Small Business Valuation

So, you’re thinking about selling your small business.

But you’re wondering: how much is it worth?

For many billion-dollar companies, it’s not too difficult to determine a valuation. They can usually find a few publicly-traded, comparable companies, look at their valuation metrics, and apply a similar multiple to their companies.

But it’s a different story for small business owners. Small businesses are typically privately-held, so you may not be able to find information – even if there was a recent sale.

While it’s more of a challenge to value a small business, it’s definitely not impossible.

In this guide, you will not only learn how to determine the value of your business, but also about the selling process including:

  • The expectations small business owners should have if they are looking to sell, including legal requirements
  • The importance of having detailed financial records if you hope to sell your business
  • Simple ways to command a higher valuation

Let’s get started by looking at two of the major components of your small business valuation:

Seller’s Discretionary Earnings

When it comes to figuring out the value of a business, the net income or earnings before interest, taxes, depreciation, and amortization (EBITDA) can be deceiving – particularly with a small business.

Let’s say your business has exhausted most of its growth opportunities. With an absence of high return on investment (ROI) options, you decide to pay yourself a hefty salary – even though you aren’t actively involved in the business on a day-to-day basis. On top of that, you may have had a few one-off expenses over the last three years. In this scenario, your net income and EBITDA would both be deceptively low.

That’s where seller’s discretionary earnings (SDE) come into the picture. Here’s how SDE is calculated:

Your starting point is your earnings before interest and taxes (EBIT). From there, you add back your non-essential expenses (things like employee outings and charitable donations).

Next, you add back one-time expenses. This is where it gets tricky: what is a one-time expense? The answer to that question depends largely on your industry, but there isn’t always a clear-cut answer. For example, is a lawsuit a one-time expense? In most cases, it probably is. But for a tobacco company, it certainly isn’t. What about a website re-design? Maybe… maybe not. Your small business website may or may not need another new website re-design in a few years.

Finally, there is the owner’s salary. You probably won’t deal with much controversy here, assuming your financial statements are in order.

So, we have EBIT + non-essential expenses + one-time expenses + owner salary = SDE.

Balance Sheet

The other component of your business’s value is your balance sheet. To determine the value of the business, you’re going to need to calculate your business assets and liabilities.

Assets

Every business has two types of assets: tangible assets and intangible assets. Tangible assets include real estate, equipment, inventory, accounts receivable, and cash. Intangible assets include patents, goodwill, and other intellectual property – note that these types of assets usually have subjective valuations.

Liabilities

Your liabilities are typically comprised of short and long-term debt. The obvious ones are your accounts payable and business loans. But you also have unearned revenue – which is easy to overlook. If your business is typically paid upfront, your unearned revenue could be a big number. Since a potential buyer would have to deliver that product/service, you need to factor it in to your selling price.

How to Determine a Market Value

There are a few business valuation methods that are applicable to small business owners.

SDE Multiplier

If you look at a large, publicly-traded company, you’ll notice that its valuation is (at least partially) based on the company’s price-to-earnings (P/E) ratio, which takes the current share price and divides it by the per-share earnings. The small business equivalent to earnings is seller’s discretionary earnings, and a common method of settling on a sale price is applying a multiplier to the SDE.

The SDE multiplier is based on similar businesses and growth trends. Let’s say you have a restaurant with an SDE of $200,000. The restaurant across the street just sold for a 1.8 SDE. That sale price would indicate that your market value might be around $360,000. But wait… your restaurant has been growing its annual revenue at a 20% compound annual growth rate (CAGR) over the last three years and expects to experience similar growth moving forward. The restaurant that just sold, on the other hand, had flat revenue over the last three years. Based on that additional information, you may be able to apply a higher SDE multiplier to your business.

The above example exposes the limitation of the SDE multiplier method. There’s a chance you’ll be able to find a similar business that recently sold, but in the likely case that you can’t, you’re going to have to do some guesswork.

Book Value

The book value of your business is calculated by subtracting your liabilities from your tangible assets. Yes, your intangible assets are excluded from the calculation.

At first glance, this valuation method seems insufficient. What about SDE and intangible assets?

It’s true that book value, on its own, is rarely enough to calculate the market value of your entire business. But it can be valuable when deployed in conjunction with the SDE multiplier – particularly for capital-intensive businesses.

For example, you have a landscaping business. The business assets – mostly trucks and equipment – are worth $150,000, and you have $20,000 of liabilities. So, your book value is $130,000. If your SDE is a comparatively low $20,000 and the industry SDE multiplier is 2.5, you would – with the aid of the book value calculation – be able to justify a valuation of upwards of $130,000.

Discounted Cash Flow

The discounted cash flow (DCF) method values your small business based on the present value of your future cash flows. If you want to do a discounted cash flow calculation, you’ll first need to forecast your business’s future cash flows. Then, you have to settle on a discount rate – it is based on the riskiness of the cash flows and prevailing market conditions.

The discounted cash flow method is an excellent way to come up with a precise valuation for your business… if the buyer and seller can agree on the assumptions. Due to the subjectivity of the variables, the DCF method – like book value – should be used in conjunction with at least one other valuation method.

Combine the Valuation Methods

“In conjunction with” is the key phrase of this section. The aforementioned valuation methods can be inaccurate or misleading on their own, but when combined, you can usually come up with a reasonable asking price. The numbers will, occasionally, be all over the place. In that case, you’ll have to rely on your best judgment, and possibly consult with an appraiser. More on appraisers in a bit.

What Should You Expect During the Selling Process?

Armed with your valuation, it’s time to move on to the selling process. Like with a home, you can choose to sell it on your own or you can sell it through a (business) broker. A business broker – like a real estate agent – will sell your business in exchange for a commission. There are business brokers that specialize in certain industries, giving them a feel for the industry-specific aspects of a sale.

Also, like selling a home, you’ll get a wider pool of potential buyers and convenience in exchange for the commission. To go with a business broker or not is an individualized decision – it depends on your level of experience and whether you have a new owner in mind.

After your business is listed for sale, you may have to be patient. Most business sales take 6-12 months from the time they are listed to the closing. You may have to deal with a few tire kickers. You may have a deal, but then it falls through. Patience is necessary.

Once you have a serious potential buyer, and you have agreed to a purchase price, you can relax… but not for long.

First, you’ll have to decide on the structure of the deal. If the buyer is willing to do an all-cash transaction, then that’s great, but that won’t always be the case. A couple of other possibilities include:

  • Offering seller financing to the buyer. You could lend the buyer a percentage of the selling price, and they would make monthly payments. They could potentially put up some form of collateral, mitigating your risk.
  • You can accept stock in lieu of cash. If you’re being acquired by a large company, you may have the option of taking equity in the new entity.

Next, you have to handle the legal considerations that come with selling a business. Some are always necessary, but others are optional. Let’s look at a few of them:

  • Letter of intent (LOI): non-binding agreement between you and the new owner. It spells out the major aspects of the deal.
  • Supplier contracts: over the course of your time in business, you may have reached agreements with suppliers. To move forward with the business sale, you have to pass those contracts on to the new owner.
  • Employee contracts: assuming the buyer wants to keep your employees, you’ll have to provide them with your employee contracts. This step helps to facilitate a smooth transition for all involved.
  • Non-disclosure agreement (NDA): before the deal is closed, there is always the potential that the buyer will back out. To eliminate the risk that the other party discloses sensitive information after a deal falls through, you may want to use an NDA.
  • Non-compete clause (NCC): what’s stopping you from starting another similar business and competing with your old one? Nothing… unless you agree to an NCC. Your potential buyer may insist on an NCC to protect their new investment.

Finally, assuming you and the buyer want to go through with the deal, the final step would be to sign a definitive agreement.

Note that this section is meant to give you the basics of the selling process, but you should consult with an attorney to get a more comprehensive list of legal requirements and advice tailored to your situation.

Your Financial Records Are Key to the Sale

If you intend on selling your business, your financial house is going to need to be in order. At the very least, you should consult with your Certified Public Accountant (CPA) and put together three years of business tax returns and financial statements.

But ideally, you’d have financial records that go back to the inception of your business. Let’s look at two examples where your financial records of 5-15 years ago would be relevant to a potential buyer:

  1. Your industry is cyclical. When the economy is doing well, your type of business thrives, but when there is a recession, sales typically plummet. Since we haven’t had a long recession in more than a decade, a potential buyer might want to see how your business performed in 2008. If your financial records only go back three years, however, you wouldn’t be able to provide that data.
  2. You have an expensive piece of equipment that needs to be replaced every 15 years. There aren’t any visible signs that show the exact age of the equipment. You purchased the equipment six years ago, but you can’t find the receipt. The buyer may insist on pricing an immediate replacement into the purchase price.

Beyond the length of time, consider the type of financial information you provide to the buyer. It’s all well and good if you can supply the prospective owner with your balance sheet, income statement, and cash flow statement – to name a few of the most common financial statements. But imagine that you provide the buyer with your customer acquisition cost (CAC) customer lifetime value (CLV). With that information, they would be able to judge the scalability and long-term growth prospects of your business – and possibly be willing to pay a premium valuation.

The calculation of key metrics, it turns out, is just one of the simple ways to command a higher valuation.

Two More Ways to Command a Higher Valuation

As touched on earlier, an appraiser can help you determine the value of your business. But in addition, they can offer suggestions for improving your valuation. Maybe the value of real estate is surging in your (business’s) neighborhood, and the comps from six months ago are too low. Or maybe your customer base is extremely loyal and you have industry-leading retention rates.

There are several potential areas for improvement, but one of the most common is your systems. As a small business owner, you probably take a lot of pride in your business. You don’t want anything to go wrong. This is a great attitude, but the flip-side is that your active involvement can decrease the value of your business. The potential buyer may be nervous as to whether the business can survive without you. Or maybe they would prefer not to be involved on a daily basis.

With all that in mind, it’s best to put systems in place to ensure that the business can continue to perform well without much intervention by the new owner. This can potentially be a major endeavor, in which case, you may or may not have enough time before the sale.  But you might just need to make a few tweaks – the ROI is well-worth it in that case.

The Bottom Line

The decision to sell your business is a monumental one; it can impact your entire life. You want a smooth selling process that culminates in a high sale price for your business. If you are ready to sell, then most of information presented will be of immediate value. But even if selling is a long way off, you can apply some of the advice in the meantime, so you are ready if/when that day comes.

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