Selling Small Businesses – What Is Your Business Worth?
When it comes time to sell your business, knowing how to enhance its value and planning ahead are key to doing it on your terms.
Selling a business can be complicated and very time consuming. Since the average business sale transaction takes anywhere from four to 12 months business owners need to be in the right frame of mind when they embark on the process. A big mistake that is often made is not planning well enough in advance to optimize its value and not having a strategy for exit.
THE CONCEPT OF VALUE
The concept of value was set forth as early as the first century, B.C., when Publilius Syrns wrote his Maxim 847: “Everything is worth what its purchaser will pay for it,” or as an early British economist, Samuel Bailey wrote in 1825, “Value, in its ultimate sense, appears to mean the esteem in which an object is held.” So, a closely held business may have a high value to its owner resulting from the efforts expended to build it, but it may have a lower value to a potential buyer who may be more interested in return on investment than past efforts of the Seller.
Thus, a proper valuation of a business will result from a dispassionate analysis of the firm’s objective and subjective factors such as: the firm’s financial condition, future income and expense risk factors, market and industry considerations, management and marketing functions, and the perceived esteem with which the business is held by its industry.
Two methods commonly used by business brokers to determine fair market value of privately-held businesses are the Multiple Method and the Discounted Future Benefits Method.
The most viable valuation method for small businesses is the multiple method. This formula applies a multiple factor to the previous year or current year projected Discretionary Earnings figure to arrive at a purchase price. The Discretionary Earnings figure is a combination of several factors:
Seller Discretionary Earnings (SDE) = Pre Tax Profit + Owner’s Salary + Additional Owner Perks + Interest + Depreciation + Adjustments for One-Time Events. Note: Net working capital and real estate would be additive values.
Typically, small businesses will sell in a range of one to four times multiple of this figure. This is a wide range, so how do you determine what to apply? In general, a one to two times multiple is for those businesses where the seller is “the business” or is “a one-man show.” In other words, if the seller leaves, so too can the customers. Businesses with declining revenues, and high-risk businesses, such as restaurants, are in the one to two-and-a-half times multiple range. Three to four times multiple is for businesses that have been around for several years, have shown sustainable growth, have a solid base of clients, assets that will not have to be replaced in the immediate future, are involved in growth industries, and have expansion possibilities. Of course, there is a lot more to factor into the equation such as current economic and market conditions and the category of buyer that the business will bring.
Examples of Positive factors that raise multipliers include:
aProprietary products, with strong brand and/or patent or trademarkaDiversified customer base – no one customer more than 10% of sales aStrong management teamaWeak competitors and a healthy market share for your companyaProducts that are early in the Product Life CycleaAbility of the company to meet some growth with current plant and equipmentaNo pending legal or government actionaFinancial ratios that are near or above industry averages and other other positive aspects.
Examples of Negative factors that lower multipliers include:
aProducts that are just like competitors aOne or a few customers make up more than 25-30% of sales aStrong competitors and a weak or declining market share for your company aProducts that are near the end of the Product Life Cycle aMajor investment needed soon in plant and equipment aPending legal or government action aFinancial ratios that are below industry averages and other negative aspects.
About the factors listed above —if your company has one, or even a few, of the negative factors — you are typical! There is no perfect business, but buyers will use these factors to negotiate the price down. You should address possible problem areas and outline how the negatives can be overcome by a new owner. Buyers will look at the price of the business and determine if they can make sufficient profits to earn a livable salary, pay the new debt service, and provide a reasonable return of their investment. Ultimately, this is the test to see if the price and terms of any deal are reasonable.
Discounted Future Benefits Method
When forecasted future earnings can be reasonably developed, then the Discounted Future Benefits Method is often preferred by some buyers. This method utilizes one of several forms of forecasted after tax earnings over a period of five to 10 years. These earnings are then converted into a value using a present value concept. This method is more applicable to larger businesses that have stable or predictable earnings. Buyers often expect a 25% to 35% rate of return from an acquisition.