The value of anything is the point in which a buyer is willing to pay an amount that is satisfactory to the seller. This is the same when determining value and selling your small business; the price is what the buyer is willing to pay and the seller is willing to accept. There are a variety of considerations on both sides in agreeing on this number:
From the Seller’s Side:
- How quickly the seller wants to exit their business.
- Who is the target buyer – 3rd party, family member or employees.
- Tax Implications – are their opportunities to reduce taxes at closing?
- How much does the seller need to support their lifestyle – ie) is it a final exit.
From the Buyer’s Side:
- How much do they have to work vs. how much they want to work – ie) are they looking for passive income or looking for day to day involvement?
- How much the new owner is going to invest to improve the business or bring it to current standards.
- Does this business provide a strategic advantage for the buyer?
- Risk Factors related to value drivers –
- Strength of Management
- Ownership Involvement
- Operating systems that improve the sustainability of cash flows
- Solid, diverse customer base with recurring revenue
- Definable Competitive Advantage
- Financial stability with foresight and controls
So, what are the steps to determine your business value? Inc.com defines the steps as follows:
- Get your financial statements in order.
- Estimate the value of the tangible assets of your business.
- Prepare your statement of seller’s discretionary earnings.
- Estimate the earnings multiple that’s likely to apply when pricing your business.
- Do the math to arrive at an early estimate of your purchase price.
- Do some price checking.
Let’s look at each of these points for clarification and explanation.
- Get your financials in order – You will need Income Statements/Profit and Loss Statements that tie to your Tax Returns. Many business owners run personal expenses through their business. In order to calculate the value of your business, you will need to be able to easily identify those expenses captured in your P&L.
- Estimate the value of your tangible assets – List all of the physical assets of the business including furniture, fixtures and equipment. Depending on the market formula for calculating value, inventory may be included or in addition to the value of the business.
- Prepare your statement of seller’s discretionary earnings – There are several valuation methods, but when it comes to valuing a small business (under $3,000,000 in value), SDE is the common denominator to which a multiple is then applied.(1)
Seller’s discretionary earnings, or future cashflow of the firm, is the amount of free cash that the new owner will have to operate the business including all necessary expenses. This means that those expenses on the P&L that are identified as “seller’s discretion” or those that are one-time, non-recurring purchases will be added back to the Net Income of the P&L.
Additionally, any items on the P&L that are either non-cash (Amortization and Depreciation) or business owner specific (Interest and Taxes) will be added back.
Here’s how it works:
Net Income
ADJUSTMENTS
Interest
Taxes
Depreciation/Amortization
TOTAL ADJUSTMENTS
ADD BACKS/ONE TIME & OWNERS PERKS
Other Owners’ Salary Market Adjustments
Owner’s Employee Benefits
Subscriptions
Travel & Entertainment
Vehicle Expenses
One Time Purchases
Charitable Contributions
Dues
Other Perks
TOTAL ADD BACKS
TOTAL SELLERS DISCRETIONARY EARNINGS - Estimate the earnings multiple that’s likely to apply when pricing your business. – There are a variety of tools available in the market that provide the guidelines for the multiple which provides the final value of the business. Multiples are based on the businesses in the same industry or sectors and their related transfer value. Typically the range is between 2 – 4 times the weighted/averaged SDE. Some of the tools utilized are: BizBuySell, Business Reference Guide, DealStats
- Do the math to arrive at an early estimate of your purchase price. – Establish Average SDE – This would require you to simply take a three – five year average or to weigh the SDE based on the years that are most representative of the business’ Net Income.
- Do some price checking. – This exercise is somewhat complex and it is advised that you work with your CPA, Exit Planner, Business Valuation Expert or Broker to ensure you have a reasonable and accurate price. These professionals can ensure your estimate syncs with that of recent comparable business sales. Keep in mind this is an asking price and the value is what the buyer is willing to pay and you, as the business owner, are willing to accept.
Deciding to exit and sell your business is probably one of the largest decisions you, as a business owner, will ever make. As with all aspects of starting, operating and growing your business – don’t do it alone!
