Most business owners looking to sell as a going concern simply want an easy way to determine what their business is worth.
It does not matter to them whether we calculate the terminal value, weighted average cost of capital, or discounted future earnings. It doesn’t need to be complicated for small business owners; they just want a rough idea of how valuation works and what their company is worth using “back of the napkin” math, not complicated and fancy Excel formulas.
Let’s skip all the financial jargon that doesn’t apply to most Main Street business owners and quickly determine your business’s value.
Business valuations should be based on the AIM: Asset, Income, or Market methods. We’ll look at the market method primarily, but first, I’ll explain how the other two methods work.
Method based on assets:
Simply divide the value of assets by the value of liabilities. Suppose you have $100,000 worth of assets and $20,000 worth of liabilities, then your business is worth $80,000 ($100,000 – $20,000 = $80,000). When you have a profitable going concern business, this may not be the method you want to use.
This method is popular with finance wizards and professors who are fond of teaching theory. Small business owners often find it challenging to grasp, let alone calculate, this concept. It is necessary to estimate the future economic benefit of the business (by forecasting financial statements), adjust for growth rates, cost structures, taxes, working capital, etc., and then discount that present value to the future economic benefit. Calculate the discounted cash flow or capitalize earnings based on discount rates. To be honest, explaining how it works leaves me feeling tired and confused.
This is the method we should concentrate our efforts on. You will know within five minutes how much your business is worth (or at least a general range) thanks to this quick and easy method. A successful sale is determined by looking at companies that share the same size, revenue, and other characteristics as yours. A successful sale is determined by the value of your business.
A simple example will help. The math is simple, and you can apply it to your own business. The BizBuySell data shows that the average cash-flowing business sells for 2.28 times the seller’s discretionary earnings (SDE).
Let’s begin by discussing what SDE is. You need to “add back” a couple of items to your profit and loss statement if your net profit is $100,000. As well as salary for one owner, this includes all personal, discretionary, and one-time expenses.
Let’s say you earn $50,000 per year. According to your CPA’s advice, you use the business to pay your family’s health insurance, gas, auto insurance, and auto repair. Depreciation and interest are also included, as well as contributions to a retirement plan. Estimated costs are $50,000 more.
Here’s how it looks:
- Net profit: $100,000
- Owner’s salaries: $50,000
- Add-back expenses: $50,000 (these must be documented and justified)
- SDE: $200,000 ($100,000 + $50,000 + $50,000)
Let’s look at the valuation:
- SDE: $200,000
- Market multiple: 2.28
- Fair market valuation: $456,000 ($200,000 x 2.28)
There you go. To calculate your business’s value quickly, you simply multiply the SDE by the industry’s average market multiple.
It’s crucial to know what your market multiple is, and access to successful transactions is crucial in this research. If you want to buy a business, you’ll likely need a business broker who holds a certified business intermediary (CBI) designation, or a mergers and acquisitions specialist. Depending on your company’s individual characteristics and circumstance, either of these professionals can determine the average market multiple for your industry. There are many factors that go into determining this, so don’t just rely on 2.28 just because it’s the market average when listing and selling your business. Consult a specialist for more information.
By determining the value of your company, you can determine if it is time to sell and cash out now, or continue to build to increase its value in the future.
Assuming the example above is true, your business is worth $456,000; however, you really want to sell it for $750,000. To justify a $750,000 valuation, you need to show exactly what you have in annual SDE.
As you can see, the math looks like this:
- Sales target: $750,000 divided by 2.28 = $328,947
- Current SDE: $200,000
- Goal SDE: $328,947
By aiming to increase your company’s annual SDE by $128,947 in the coming years, you can justify your $750,000 valuation.