By: Greg Dupuis
The most common question I get asked is; What is my business worth? Unfortunately, there is no easy answer to this question without knowing the specifics of a particular business. I can address the subject of valuation so you can understand how buyers will value your business when you decide to sell. Although there are various methods to determine value, three of the more popular methods used are Multiple of Earnings, Comparable Transactions, and Income Capitalization. Let’s briefly look at each three methods and remember that the final value of your business will be determined by many factors including the price, terms, and market conditions when you sell.
Multiple of Earnings
Here a multiple of the companies earnings, whether it be EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), net income, or SDCF (Seller’s Discretionary Cash Flow) is used to calculate value. Regardless of what type of earnings is used, it is generally “adjusted” by adding back any personal or discretionary expenditures that are not directly related to the business. As an example, the expenses your company paid for discretionary travel (perhaps it was more vacation than travel) would be added back into the reported profit of the business. Keeping accurate records and being able to document all adjustments is critical. Your broker will then use this total discretionary cash flow as a tool to gauge a selling price based on a multiplier for your specific company and industry.
Tip: If possible, an owner should start preparing for a sale several years in advance and minimize any personal or discretionary expenses run through the business. Your accountant won’t like this but this “investment” in taxes will be rewarded during a sale. A business showing no or low income receive lower offers and potential purchasers will not be able to obtain financing.
Comparable Transactions (Market Comps)
Comparable Transaction Pricing is based on the theory that similar companies will sell for similar prices. Utilizing data from recent sales of other businesses that have sold, can be a good way to gauge the value of a business. Although this technique is common, it presents many difficulties since each business is unique as their owners and often times your business model, location, or reputation will be difficult to match. This technique is good in “commodity” type situations such as real estate where each target is relatively similar but it is difficult to apply on small business transactions. The data on private transactions is hard to come by and it does not account for transaction terms which can often account for 25 percent or more of the true price received. Remember, unless you are going to sell 100 companies, an “average” does not help you in any one transaction.
The comparable market method does help to provide a reality check as you take into account all data from the various valuation methods and it also can give you insight into how active your industry is. A professional Business Broker can help make sense of market comparables for you.
Tip: Unless you are a billion dollar public company with shares traded on a public stock exchange, do not expect to receive the same “multiples” these companies get.
Income capitalization is a method to quickly put a “present value” on a future stream of cash flow. Many investors like this approach since it is simple and can provide a quick comparison of several opportunities.
Company Value = Net Income/Capitalization Rate
The capitalization rate equals the rate of return required by an investor for an investment of a particular risk level (also know as the discount rate). Example: If a business had a net income of $150,000 and an investor required a 25% rate of return for investments with this type of risk, they would be willing to pay $600,000 for the business; $150,000 divided by 25% equals $600,000. The problems with this popular techniques is that it assumes future cash flows of the business are stable and different Buyer’s will have different capitalization rates or required returns on investments. Generally, for private, stable businesses, investors will require a rate of return of between 25% and 35%.
At Bridge Ventures, we take the time to understand your business and work with owners to maximize value throughout the selling process. We understand that business values typically fall within a range that can be influenced by many factors. Bridge will work with you and help you focus on what you can control to increase the value of your business.
If you would like to view a short video to learn what an owner can do to increase the value of their business, Click Here.