Do you know the value of your business? Most owners don’t, and it could cost them. Even though most businesses in the US are technically small businesses, understanding the true value of these companies has not been generally accepted. Every owner who wants to sell their company will eventually go through the valuation process. However, there can be benefits for every business owner, not just sellers, to get a valuation. Understanding the importance of value, how the value is calculated, and how the company compares to the industry can give business owners insight into what their business truly looks like.
The Importance of Value
Valuations are technically a subjective report, since an “objective” report would be someone actually offering to buy the company for a specific value. Even though they may be subjective, business valuations may still provide meaningful insights. It is estimated that 98% of small business owners do not know the value of their business. In other words, almost every small business owner is ignoring the benefits of this process.
Regardless of whether you are ready to sell your company, I’d argue how important it is to know the value of your company. Going through the exercise of obtaining an official valuation can not only help you plan for the future but also give you solid evidence of the state of your business. A valuation at least every few years can help you understand which parts of your business could be improved, and which parts are the most valuable to potential buyers.
In order for any broker or mergers & acquisitions (M&A) professional to value your business, they need a lot of data and documents to review. All P&Ls, balance sheets, tax returns, and other documents will be required for at least the last 3 to 4 years. Since many business owners do not have accurate or easily accessible business records, this step alone could pay dividends to help get your business to a more sellable state.
Valuation Calculation
For many small business owners, there are two main ways to value a business. Either the value is determined using an income-based approach or an asset-based approach. The better valuation method depends on the specific company. You could imagine a service company with essentially zero assets but still generating plenty of revenue. It would be better to focus on the income of the business in this case, since the asset value would be nothing.
The main approach for income-based valuations takes the profits of the company and tries to calculate the “real earnings”. This could be either EBITDA (earnings before interest, taxes, depreciation, and amortization) or SDE (seller’s discretionary earnings). In general, both metrics will “add back” certain expenses to give you the take-home profits that a business owner has access to. These take-home profits are one of the most valuable pieces to potential buyers, since the true profits the company creates.
An asset-based valuation may be simpler, assuming it applies to the business. In general, adding together the fair market value of all the assets of the company would provide a total valuation for the company. There is some accounting work to do here, since these businesses have likely been depreciating the assets since they were purchased. As a result, there could be a difference between the value of the assets on the books and any actual sale of them.
Comparisons
Once the earnings have been valued (usually through determining EBITDA or SDE), the next step is to compare the business to the rest of the industry. The comparison can include current companies in the same industry, as well as recently sold companies in a similar space. This is when the “multiple” is introduced, where a company’s EBITDA or SDE is multiplied by some factor to reach its true valuation. For example, a 2.5x multiple for a company with an SDE of $500,000 would sell for a price of $1,250,000.
Once again, this multiple is technically a subjective number. So, to more narrowly define the true multiple, valuations will look at recently sold businesses in the same space and see what multiple they used. As a result, certain industries could have a much higher multiple than others. Usually, there will be a loosely defined range of multiples that may apply to your business. This range is where you can begin to see the benefit of understanding a valuation.
It is not hard to imagine, if your business was the “best in the industry”, that your multiple would be at the top end of your range of multiples. Alternatively, if your estimated multiple is at the bottom of the range, that is a good indicator that your business does not compare well with other similar companies. This can be extremely helpful because you can begin to learn what changes could occur to increase your multiple. Perhaps your costs are abnormally too high and cause your SDE to decrease. The multiple will give you a good gut check to know the health of your industry as well as your company.
Valuations are Important
Working through a valuation for your company can provide immense benefits. Just like any other asset, understanding the value and the levers to change the value can significantly improve your business. While the result is technically subjective, the process to organize your documents, calculate your earnings, and compare the company against the industry can be objectively helpful. Work with professionals to help you understand the situation that you and your business are in.
TC Falkner 