6 Rules of Thumb for Business Valuation
When it comes time to buy or sell a business, it’s important to set your personal feelings aside in order to do an accurate business valuation and establish a realistic and competitive selling price. You’ll need to objectively analyze the business, study the current market, and consider employing the expertise of a professional business appraiser. So what are the rules of thumb for business valuation?
There are many acceptable business valuation methods. One may be more suitable than another, depending on the type of business being valued, including its industry, size and circumstances of sale.
1. Prepare the financial statements and determine the SDE.
The first rule of thumb for business valuation is preparing the company’s financial statements. The owner should gather the financial records for the past three years including: an income statement, a cash flow statement and a balance sheet. If the business hasn't been operating for three years, consider using a projection model.
Next, work with an accountant to transform the income statement into a seller’s discretionary earnings (SDE) statement, which takes into account non-recurring purchases and discretionary expenses to more accurately reflect the value of your business.
2. Establish the asset value of the business.
The second rule of thumb for business valuation is to establish the asset value of the business. First, estimate the value of the company’s tangible assets by taking inventory of all the physical aspects of the business such as fixtures, equipment and inventory.
Next, estimate the value of the company’s intangible assets, including intellectual property, contracts, partnerships, brand recognition, and more. Assigning value to intangible assets can be tricky and it may be best to consult with a business broker or professional appraiser.
While asset valuation gives you a clearer picture of the business’s current value, it fails to clearly reflect the value of the company’s earning potential. Since buyers are primarily interested in their investment’s future earnings, it’s a good idea to quantify an estimate of the company’s earning potential through price multiples.
3. Use price multiples to estimate the value of the business.
Another valuation rule of thumb is using price multiples, which base the value of the business on a multiple of its potential earnings. Price multiples provide buyers with a tool to estimate their return on investment. They are a quick way to arrive at a general estimate of the business’s sale price.
Once you’ve established the asset valuation of the business, the next step is to determine the multiple that applies to the geographical region and type of industry. These numbers combine to form an equation that results in a fair estimate of the business’s sale price.
For example, nationally the average business sells for around 0.6 times its annual revenue. Once you’ve determined the annual revenue and found the correct multiplier, it becomes a simple matter of plugging the numbers in and then doing the math. The trick is to find the right multiplier for the business, since they can vary quite a bit.
4. Use comparables (or comps) of ‘For Sale’ and sold businesses.
Recent sales of comparable businesses (or ‘comps’) are a popular valuation rule of thumb that will offer you a realistic picture of what similar businesses are selling for. By identifying examples of similar businesses that have sold in the same area, you can get a better sense of a realistic selling price.
Comp data can be accessed through several online sources, as well as through business brokers, who can help to provide you with the right multiplier for your market. BizBuySell provides an inventory of hundreds of thousands of successfully sold businesses and over 50,000 businesses listed for sale. You can narrow your search by industry and geographic location, and then narrow it further by gross income and cash flow.
5. Improve the value of the business.
If an owner is disappointed when they discover the estimated value of the business, there are many ways to improve it. In fact, the sooner the owner begins working on increasing the business’s selling price the better. Remember that buyers are interested in businesses that offer the greatest potential for future profit. Documentation of several years of profit growth will add value to the company.
Buyers are looking for an easy transition into their new business, so evidence that the business is well-organized and running smoothly will also add to the company’s value. A clean and well-oiled machine with a neat, organized package of detailed financial records, compliance with health and safety regulations, renewable leases, employee policies, staff with transferable contracts, supplier lists and an established client base will go a long way. Potential buyers will be impressed and more likely to feel the business is a good investment for them.
Seller financing is yet another way that owners can potentially improve the value of a business. Partially financing the sale can benefit the owner with a higher selling price, collected interest, and a wider field of potential buyers.
6. Consult with a professional appraiser and get a formal valuation.
Hiring a professional business appraiser not only allows you to benefit from his or her expertise, it provides the objectivity that you may lack when it comes to making a fair assessment of the business. Many brokers are experienced at conducting a formal valuation or have connections with qualified professionals. Valuing a business correctly is essential in a competitive market, and enlisting the help of a third party professional will not only eliminate seller sentiment from the sales process, it will also shorten it by aligning the business value with up-to-date market conditions.