Whether you are buying or selling a business, how do you know what it’s worth? The answer is both very simple and very complicated. A business is worth exactly what the buyer is willing to pay for it and what the seller is willing to sell it for. So, how do you figure that out?
There are three main approaches to determining the value: Asset Approach, Market Approach, and Income Approach.
Asset Approach – determines the market value of the assets and liabilities. This approach starts with the balance sheet and subtracts liabilities (what you owe) from tangible assets such as cash, all or some of the accounts receivable, inventory and other assets. Now for the tricky part. Add back the value the intangible assets, often called “Good Will.” Intangible assets are things like customer lists, brand value, patents, copyrights, and trademarks. These assets have real value, but that value is in the eyes of the beholder.
Income Approach – Simply put, a business is worth the present value of the income stream that it will bring to the investor. This is where spreadsheet geeks like me have some fun. To start with, look at the history of the business to project a future growth rate. Also look at the expenses. Often in family-owned businesses, the owners and members of their families are employed at salaries greatly in excess the market value. While this may be very rational for the existing owner, it layers unnecessary expense into the business. Once you’ve built your “dim-the-lights” model, forecast it for a minimum of five years and then bring that total value back to today’s value. The challenge with this approach is that there are many assumptions necessary to develop the forecast. Significant variations from assumptions to reality will either over- or under-value the business.
Market Approach – Revenue: Just like buying or selling real estate, the market approach looks at what similar businesses in your industry have sold for. With the Revenue-Based Market Approach, you would look at what a competitor recently sold for. Let’s say you know a competitor doing $1,000,000 in sales just sold for $500,000. Then your business would be worth a 0.5x multiple of your revenue. While this is simple to calculate, the issue is that it does not factor in important items such as cash flow, profits or intangible assets.
Market Approach – Profits (EBITDA): Most corporate acquisitions are based on EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization.) For smaller businesses, under $1,000,000 value, most accountants and brokers look at owner’s benefit which includes net income plus depreciation, interest, owner’s salary and fringe benefits. Let’s say the competitor above: 1) Had revenue of $1,000,000; 2) Had an owner’s benefit of $100,000; and 3) Sold for $500,000. The multiple of the owner’s benefit would be 5x. Depending on the business, multiples range from less than one, for a business where the owner is deeply involved in the business and has a risk from competition to 5x+ for a business that is relatively turnkey, essentially running itself. Prospective buyers do not want to buy a job, they want a business. The larger the business and the more autonomous it is the higher, the multiple.
So how much is your business worth? The truth is that both the buyer and the seller will us most of these methods to determine value. The buyer will want to get the lowest price to increase the value from the acquisition. The seller will be overly optimistic in their projections to get the most that they can. If you truly want to know, let’s talk. If you already have a valuation and you don’t like it, give me a call and I can help you with a specific plan utilizing proven business-building techniques to increase the value of your business over the next year or two to get the most out of your business.