One of the most common question I get asked as a business broker is, what is my business worth? I wanted to address this in an article to cover the basic concepts involved in business valuation. I will introduce a few common terms you need to know and how they apply to valuing a small business. I will also discuss who can help you when it comes to valuing your business and what to expect in the process.
First off, if you are considering selling your business or beginning to plan an exit strategy for down the road, a business valuation shouldn’t cost you anything. A business broker should be able to meet with you and review your business operations, financial statements, and comparable market listings to provide you an estimated range for the value of your business in today’s market. Some business brokers will charge a fee for this, so ask up front. NEO Business Advisors does not charge a fee for an initial consultation. If you want to proceed with a business valuation we can provide you a quote during that consultation. The consultation is a no-cost, no-obligation service we, and many other business brokers, offer as part of our role as consultants to the business community. Our hope is that when you are ready to sell your business your experience with us up to that point leads to a business listing if we did our job right.
Every business has several different “values” depending on who you ask:
1. What the business owner, seller, believes the business is worth
2. What a business broker determines to be the Fair Market Value of the business
3. What a lender is willing to finance or lend for the purchase of the business
4. And ultimately, what a buyer is a willing to pay for the business
We can’t cover all of the terms related to valuing a small business in a focused article but will address several of the key terms you will hear during a business valuation. To research additional terms, we recommend the International Business Brokers Association (IBBA) Glossary of Terms.
Business Valuation Terminology
Valuation: “The act or process of determining the value of a business, business ownership interest or intangible asset(s) using one or more valuation methods” (IBBA). Also referred to as an appraisal, or estimated value.
Fair Market Value: “The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts” (IBBA). When we discuss the value of a business for the purpose of this article, we will assume the valuation is a Fair Market Value.
Seller’s Discretionary Earnings (SDE): “The earnings of a business enterprise prior to the following items: income taxes, non-operating income and expenses, nonrecurring income and expenses, depreciation and amortization, interest expense or income, one owner’s entire compensation, including benefits and any non-business or personal expenses paid by the business” (IBBA). Also referred to as Discretionary Earnings (DE) and Seller’s Discretionary Cash Flow (SDCF).
EBITDA: “Earnings of a business prior to interest (expense or income), income taxes, depreciation and amortization expenses” (IBBA). In the valuation of small businesses, we typically assume a buyer will replace an owner-operator seller and therefore value the business based on SDE instead of EBITDA. Larger transactions, institutional buyers, and private equity groups will typically value a business using EBITDA since they will hire a manager to replace the business owner in the operations management role and there will be a salary associated with the replacement manager.
Add-Backs: “All or a portion of expenses that are added back to net income in an effort to place the figures as close as possible to the economic earnings that were actually derived from the business” (IBBA).
Valuing a Small Business
Now that we have covered a few of the key terms involved in business valuation, let’s look at how we actually determine the value of a small business.
The first thing we need to do is gather the financial statements required to conduct a business valuation. A business broker will need to review the last three years tax returns, the last three years of profit and loss statements and a current year-to-date profit and loss statement.
Next, the business broker identifies the Net Profit/Loss and the Taxable Income lines of the financial statements as a starting point. However, this typically does not reflect the true value or benefit of the business to the owner.
The business broker will need to recast the financial statements to the Seller’s Discretionary Earnings (SDE) term defined above. To do this, the business broker will apply certain add-backs to the Net Profit/Loss or Taxable Income. Some add-backs will be pretty standard while others vary widely by the individual business, industry, and accounting principles used in the business operations.
Standard add-backs for Seller’s Discretionary Earnings (SDE) include Owners Salary, Owner’s Benefits, Depreciation, Amortization, Interest Expense/Income, Non-Operating Expenses/Income, One-Time or Non-Recurring Expenses/Income.
Other add-backs may include Legal Fees, Accounting Fees, Professional Fees, Legal Settlements, Personal Expenses (Travel, Meals/Entertainment, Vehicles, Telephones, Rent, Utilities, etc).
Once Seller’s Discretionary Earnings (SDE) is calculated the business broker will apply a Cash Flow Multiplier (or SDE Multiplier). The multiplier is derived from an evaluation of the business operations, market/industry conditions, competitive advantages, competition, condition of assets, customer makeup, employee tenure and many other factors. This will also be cross referenced with comparable businesses currently listed in the market.
After the multiplier has been applied, the value of Furniture, Fixtures and Equipment (FF&E) at current market value will be added along with the value of any Inventory at cost to determine the Fair Market Value of the business.
Sample Business Valuation for a Small Business
$10,000,000 Gross Revenue
$800,000 Taxable Income
+ $125,000 Owner’s Salary
+ $30,000 Owner’s Benefits (Health Insurance, Life Insurance, Pension)
+ $230,000 Depreciation
+ $100,000 Amortization
+ $20,000 Interest Expense
+ $35,000 Auto Expense (Personal)
+ $50,000 Roof Replacement (Non-Recurring One-Time Expense)
+ $1,250 Telephone (Personal Cell Phones)
+ $2,500 Contributions (Charity – Discretionary)
+ $13,000 Travel (Personal)
+ $3,250 Meals and Entertainment (Personal)
– $60,000 Rent (Normalized to fair market rent – Real Estate Owned and No Rent Expense)
$550,000 Total Add-Backs
$1,350,000 Seller’s Discretionary Earnings (SDE) = Taxable Income + Total Add-Backs
x 4 Using an SDE Multiplier of 4
+ $800,000 (FF&E at Current Market Value)
+ $300,000 (Inventory at Cost)
$6,500,000 Fair Market Value of Business
If you are ready to learn what your business is worth in today’s market, contact NEO Business Advisors to schedule your free consultation and no-cost, no-obligation business valuation today!
NEO Business Advisors