How to Value My Business
What is My Business Worth?
There is an old adage among business brokers, the 1-2-3 rule: Pricing a business at one times earnings will cause the business to be sold quickly, at two times earnings will take a year to sell, and at three times earnings- good luck. This illustrates the correlation between sales price and time to sell. Accordingly, as the asking price decreases, the number of available buyers (buyer pool) increases. As the buyer pool increases, so then, do the odds of a sale. The amount of buyers that a business listing will attract is such an important issue when considering a business valuation.
Although, the 1-2-3 rule is a good ballpark when discussing valuations in a theoretical sense, the fact is that some businesses will sell for more than three times earnings. Some stock market companies sell for 30 times earnings or more. Even private companies can sell for 15 or 20 times earnings, especially as a result of a takeover or merger situation. There must be a good reason for this though. Investors will simply not accept the risks associated with buying small businesses if they think they will have to wait more than three years to break even. Nevertheless, in a takeover situation where a company is buying a competitor, the acquiring company may make up the difference by increasing its market share. The bottom line is that the return on investment is calculated ahead of time by buyers and the multiple of earnings they are willing to pay correlates to the projected risks and rewards.
What Valuation Method Should I Use?
There are different methods that are used to value small businesses: a percentage of gross sales, a multiple of net income, or in the case of an asset sale, the fair market value of the assets. Small businesses by definition are generally limited to businesses with less than $20 million in revenue. Above that number, business sellers will most likely use investment bankers to get their deals done. Investment banking deals entail equity partners, multiple financing partners, accountants, attorneys, and valuation experts. These deals are not handled by business brokers and the deals are valued quite differently.
To be frank, there are about ten different known methods of business valuation computations. Some entail a complicated process and for the most part, you will need to buy a computer program to assist you with their calculations. For our purposes, we will focus on the most commonly used methods: the percentage of sales and multiple of net profit. These two methods are similar in that they use prior sales comparisons to show what comparable businesses have sold for based on a percentage of sales or a multiple of net profit.
If businesses in a particular industry have been selling for 50% of their average annual sales, then you would assume that a seller of the same type of business will have a comparable sales price to sales ratio. Unfortunately, every business is not average, and you will have to look at other factors to come up with a more accurate prediction of the selling price. The compared valuation price will need to be adjusted up or down based on favorable or unfavorable business conditions like location, market share, or sales growth. Thus, if a business is better than the average business in the industry, it should command a higher than average selling price.
Likewise, you can use net profit to come up with an average multiplier. The same comparable sales report can be used to obtain the average net profit multiplier in that industry and the resulting number gets multiplied by EBITDA or SDE to obtain an average valuation figure before adjustments.
You should actually use both methods in order to get a better picture of the health of the particular business being sold. The idea is to come up with a price range for the business being valued. Let’s say a listing has higher than average revenue but lower than average profit, the high revenue indicates strength and the low margin on profit indicates weakness; still, you will still need to account for all of the other factors before obtaining a value range. By gathering all of the information and using a price range, you can move the valuation up or down in the price range based on all of the factors being considered. When factors indicate strength or weakness, you’ll need to account for how much it will affect the price. This takes some research and analyzation of other companies. It also takes some estimation. Your initial estimation may not be perfect, and you may have to adjust the price as you learn how buyers react to your estimations.
Other Factors Besides Earnings to Consider When Valuing a Business
Some of the factors to consider beyond revenue and profit are earnings growth, future expected earnings, sales contracts, industry relationships, accounts receivable, inventory, intangible assets, location, lease value, market trend, industry trend, strength of employees, strength of management, condition of assets, and any other things you can think of that may add or subtract from value. The final tweak to valuations comes down to a question of how quickly an owner wants to sell. If they want to sell quickly, they can price the business aggressively, if not, they can price is high and wait for the right buyer. It is your job to come up with a valuation range and the seller’s job to choose how you price it for them.
Inventory and assets are constantly issues to be dealt with for valuation purposes. For the most part, inventory and assets are included in the price of businesses and not added as an extra cost. The reason being, both inventory and assets are what produce income for businesses. If you remove those things, there is usually no business left. For example, if you remove the groceries from a grocery store, there is nothing left. The same goes for a dry cleaner, if you remove the laundry machines, there is no more equipment left to do business.
Buyers need to step into a business and continue using the inventory and assets to produce the same amount of sales as the sellers have. This speaks to the reason we use multiples or percentages for comparable sales: A grocery store that sells $10 million a year that is valued at 50% of sales is worth $5 million and a store doing $1 million is worth $500,000 but only if they are stocked with the same amount of inventory as the sellers used to gain their previous sales revenues. Some brokers will try to sell businesses with inventory listed separately. This is a problem if they are using the same multiples and adding the inventory as an extra cost to buyers.
Along the same lines, restaurants have to maintain their assets to keep customers coming in. If tables and chairs get worn down, then less customer will eat at the restaurant and business goes down. Sellers simply cannot pass on the cost of capital improvements to buyers. They are selling a restaurant that is supposed to generate the same amount of business that it has over the past few years for the seller. The improvements to assets are depreciated and expensed. Sellers have the advantage of depreciating the old assets and gaining the income over the years that should be used to make these types of capital improvements. They have to give up that value to buyers, if not, they are selling a business that won’t make as much money as it did in the past due to the condition of its assets.
In essence, buyers are paying for goodwill, and goodwill is composed of future earnings. Although restaurant sellers spend a lot of money on building the kitchen, the assets are almost worthless on the open market. Restaurants derive their value from the amount of business they are able to generate. In this case, capital improvements are necessary to maintain the same level of business but not to bring in more business. If the assets were left to deteriorate more, business would suffer, and the valuation would drop, at the same time, by replacing these assets, business would be expected to stay the same but not increase.
Alternatively, let’s say a bus company just paid $500,000 for a new bus the week before your valuation and the reason for the purchase was the company needed an extra bus to bid on a contract. In this case, the asset is not currently being used to generate the income that you are using to value the business, therefore, it’s not included in the sales price and the company can charge extra money for the bus. The same can be said for a grocery store that gets a delivery just before the closing of a sale. Any amount of inventory above the average amount of stock should be an extra cost to a buyer. The idea is that we are basing the sales price on inventory and assets that are necessary to maintain the same sales figures for the buyer as the seller.
When Selling a Business Target Your Buyers
Another important aspect to be considered when doing valuations is to distinguish the target buyers for each business. Different buyers will pay different amounts for the same business. A strategic buyer is looking to buy the accounts or the location from its competitors and will likely pay the lowest amount of any buyer. Their motivation is to take over more market share in their industry. They are basically looking for asset sales.
The most common type of buyer that small business brokers work with is the income buyer. These buyers are looking to buy a job and work in the businesses. They are generally looking to leverage their money and buy a business with the largest net profit that they can afford. If they pay cash for a business, then they expect a deep discount. If they are able to finance a business, then they are willing to pay an average price or a bit higher than average based on the amount of financing available to them. Their main concern is to maximize the yearly take-home pay from the business. A loan payment doesn’t usually have a large effect on the take home pay, so they are willing to pay more for a business as long as they can finance the extra price difference. The last type of buyer is the equity fund. This is normally a group of investors, but sometimes only one or two wealthy investors. They are looking for a return on their income and they don’t want to work in the business. Their criteria usually include businesses with management in place, and net profit (EBITDA) over $500,000. It is common for investors to pay multiples of seven times EBITDA or more. Thus, you need to be aware of your target buyer and price the business accordingly.