5. How to Value a Business for Sale
Accurately valuing a small business is often the most challenging part of the process for prospective business buyers. However, it doesn’t have to be an overwhelming or difficult undertaking. Above all, you should realize that valuation is an art, not a science. As a buyer, always keep in mind that the asking price is NOT the purchase price. Quite often, it does not even remotely represent what the business is truly worth.
Naturally, a buyer’s valuation is usually quite different from what the seller believes their business is worth. Sellers are emotionally attached to their companies. They usually factor their years of hard work into their calculation. Unfortunately, this has no place in the equation of a business transaction.
The challenge for you, the buyer, is to formulate a valuation that is accurate and will provide you with an acceptable return on your investment.
Here are several efficient ways to calculate the value of a business:
1. Asset Valuation: Calculates the value of all business assets and shows the appropriate price.
2. Liquidation Value: Determines the value of the company’s assets if it were forced to sell them in a short period of time (usually less than 12 months).
3. Income Capitalization: Future income is calculated based on historical data and a variety of assumptions.
4. Income Multiple: The net income of a business (profit/owner’s benefit/seller’s cash flow) is subject to a certain multiple to determine a selling price.
5. Rules Of Thumb: The selling price of other similar businesses is used as a multiple of the cash flow or a percentage of the revenue.
Let’s look at each to determine what’s best for your intended purchase!
1. Asset-based valuations
This type of business valuation does not work for purchases of small businesses. Assets are used to generate revenue and nothing more. If a business has a great asset base, but does not make much money, how valuable is the business altogether? Conversely, if a business has limited assets, such as computers and office equipment, but makes a ton of money, isn’t it worth more?
2. The selling price of other similar companies as a reference
This particular method is too general, as it is difficult to find two businesses that are exactly the same. The valuation should be based on what profits the buyer can reasonably expect to gain from the company, as long as the future of the business is representative of past historical financial data. However, this method is good for starting an evaluation, but it is a little too general to be the only evaluation method.
3. The Multiple Method
This is clearly the way to go. You have probably heard of businesses selling at “x times earnings.” However, this method can also be quite subjective. When buying a small business, every buyer wants to know how much money they can expect to make from the business. Therefore, the most effective number to use as the basis of your calculation is what is known as the total “Owner Benefits”.
The amount of Owner Benefits is the total amount of money one can have available from the company, calculated based on past data. The Owner Benefits is not cash flow! It is, however, sometimes referred to as Seller’s Discretionary Cash Flow (SDCF).
The theory behind the Owner Benefits is to take the business’s profits plus the owner’s salary and benefits and then to add back the non-cash expenses. History has shown that this methodology, while not bulletproof, is the most effective way to establish the valuation basis of a small business. Then, a multiple, based upon a variety of factors, is applied to this number, and a valuation is established.
The Owner Benefits formula to use is: Pre-Tax Profit + Owner’s Salary + Additional Owner Perks + Interest + Depreciation less Allocation for Capital Expenditures
What Multiplication Coefficient to Use?
Typically, small businesses will sell in a one to three-times multiple of this figure. Now, this is a wide range, so how do you determine what coefficient to apply? The best mechanism we have found is that a one-time multiple is most suitable for those businesses where the seller is “the business”. In other words, once the seller withdraws himself from the business, so will the customers. This is a common situation in the case of consulting businesses, professional practices, and one-man businesses.
Companies that have a strong track record, stable client database, historical pattern of growth, more than 3 years in business, perhaps some proprietary item, or an exclusive territory, a growing industry, etc., will sell in the 3-times ratio. The others fall somewhere in-between.
Here comes the big question: what number/multiple do you apply to the Owner’s Benefits? The answer is simple: nearly all small businesses will sell in the 1-to-3 times Owner Benefits window. Of course, this is a very wide range.
Also, the actual total Owner Benefits figure will impact the multiplier. As the Owner Benefits number increases, so will the multiple. As an example, a business generating $200,000 in OB, may be worth a 3 times multiple, but one generating $500,000 or $1,000,000 can be worth a four or five times multiple.
4. Other Rules
When thinking about buying a business, it is also necessary to calculate the Return on Investment (ROI) that you can expect to achieve. An investment in commercial real estate, which is a solid, stable investment will probably generate a 10% return on your money. Moreover, when the real estate market heats up, the return can diminish to 5% or so, and the investors are still satisfied.
Buying a business is clearly a greater risk than real estate, so a faster ROI is desirable. A 25% return on your investment should be the minimum target and you can, if negotiated well, get as high as 35% - 50% ROI.
5. If You Have Never Done This…
If you are unfamiliar with an income statement, then educate yourself or get a professional to help you. It is important for this process! Work together with your accountant, if necessary, to determine the true Owner’s Benefits of the business.
Be careful about the add-backs. Make certain that any benefits being added back are not necessary expenses needed to run the business. You can only add back something that has been expended.
Calculate a multiple in the 1-3-times window, based upon the business’s strengths and weaknesses. Note that the multiple will increase along with the Owner’s Benefits figure.
Determine your investment level and an acceptable ROI. Understand that value is personal! If the business is right for you, it is all right to pay a slight premium, but not to splurge.
Consider applying other valuation formulas, simply as a test to your figure.
6. Professional Valuations: Do You Need One?
For most small businesses, hiring a professional to perform a valuation is not necessary. First of all, it is expensive, and more often than not, it simply does not reflect reality. Do not waste time or money getting a professional valuation done for a small business acquisition. Let the seller do that if they so choose. If you want to look at a variety of scenarios, there are some very good, inexpensive software packages available that will do the same thing at a fraction of the cost.
However, for a large investment, take the time and consult with experienced professionals, especially in financial or legal matters.
Some Key Points
- Remember that, despite mathematical formulas, valuations are not completely scientifically based. They are the result of subjective processes and can have a highly situational character.
- Use a variety of methods to value a business.
- Owner’s Benefits is the number on which to base your multiple.
- Uncover how the seller established the asking price.
- Valuation is a personal formula. What’s the business worth to YOU?
- Consider the potential return on your cash investment.
Final Word: Never, ever buy a business just because the price is right – first and foremost be certain that the business itself is right for you!