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Small Business Valuation Concepts – what is my Business worth?

Small business owners should be concerned about the value of their business. Buyers must be! To begin with, the definition of small business varies widely. We generally define small businesses as companies with a “market value” at or below about $2 million. With current SBA lending rules, these businesses can be purchased by individuals as opposed to Merger and Acquisition candidates that are usually purchased by other companies. This distinction also points to one very significant difference in the way these businesses are valued. The individual buyer is focused on the Seller’s Discretionary Earnings (SDE or Owner Benefits). As an owner/operator, this buyer will have at his disposal all of the earnings of the business including the owner’s salary. The M & A buyer will be evaluating based on EBITDA (Earnings Before Interest, Taxes, Depreciation & Amortization). The M & A buyer will need to allow for management salaries. It is crucial when discussing “earnings multiples” to know if SDE or EBITDA is appropriate.

This entire discussion is based on “business market value”. There are many methods and formulas associated with business valuation. Our objective is focused on the Most Probable Selling Price (MPSP) in this market. To some degree, this method of valuation is based on the theory of substitution. Buyers have options. They can buy the business being offered. They can start (substitute) a new business from scratch or they can buy (substitute) another business that is currently being offered. They sometimes elect to wait to see what else might become available.

Since a business purchase is an investment decision, the relationship between the earnings of a business and the price is paramount. A number of steps are required to use this evaluation tool. In our approach, the first step is to determine an accurate earnings number for each of the past three years. Working from company Tax Returns, Income Statements and Balance Sheets, we will interview the owner and his accountant to determine a true Seller Discretionary Earnings number. Some businesses require multiple adjustments to account for non-recurring items, fringe benefits, and any number of events that may occur in the financial life of a small business.

Once an accurate earnings picture is developed, we will compare this to actual closed sales of similar companies. Factual data on small business sales, unlike real estate sales, is not readily available in the public records. The Business Brokers of Florida (BBF) maintains a data base of all of the businesses sold by it’s members. The BBF has approximately 800 members in Florida. It is one of the largest broker organizations in the US. Our data base of Sold Listings contains approximately 15,000 actual sales. Other sources may include the Institute of Business Appraisers (IBA) and commercial organizations such as Bizcomps, BizBuySell.com, Pratt Stats, etc. The results from this data almost always vary widely! There is no precise answer.

When we look at similar companies, we may employ a number of criteria. We may use broad categories such as manufacturing, distribution or service. We may use SIC or NAICS codes. We may use companies that could appeal to a similar buyer. Some businesses (engineering, surveying, electrical contractor) may require specific licenses. We will consider other licensed businesses as comparables. Whenever possible we look for data on similar size businesses relative to revenue and earnings. Because the data varies widely and no two businesses are alike, it is critically important to identify a large number of comparables so that meaningful averages can be developed.

From the data that creates these averages, we almost always find a reasonably broad range of multiples. It is not uncommon to find comparables that range from one to five times earnings. The averages however will begin to form a relatively tight group of numbers

Once the averages are established, a multitude of other factors must be considered. A most significant factor can be trend. Are revenues growing or shrinking? What are the Gross Profit and expense trends?  Is there a backlog and which direction is it going? What is happening with payables and receivables?

We must also consider the quality of earnings. How seasoned are they? One year, three years or more? Is the plant and equipment updated or fully depreciated? Is the lease or other property cost stable or rising? How diversified is the customer base? Are earnings derived from a few large customers or many small ones? Where and how strong are the customers? Where and how strong are the competitors?  What is the status of this particular industry?

At this point, a range of value is beginning to emerge. Now, additional factors must be considered. Will the business qualify for SBA or other financing? How much debt does the current owner need to liquidate from the proceeds of the sale? How can a sale be structured so that it makes sense for buyer and seller?

From the buyer’s standpoint, the sale must make sense as an investment. Buyers will need to make an initial investment for both down payment and working capital. They will expect a return on that investment. They can calculator money picput that money into bank CD’s, treasury bills, mutual funds or other relatively safe investments. They will want a higher return from a relatively risky investment in a small company. They will want a return on their time. Business owners generally work long hours and will require a salary commensurate with the job duties. The business will have to provide enough cash flow to service any debt associated with the purchase. And finally, they will want some return over and above meeting these minimums.

In our valuation scenarios, we consider three ratios. The earnings multiple generally gets the most weight. We also consider sales price to gross sales. This can be a meaningful number in many businesses but must be evaluated. If two businesses have gross sales of $1 million but one earns $200k and the other earns $0, chances are good that the businesses are not worth the same amount. Our third ratio considers assets and goodwill. At a business closing, buyer and seller must agree on the value of the tangible assets being transferred. The formula Sales Price minus assets divided by earnings provides a measure of how much the buyer paid for goodwill.

In the final analysis, a business is worth what a willing buyer and seller can agree on. Many buyers enter the search with an agenda. They have growth plans and other desires that influence their decision. Many sellers have motivations that don’t appear in the financial statements. There may be health issues or financial matters outside the company that cause them to accept or reject a certain offer.

In spite of all of these variables, buyers and sellers reach agreement every day. Your broker and other advisors will be there to assist in reaching this very important conclusion.

John W. Hoyt, Jr.

Certified Business Intermediary

 

Call me today at 407-869-6446 for a FREE, thorough and defensible Business Valuation.

Find out what your Business is worth

Goldcrest Commercial Business Consultants, Inc.

Buy or Sell an Orlando Business: 407-869-6446