valuing a company than a few multiples being applied to the revenue or cash flow, but these “rules of thumb” can be helpful in setting expectations. No matter how you package it or describe it, at the end of the process, valuation is a function of the owner/seller expectations.
Choosing the right valuation method for your business requires the consideration of myriad factors. On top of basics like industry and revenue, you must also account for your business’s size, growth rate, and financial stability. No two companies will match up in every one of these areas. Thus, you cannot automatically choose the method used by your closest competitors. The number of factors involved in this process should explain why it usually makes sense to look into business valuation professionals. Very few business owners have the time to lay out every potential factor and, based on these criteria, figure out which method to use.
For more thoughts about selling your business, you may enjoy “What To Expect If You Sell Your Business”.
Copyright ©John Trenary 2021