Selling a Business Part 3: What’s My Business Worth?

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How to Sell a Business: Part 3

This is the third of a five-part series on selling your business.
To get the whole picture, read Part 1 and Part 2.

What is Your Business Worth?

Welcome to Part 3 of our five-part series this month on how to sell a business. In Part 1, I gave you an overview of the process. In Part 2, I described the process in more detail but focused primarily on planning for the sale. In this post we’ll look at ways to arrive at the likely market value of your business – what we refer to as the most probable selling price.

Before we go any further, I want to define the “most probable selling price”, or MPSP. The MPSP is an estimate of value that is derived from the analysis of your business’ financial records, tax returns, balance sheet, inventory, contracts, payables, receivables and sundry other aspects of your business’ health. It does not necessarily represent what the actual selling price of the business will be because there are many external factors that influence a selling price including, but not limited to, the market itself, economic conditions at the time of sale and, most importantly, the levels of compulsion and motivation of a willing seller and a willing buyer. Valuing a business – arriving at the most probable selling price – is not a “back of the envelope” effort. Aside from analyzing the items mentioned above, the business owner, or the business broker, must survey the market to see what similar businesses have recently sold for. So, estimating the MPSP is essentially determining what the market says the likely value is.

What is the Basis of a Business’ Value?

If the business is not being sold as a liquidation of assets, as a rule, businesses are valued based on their earning power. A buyer’s first question is, “how much money can this business generate for me and my partners if we buy it; how much money can we make?” You need to figure out what your business’ actual earning capacity is. This is the main component of a valuation and what we’re going to focus on in this post.

Related: Does your business meet the basic needs of the buyer?

So, what do I mean by “your business’ actual earning capacity”? Many people look at the bottom line of the P&Ls and use that number. Others look at the tax return to find the net income number and use that. Neither is correct and both are likely to be lower – sometimes significantly so – than the real number and the real number is the one you have to determine.

Using the bottom line numbers on either the financial statements or the tax returns will almost always result in a lower valuation for your business. Why? Because privately-owned companies tend to keep reported profits – and thus taxes – as low as possible. To accomplish that, even moderately savvy business owners and their accountants take advantage of tax provisions and expensing rules, reasonable expensing of what are essentially benefits of owning a particular business, inventory “shrinkage” and other legitimate means to reduce their taxable income. You need to ferret these numbers out to find what the business is really generating for you and any other owners.

How Do I Find the REAL Number?

The mechanism for getting to the “real” number is called “financial recasting“, a process that entails an analysis of both the P&Ls and tax returns. You’re looking for expenses that either aren’t really expenses or are not recurring expenses. A couple of examples of the former would be depreciation and amortization expenses. These are accounting terms occasioned by complex and in many cases incomprehensible tax regimes. Neither took the first dollar from the company’s coffers. These “expenses” get removed from the “recast” expense column and added to the bottom line.

Examples of non-recurring (also called “one time” or “extraordinary”) expenses would be the costs of a move if the business out-grew its previous location; new software or a tech upgrade; the purchase of a piece of equipment or machinery; the costs of establishing a new production line, etc.

If your business sells physical products to consumers, you must pay particular attention to a category usually not found on any financial documents but one that we refer to as “from inventory” or “shrinkage”. Because the owners of such businesses are also consumers, it is likely that they have periodically availed themselves of some of what their business sells. For instance, the owners of a motorcycle dealership most likely own motorcycles. If they need parts or want to accessorize their bikes, it would be reasonable to believe that such items, as they are removed from inventory, are “expensed”, possibly in a P&L line item category titled “Shrinkage”. This consideration must be applied in every consumer-facing industry from furniture and book stores to delicatessens and wine and cheese shops – and everything in between.

A classic example of this issue is a restaurant. How many meals do the owners, the partners or the families eat for free? This “expense” has nothing to do with operating the business and everything to do with the benefits of owning that business. If your business is consumer-facing, estimate this “expense” and add it back to the bottom line.

Here’s a personal example. I had a client that owned a specialty wine, cheese and prepared foods shop with revenue of a little more than $1 million. When we began the valuation process, I asked, “how much would you estimate is the value – at cost – of what you take out of the business in wine and food on an average month?” The answer was about $2,000.  That meant that we added $24,000 to the bottom line as we continued with our recasting.

The expenses need to be analyzed thoroughly to find every dollar that was spent on something that was not critical to the operation of the business; something that did not drive revenue dollars to the bottom line. Every one of those dollars should be added to the net. The number that results from this exercise is what we refer to as “discretionary earnings” or the benefit of owning this particular business. This is what buyers are interested in and it is what they are willing to pay for.

So, What’s My Business Worth?

The second question a buyer will ask is, “What am I willing to pay for this amount of income?” There are a couple of ways to determine this but one of the first questions you might ask yourself is, “What would I pay for this amount of money?” That simple question will give you some perspective. Many times when we do a valuation, the owners are disappointed in our conclusion. It is at this point that we ask that question of them. The response usually takes a minute or two as reality sinks in.

What someone will pay for a certain amount of dollars – a certain cash flow – varies by industry, the price of money (interest rates), the competition for the buyer’s money (which includes other businesses that are for sale as well as other investment vehicles such as stocks, bonds, real estate, etc.) and sundry other aspects. It also is impacted by the buyers’ perception of the likelihood of the business being able to continue generating at least the same amount of discretionary earnings in the future. (This is one of the reasons you want three years of financial results – you want to establish a trend – and why your financial planning and preparation for sale should be three years in length.)

The “Multiple”

So, now that you’ve discovered your business’ actual earning capability and know how much it really makes, how is the value calculated? Different people have different methods but arguably the most often used method is applying a “multiple” to the discretionary earnings (true net). Another method is to capitalize those earnings by applying a specific rate of return similar to how commercial real estate is valued. But a “multiple of earnings” is what we hear most often from business owners who think, quite incorrectly, they know what they’re talking about, so let’s focus on that.

But what multiple? As mentioned above, this varies by industry and other factors but you can start by realizing that few private businesses – especially those with revenue of less than US$20 million – will sell for more than three times earnings (adjusted or discretionary earnings); most will sell for something between two and two and one-half times. Granted, some will fall outside that range. To the low end will be businesses that are growing slowly or not at all, or are in industries that are undergoing upheaval of some kind. To the high end will be businesses in industries that are experiencing consolidation or growing rapidly. As I write this, technology and network security come to mind; and in the US, healthcare.

Let’s look at a very generalized and simple example. A business had sales in its most recent year of $6.5 million and taxable net of $450,000. After analyzing and recasting the expenses – adding back expenses like depreciation, amortization, the cost incurred when the owners moved the business to larger facilities in Dallas, health club membership for the owners, etc., etc., etc., the owners’ business broker tells them that they had a “true net” – discretionary earnings – of $940,000. If other businesses in the same industry as the subject business sold for an average of 2.5 times discretionary earnings, the likely value of the subject business is in the neighb0rhood of $2,350,000. And, if you know what those businesses sold for, you can determine what the sales prices were relative to their gross revenue. Apply that multiple to see if your earlier number is realistic; they should not be dramatically different.

So, the real question is how do you find what other businesses sold for? Googling “how much is my business worth” will illustrate that there are countless books, databases, SBA advisors, CNN articles, business appraisers, online calculators, lender blogs, etc., etc., that can give you some general pricing ideas. None of the good ones are free. However, the biggest problem with most of these sources is that by the time they are published they are more or less outdated. The best way to find what your business is worth is to have it valued by a professional business broker.

Most professional business brokers subscribe to various databases that provide information on business sales. We pay monthly or yearly fees to access this data but it is tremendously useful insofar as it’s accurate and up to date. There are databases for general business sales, Main Street business sales (a category that we define as businesses with less than roughly $1 million in revenue), Middle Market business sales (a category that we define as businesses with more than $1 million in revenue), business sales that utilized SBA financing and more. Our experience with each of these databases is that they are generally accurate and, if your financial recasting is done properly, you’ll have a very good idea of what the marketplace suggests your business may be worth.

(For a detailed discussion on SBA financing, I suggest that you listen to this interview with Dave Moore of Acclivity Financial, an SBA Preferred Lender.)

We do business valuations all the time and would be happy to help you with yours. If you are satisfied that you know what your “real” earnings are – your discretionary earnings – and don’t want a professional opinion of value, for a small fee we can do the industry research to determine what the multiples should be for your business and you can take it from there. If I can help you in that way, send me an email.

If you have any questions, leave them in the Comments box, below, or send me an email. If we get enough on the same topic, I may do a post or podcast tackling that topic specifically.

Finally, we’ve had several people ask if we have a course to teach them how to become business brokers. I’ve been thinking of putting together such a course and will do so if there are enough people interested in it. So, let me know your thoughts on this, as well.

Joe

The author holds a certification from the International Business Brokers Association (IBBA) as a Certified Business Intermediary (CBI) and can be reached at joe@WorldwideBusinessBlog.com

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