We are going to start a new column that is intended to answer basic questions that some may have but afraid to ask. “There are no stupid questions” sound good in theory, until you have one that you think everyone around you knows, and you would be laughed out of the building for asking.
So, for all the well-versed, high-powered finance types, keep it moving, this is not for you. If you have just started a new business, maybe you slept through accounting class, or numbers just have never been your thing, welcome to “Treat Me Like I am in Kindergarten”.
Our first topic, business valuation. We hear all the time, “how do I value my business if I am looking to sell?” Good thing is, there isn’t really a hard and fast set of rules to go by. Bad thing is, your business is only worth what someone is willing to pay for it.
Somewhere in the middle is what we are going to discuss briefly here.
While there are no strict rules on business valuations there are a few key parameters which are generally accepted as a jumping off point.
First, how much money does the business make. EBIT, EBITDA, Net Income, Net Profit, Discretionary Income, are all typical places sellers and buyers usually like to start. After all, no matter what your sales or revenue numbers look like, if you aren’t making any money, you don’t really have a business, but an expensive hobby. If buying a business, start with EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). This is a great way to evaluate actual operating success without factoring in the way a business does their financing or tax decisions which can vary from entity to entity.
Most sellers will want you to base your decisions on some version of Seller’s Discretionary Earnings/Income. This is used to give the potential buyer an idea of actual cash flow of the business if the current owner were to be out of the equation. So, things like officer’ salary, officer’s benefits, rent (if selling the building), some travel and entertainment, officer’s benefits, are often added on to EBITDA to increase the true earnings of the business.
So once earnings, no matter how they are calculated, are established, typically a business will tack on a multiplier of earnings to come up with the sales price. For easy math, let’s say a business has annual earnings of $500,000. The sales price, or valuation, or this business is $1,500,000. So, this business’s price is based on an earnings multiple of 3. How does one come up with a multiple that is appropriate for their business? Many factors can weigh in like sustainable management, industry, competition, product offerings, etc. So, if you have a truly unique product in an industry without much competition, and opportunities for growth, naturally you can ask a higher multiple for your business. If you have a business that doesn’t have a strong management team, or the owner is the lifeblood of the business, a product/service that is not easily distinguished from competitors, a lower multiple is probably what is in store.
Additionally, most industries have an average or guideline of what multiple businesses are being sold for. Viking Mergers has a pretty good breakdown by industry. BizBuySell can have industry averages from time to time. Or if you really want to get crazy, check out the annual Pepperdine Private Capital Markets Report which is a snoozefest, but has tons of useful information should you want to dive deep.
Again, this is the “101” version of business valuation and there are many, many other factors that will be at play. The best thing to do is get some advice from firms or people that have done this before and can hold your hand throughout the process. The cool thing is, no one is going to be right, and there is no one way to value a business. All this adds up to some spirited negotiations should you want to sell or buy a business.