Many business owners wonder, “What is the value of my small business?” This article provides a simple way to value small businesses that are typically owner-operated with revenues under $3,000,000.
When you are anticipating selling your business, you should obtain a valuation to plan appropriately and, in some cases, to use as a negotiating tool. For smaller businesses, your broker should be able to prepare a simple valuation. For larger businesses, it is worth having a valuation properly prepared by a valuation professional. This person may be independent, work with your accountant or be part of the broker’s firm.
Preparing a detailed valuation is beyond the scope of this article. Formal valuations often calculate values three or more ways. These valuation reports can be 50 pages or more.
Covered here is a simplified valuation based on the market approach to valuing businesses. Do not use it for anything other than general planning without seeking the advice of your trusted advisors and an expert in business sales, mergers and acquisitions.
Small, owner-operated businesses with an active working owner who performs day-to-day tasks such as sales, production, direct management, etc., can be valued using the following formula: Owner’s salary plus profits plus expenses benefiting the owner (such as underemployed family member on the payroll; exotic travel to conventions; auto; heath insurance; pension to owner, etc.) plus one-time charges (perhaps a large legal bill in one year only) plus interest plus depreciation and amortization equals the Seller’s Discretionary Earnings (SDE).
If you are an absentee owner in a business that is usually owner-run, you can add your manager’s salary back to the cash flow. If you have cost advantages your Buyer will not have, subtract these. Those often involve rent where you own the building the business occupies. Most Sellers adjust the rent to market cost at the time of the sale, so that should be factored into the formula.
Some people call this “normalizing” the cash flow. The idea is to show a Buyer what her normal discretionary earnings will be. They are called discretionary earnings, because the owner decides what to reinvest and how to pay herself. You can pull many of these figures directly from the company income tax return. The total is then multiplied by a value called a multiplier. In most cases, the multiplier is 1.5 to 5, with between 2.3 to 2.7 being about average and above 3 rare for small businesses.
An example of calculating value: Consider this example of Bob Smith, who owns Smith Electric. Bob has a steady base of service work, with some new construction mixed in. Bob has four service crews and still often performs remodeling jobs himself. Bob makes about $100,000 in salary. His wife makes $35,000 working one day a week as the bookkeeper. Bob drives a company truck all the time. He has health insurance through the company. He spent $12,000 last year on interest and had $35,000 in depreciation. Bob runs the business from an office warehouse, which he owns. The business does not pay rent to Bob for Smith Electric’s 2500 square feet of space.
The valuation math would work like this: Salary $100,000, plus excess salary to wife estimated at $20,000. Plus personal use of truck estimated at $5,000 plus health insurance at $11,000 plus interest at $12,000 plus depreciation at $35,000, minus $24,000 estimated rent. This totals $159,000. Assuming Bob has a high percentage of service work which tends to be predictable, then his multiplier might be around three. That would put the value of his business at about $477,000. If Bob mainly performed new construction work obtained from competitive bids, his multiplier would be around two because of the risk involved in obtaining future work.
With small businesses, you take the last three years’ tax returns and make these adjustments. Compare the three to identify the trend. If the trend is rising, select the average-to-high figure. If the trend is falling, select the average-to-low figure. If there is no trend then use the average against the multiplier.
Unfortunately, most small business owners are disappointed with the valuation of their business. Small businesses tend to be owner-operated. This means that owners are getting paid for their labor and receiving a profit for their business risk. Only the profit portion of what has been earned is available to pay the purchase price of the business.
Unprofitable businesses are very difficult to sell. Obviously, the above formula results in a value of $0.00. They generally sell for asset value, and asset value is usually not very much. Of course, superior locations that are owned or come with below-market leases, grandfathered licenses and other tangible or intangible assets have value and can be sold.
Because most owners view these resulting values as low, most business sales occur only when the owner needs to move on to something new. It is not because the price is something the Seller could not refuse. Calculating your value every year as part of a planning session is recommended. Improve your profits and improve your value.
Gregory Caruso, CPA, Attorney and Certified Valuation Analyst, is a Principal at Harvest Associates in Baltimore and Bethesda, Maryland. The preceding article is excerpted from his book, 11 Secrets to Selling Your Business.