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What Is My Business Worth?

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Overview

There is no black and white rule or formula for pricing a business. All pricing is a subjective decision, primarily made by a Buyer that is a function of risk, return and alternative investments. The process of Valuation is really an attempt by Sellers to guess at the market’s perception of those two factors. When it comes right down to it, a business is just a financial investment for which a Buyer expects a return for his money and effort.

The value of a business (which for this discussion we will equate to price) is a function of its cash flow. There are many formal valuation methodologies, the most popular of which include:
  • Tangible Asset Value
  • Multiple of Sellers Discretionary Earnings (SDE)
  • Comparable Transaction Method
  • Discounted Cash Flow
  • Capitalization of Cash Flow
  • Excess Earnings
  • Enterprise Value

The simplest and most commonly used in valuing small businesses is the Multiple of Cash Flow approach.

That is, a correlation between value and cash flow generated by the business to other, similar business that have been sold. The underlying rational for this approach is that the market (i.e. recent business buyers) will intuitively buy a business for an amount that incorporates all of the various factors affecting the “value” of a business, such as: the competitive environment, industry trends, ease of entry, expertise, risk, etc… This approach will provide a pricing that is a “standard” or average for a type and size of business. This can then be adjusted for the degree to which the specific business is different than the “average” business.

Determining Cash Flow

We generally find that we can quantify this market pricing approach by evaluating the ratio of the sales price to cash flow. The cash flow figure that we use is referred to as “seller’s discretionary earnings” (SDE).  It is the amount of cash that a new Buyer is likely to see generated from operation of the business, before any taxes or debt service. It is calculated by taking the cash flow from operations (also known as “EBITDA”), then adding back all of the discretionary expenditures, such as owner compensation and benefits that have been run through the business, as well as one-time or extraordinary items.

For example:

Revenue

-          Cost of sales

=    Gross Profit

-          Operating Expenses

=     Net Income

+/-  Adjustments (examples may include):

        + Discretionary (i.e. “personal”) and one-time expenses

        + Depreciation

        + Interest

        + Owner Salary

          =   Sellers Discretionary Cash Flow (SDE)

To determine a market value we will then multiply the SDE of the target company times the ratio of (Sales Price/SDE), or “multiple” for comparable businesses.


What is the Multiple?

The multiple is a numerical value that qualities the risk, or attractiveness of a business.

For small businesses it is generally between 1 and 3.5.

·         The lower the number the higher the risk (i.e. small, owner centric, etc.)

·         The higher the number the less the risk (i.e. more structure, brand name, tenured employees, etc.)

The multiple can either be “built-up” through a thorough, but somewhat subjective analysis of the specific business or obtained by review of similar transactions.


Putting it all Together

The value then is determined by multiplying the multiple times the SDE, and adjusting for known variations from the “norm.”


FAQ

 

1.       What about inventory?

       Inventory is generally added to the base valuation amount determined above.

2.       What about Furniture, Fixtures and Equipment (FFE)?

Or, my FFE alone is worth more than that!

The value of a business’ FFE is what is generates in terms of earnings for the business. Therefore it is included in the above valuation. If the FFE is really worth more than the valuation amount – then sell the equipment, not the business!

3.       What if the business isn’t generating any cash flow?

 The value of a business is really the greater of the value of the cash flow or the assets.

If a business is not generating any cash flow, or the valuation determines that the value is less than the fair market value of the equipment – then it would be considered an “asset sale.”

Asset sales are difficult, but possible. Please consult with us for a discussion of our approach.

4.       The business could do much better. How do you value potential? 

Generally buyers do not value potential. Business are purchased because they have potential, but priced on what they’ve done.

5.       How are A/R, A/P and other assets and liabilities figured into pricing?

The balance sheet accounts can have a very profound effect on the structure of a transaction and the actual amount of cash transferred. But the basic value of the business, as described above is a function of cash flow.  

6.       Will a Strategic Buyer pay more than the value as formally calculated?

Maybe.

A Strategic Buyer is one who is typically in the same or a similar business that intends to incorporate the target business into their existing operations. They may realize economies of scale that allow a higher purchase price, than that an investor or operator could rationalize.  

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