Business owners who are ready to sell their business will often wonder, what is my business worth?
This is likely the first question they’ll ask themselves since it is the most important; the value of the business determines how much they can obtain if they sell the business. But, before you plug a couple of numbers into a business valuation calculator or base a business valuation on a rule of thumb such as a business’s revenue, let’s consider a few things. Business valuations are complex. No two businesses are the same. A mistake can cost you hundreds of thousands, if not millions of dollars. Is that worth it?
Business owners who are ready to sell their business will often wonder, what is my business worth?
This is likely the first question they’ll ask themselves since it is the most important; the value of the business determines how much they can obtain if they sell the business. But, before you plug a couple of numbers into a business valuation calculator or base a business valuation on a rule of thumb such as a business’s revenue, let’s consider a few things. Business valuations are complex. No two businesses are the same. A mistake can cost you hundreds of thousands, if not millions of dollars. Is that worth it?
Rules of Thumb
If you’d like a few simple rules of thumb, do NOT start with a percentage or multiple of revenue. Revenue, while necessary, does not ultimately pay the bills. Other rules of thumb might be industry-specific, such as a multiple of renewal revenue in an insurance agency. This is a dangerous way to value a business. These rules of thumb might tell you what cash flow ‘should’ be, but what if the seller is selling products or services at cost or slightly above cost? This increases revenue, but not cash flow. Want to do it right? Start with what the business earns in a given year. Most business brokers would define this as Seller’s Discretionary Earnings or SDE, for short. You can think of SDE as EBITDA (Earnings Before Interest, Taxes, Depreciation, & Amortization) + Owner’s Salary (salary, NOT distributions) + one-time adjustments. Most small businesses trade for 1 – 4 times their annual Seller’s Discretionary Earnings (SDE). Why 1 versus 4? What adjustments are included in SDE? Is SDE the same as net profit (answer = no)? These are the million dollar questions. Most online guides are wrong. You must know what adjustments are acceptable to buyers and the banks. This is also where most business brokers go off the tracks. Here at CGK, we know what is acceptable and what is not.
Most medium-sized businesses trade off of a multiple of adjusted EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). Depending on the size of the business, the trends, and the industry, this is normally 2 – 5 times for lower-middle market businesses and 3 – 8 times for solid, middle-market companies. When do we use adjusted EBITDA versus SDE? What’s the difference between the two? What adjustments are acceptable for these businesses? What about multiple expansion or contraction during the business cycle? You may say, “These numbers are backwards-looking, what about my future numbers?” “What’s this ‘intrinsic value’ that Warren Buffet talks about?” Do you see the problem with ‘rules of thumb’? For a relatively inexpensive business valuation, especially compared to the money at risk, CGK Business Sales can guide you down the right path, so you can make an informed decision. Can you really afford to make a mistake?
Multiple Approaches to Business Valuations
There are a number of different business valuation methods that are in use today, but three that any business owner will want to know about are the asset approach, the income approach, and the comparable transactions approach.
Rules of Thumb
If you’d like a few simple rules of thumb, do NOT start with a percentage or multiple of revenue. Revenue, while necessary, does not ultimately pay the bills. Other rules of thumb might be industry-specific, such as a multiple of renewal revenue in an insurance agency. This is a dangerous way to value a business. These rules of thumb might tell you what cash flow ‘should’ be, but what if the seller is selling products or services at cost or slightly above cost? This increases revenue, but not cash flow. Want to do it right? Start with what the business earns in a given year. Most business brokers would define this as Seller’s Discretionary Earnings or SDE, for short. You can think of SDE as EBITDA (Earnings Before Interest, Taxes, Depreciation, & Amortization) + Owner’s Salary (salary, NOT distributions) + one-time adjustments. Most small businesses trade for 1 – 4 times their annual Seller’s Discretionary Earnings (SDE). Why 1 versus 4? What adjustments are included in SDE? Is SDE the same as net profit (answer = no)? These are the million dollar questions. Most online guides are wrong. You must know what adjustments are acceptable to buyers and the banks. This is also where most business brokers go off the tracks. Here at CGK, we know what is acceptable and what is not.
Most medium-sized businesses trade off of a multiple of adjusted EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). Depending on the size of the business, the trends, and the industry, this is normally 2 – 5 times for lower-middle market businesses and 3 – 8 times for solid, middle-market companies. When do we use adjusted EBITDA versus SDE? What’s the difference between the two? What adjustments are acceptable for these businesses? What about multiple expansion or contraction during the business cycle? You may say, “These numbers are backwards-looking, what about my future numbers?” “What’s this ‘intrinsic value’ that Warren Buffet talks about?” Do you see the problem with ‘rules of thumb’? For a relatively inexpensive business valuation, especially compared to the money at risk, CGK Business Sales can guide you down the right path, so you can make an informed decision. Can you really afford to make a mistake?
Multiple Approaches to Business Valuations
There are a number of different business valuation methods that are in use today, but three that any business owner will want to know about are the asset approach, the income approach, and the comparable transactions approach.
Asset Approach to Business Valuation
This business valuation approach is done by determining the values of the assets and liabilities for the business. The liabilities are subtracted from the assets, and the difference is going to be the value of the business. This can be a great way to determine the value of the business if the business may not continue and needs to be liquidated, as it’s relatively simple to determine the value of all assets and liabilities. However, this doesn’t take into account things that are valuable to the business but that don’t have a price that is easily determined, such as intangible assets. In general, the asset approach is usually not used for businesses that will remain as a going-concern, though it can be a baseline figure.
Income Approach to Business Valuation
This method takes into account what the business will make in the future and discounts this amount back to a present value. Examples of this approach include discounted cash flow and capitalization of earnings methods. For instance, in the discounted cash flow (DCF) methodology, the future amount the business should likely earn is determined. Then, a discount rate is applied to determine the terminal value and present sum of the business’s future cash flows. This determines the current value of the business. Sound confusing? It is. A properly trained M&A advisor can walk a seller through this important way of valuing a business. This lets potential buyers see how well the business could do in the future, plus allows for businesses with uneven cash flows to be properly valued. The income approach is the theoretically correct way of valuing the business, so it cannot be ignored. Though, predicting future cash flows is, of course, hard, especially when it comes to the cyclical nature of most businesses and economic cycles.
Comparable Transactions Approach to Business Valuation
This is a common way to determine the value of a business. The business model is compared with similar ones that have been sold recently to determine the value of the business. This method takes into account the current market for buying and selling businesses, and is a common methodology for business valuations. This method can suffer from peaks and valleys in different economic cycles. It can still be an effective way to market a business and is one that has often been used very often in the past to determine the value of a business before it is sold. As part of the comparable transactions approach, many buyers and sellers may speak of market multiples, often valuing the business as a multiple of adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization) for larger businesses or SDE (seller’s discretionary earnings) for smaller, main street transactions. There are often adjustments made for buying the entire business, called control premiums, or discounts, for lack of marketability or size. Which multiple is used and the adjustments made, either via add-backs or discounts/premiums, can make or break the value for a seller
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GregKnox
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Greg Knox, CFA has spent his 20+ year career in investment banking, private equity, a hedge fund, and institutional trading, at institutions as Deutsche Bank, T. Rowe Price, and Wachovia. After his MBA at Cornell...(click Greg's picture to read more)
DerikPolay
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Derik Polay has over twenty years of experience in distressed securities and mergers and acquisitions and seven-plus years of upper-management positions at small and middle-market businesses. Derik’s previous ... (click Derik's picture to read more)
EricLewis
ManagingDirector
Eric Lewis has over 17 years of experience in the financial industry. He has worked for a breadth of companies ranging from investment banks to proprietary trading firms. Following his MBA at the University of Chicago, Eric... (click Eric's picture to read more)
JasonClendaniel
ManagingDirector
Jason Clendaniel has been in “business” since he was seven years old. Whether mowing lawns, or delivering papers, Jason learned business from the ground up. After graduating from the United States Naval Academy... (click Jason's picture to read more)
MatthewMistica
ManagingDirector
Matthew Mistica has 13+ years of experience in finance and entrepreneurship. Matthew spent 7 years in Corporate Finance working for Chevron and Shell Oil. After his MBA at the University of Houston, Matt became... (click Matthew's picture to read more)
WesMcDonough
ManagingPrincipal
Wes McDonough has over 18 years of experience in M&A, corporate finance, and entrepreneurship. Previous to CGK, Wes held numerous positions, including accounting, payroll, billing, project management, and IT/Application Support at ... (click Wes' picture to read more)
MatthewZienty
ManagingDirector
Matthew Zienty has 20+ years of financial industry experience in areas ranging from institutional equity trading, currency trading, financial sales, RIA valuations, payout/loan negotiations & compliance. He has worked for ... (click Matthew's picture to read more)
DavidSmoot
ManagingDirector
David Smoot has 20 successful years working for Fortune 500 companies in sales and finance and owning his own small businesses. His leadership roles included sales, finance, managing multi-million dollar product launches, training new ... (click David's picture to read more)
ThomasLennon
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Mr. Thomas “Jay” Lennon is an Air Force veteran, combat aviator, and distinguished leader with 26 years’ experience leading multi-million dollar projects, finance, and organizational transitions, inside and outside of the.... (click Jay's picture to read more)
LanceHupfield
Director of Business Development
Lance Hupfeld has over 25 years of experience in sales and business development management. With a broad array of valuable experience, Lance has deep knowledge in healthcare consulting... (click Lance's picture to read more)
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