How to Value Your Business

If you are like most business owners, you are likely curious about how a buyer will value your business.  How much would you get for your business if you tried to sell it today?  There are many reasons why you may need to know the value of your business.  What is the effect Covid has had on your company's value? Here are some of the most common:

• Ready to sell your business and retire or do something else
• Looking for financing and using the business as collateral
• Estimating your net worth
• Looking to attract investors or bring a partner into the business
• The spouse that ran the business has passed away
• The court has ordered it for a divorce proceeding

The most common reason for a small business to need a valuation is to sell or bring on a partner/investor.  If you have watched Shark Tank you have heard about the common negotiations where they establish the value and then start making offers.  The foundation of the statement “I will give you $200,000 for 20% of your company” is valuation.

Step 1: Which Method of Valuation is the Best Fit

There are different methods used to value small businesses.  Three of the more popular methods are:

The Asset Value Approach -  This approach is probably the easiest to understand.  It is simply all of the assets of the business minus the liabilities.  This gives you the adjusted net value of the business and is basically a balance sheet exercise in valuation.  This approach is typically used when the subject company is not producing strong cash flows and the assets are more valuable than the future cash flows.

Discounted Cash Flows - This more complex formula uses historical performance and future projected cash flows.  The projected future cash flows are then discounted to a net present value.  For small and lower middle market companies, this method is not often used.

Multiples/Comps - This is the most commonly used method for small, middle-market, and even publicly traded companies (P/E Ratio is the term used in public markets).  In this approach, we establish the company's cash profits by calculating EBITDA, Seller’s Discretionary Earnings, or Owners Benefit depending on the company size and situation.  This number is essentially the profit and benefits the owner(s) of the business receive.  We then multiply this number with a comparable multiple.  We will use this method in our example and dig deeper.

The primary purpose a business serves is to produce something useful or of value in exchange for some sort of consideration, usually money.  Valuing established earnings and comparing them to similar profile companies' actual sales is the most logical way for a buyer to evaluate the cost of earnings and potential.  We will begin by establishing the true earnings of your business in Step 2.  

Step 2: Establish Your Company’s Actual Earnings

Establishing earnings based on the historical trend is the foundation of the multiples/comps method.  The true earnings of a business are commonly referred to as EBITDA (Earnings Before Interest Taxes Depreciation and Amortization) or SDE (Seller's Discretionary Earnings).  SDE is also referred to as Owner's Benefit.  SDE is calculated for small businesses while EBITDA is used for more established and relatively larger businesses. 

Please note these are my guidelines based on private equity, SBA, banking, and business broker industry standards and guidelines.  

EARNINGS BEFORE INTEREST TAXES DEPRECIATION & AMORTIZATION (EBITDA)

Calculating EBITDA is exactly in the name itself.  The purpose is to understand the cash flows prior to balance sheet, capitalization, and other factors that can be changed and vary depending on the owners' objectives.  Let's take a look at the financial summary of an example lower middle market company.

SELLER'S DISCRETIONARY EARNINGS (SDE)

For small businesses where the owner runs the day-to-day operations of the business and the net income of the business is less than $1 million, the number we are first looking come to understand is SDE (Seller's Discretionary Earnings) or Owners Benefit. Simply put, this is how much money the owner is able to take out of the business annually.

To calculate this, typically we would have taken the P&L statement for the last three years. I would argue due to Covid, we will be looking at 2019 until 2020 falls off of the three years.  Each year we add back all of the owner’s benefits to the net income. This includes the owner’s salary, relatives that may take a salary not reflected in the amount of work or value they offer, travel expenses that may not have been fully necessary to the business, car payments that are not necessary to the business, and other expenses that a different owner could take as their own or stop without disrupting the business. Let’s look at the four-year history of Company A and calculate SDE.

It's important for you as a business owner to understand that the more reliable your cash flows, the stronger your argument to have a higher valuation. If your P&L shows three straight years of steady revenue growth and your net income did as well, you are demonstrating a consistent stream of cash flows that will give a potential buyer confidence that the cash flows will continue when they take over the business.

Step 3: Apply a Sales Multiple for the Estimated Market Value

Now that you know how much money you are really making we have to find some market multiple comparables.  This is done by reviewing other recent comparable transactions.  This part may be a little trickier to get your hands on that data unless you subscribe to one of the industry services that track and share this data.  The chart below gives the median multiple based on Enterprise Value.  Obviously many more nuances, such as industry, profit margins, contracts, team, etc., but this gives you a good idea as a baseline based on size.  

LOWER MIDDLE MARKET  EXAMPLE (EBITDA AS BASELINE)

In the example lower middle market company, we will use the range of 4.5x-6.5x to derive our value range.

SMALL BUSINESS/MAIN STREET  EXAMPLE (SDE AS BASELINE)

The majority of small businesses sell for 1.5x to 3.5x the Seller’s Discretionary Earnings.  With that, you can develop a range for your business as shown in the chart below.

Companies A & B in these examples certainly have some good things going for themselves.  Revenues and profit show steady growth and not big swings.  From a financial perspective is a great sign of predictability.  Company A could also make the argument That using the last year’s SDE and not an average would also be more accurate as it has shown a steady predictable increase.  Company B is eclipsing 2019's earnings making the strong argument they have bounced back from 2020's covid impact.

The two companies' values are fairly big ranges, so what factors come into play to decide where in that range these companies should be valued at?

factors that determine a fair market value

Market Multiple Comp - Searching database for comparable company profiles for companies that have sold recently.

Current Owner is the Secret Sauce - Is there a big risk of company performance deterioration when the current owner departs? If so, this is a big risk and will decrease value.

Customer Concentration -  Do one or a few companies compromise a big percentage of company revenues?

Contracts - Are there contracts in place that continue after the close that will increase the probability of continued cash flows?

Industry - Is the company in a declining or growing industry, historically risky or safe?

Monthly Recurring Revenue - Is there a significant % of revenues that are tied to a recurring payment agreement (ie. maintenance contracts, retainers, and other recurring income)?  Predictable recurring revenues also give confidence in the continuity of cash flows.

Asset Condition - Have the company equipment, vehicles, and other assets been well maintained?  If they have not, buyers will have to plan to make a big capital investment in the near future which will decrease the value of the business.

Record Keeping - Has the bookkeeping and other records been documented and tracked properly and well organized?

Marketing Database - Has the company accumulated a database of contacts that fit its buyer profile to market to?

Thoughts on Covid’s Influence on Valuations

The big topic this year is how to factor in Covid and its ramifications on the three-year performance of a company when trying to calculate SDE.  

My approach will be to include 2019 until the close of the 2023 year when the trailing three-year history will no longer include 2020.  Factoring the company’s ability to return to its 2019 level or above is key to re-establishing an existing pattern of cash flow and argument to calculate EBITDA/SDE with a heavier consideration of 2021 and 2022’s performance. 

In Company A example, I would argue that Covid weighed down the average SDE by $160K.  My personal opinion for valuing Company A would be to use a number closer to the average of 2021-2022 given that the business has rebounded and exceeded pre-covid numbers. 

Company B has also achieved pre-covid earnings and is showing a good trend.  This is what most valuation experts will be looking for when they are deciding the weight of the covid depressing the valuation "unfairly".

In Conclusion

Knowing how much your business is worth is an important exercise.  I recommend completing this once a year as part of an annual review of your business. 

If you are considering selling your business, you want to make sure to get a professional involved to help you establish value.  There are many options like paying an accountant or valuation firm to conduct a valuation or appraisal.  Another option is to find a qualified Business Broker to help you.  This is a great option because the Business Brokers are in the market and see transactions on a regular basis.  The good ones know what companies are going for and what is an effective price point to market your business for sale.  

If you are interested in getting a free valuation completed, please contact us here and we will schedule a time to review your company and provide you with a confidential valuation along with tips to improve your value and get the most out of your sale.

DEFINITIONS

P&L (Profit & Loss) Statement: The P&L also known as an Income statement is a financial report that shows a business's net income by subtracting the expenses from the revenue in a given timeframe.

PE Ratio: The Price to Earnings Ratio is the ratio of a company's share price to the company's earnings per share.

EBITDA: Earnings Before Interest Taxes Depreciation and Amortization is the measurement of the company's profitability of the operating business before the effects of debt and other capital structure-related expenses.

SDE: Seller's Discretionary Earnings (aka Owner's Benefit) is the calculation of the total financial benefit that the owner-operator would derive from a business.