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Introduction
Business valuation is a complex task. There are scores of factors that can affect the value of your business, and dozens of different approaches to valuation. Books on the subject run 500 pages or more, and are filled with indecipherable formulae and tables of number after number. Many of the key judgments are highly subjective, and it is not uncommon for different brokers and appraisers to differ dramatically in their estimates of value.
What follows is a very rough overview to introduce potential buyers and sellers to the topic. It must not be relied upon for actual pricing of or offer on any specific business.
The Value Pyramid
To understand how businesses are valued, review the Value Pyramid
chart above, which represents a simplified framework for determining
the value of a business. The four key value factors are:
- Seller’s discretionary earnings
- Desirability/ strategic value
- Risk
- Terms of Sale
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Seller’s Discretionary
Earnings
The foundation of value, especially in the market for small- to medium-sized businesses, is Seller’s Discretionary Earnings (SDE)—the financial benefiting accruing to the owner of a business. A simplified summary of how SDE is calculated for any given year follows:
| Figure |
Explanation |
Pre tax net income + |
|
Salary paid to owner + |
Assuming one full time owner. If the business is operated absentee, substitute the general manager’s salary |
| Non-operating expenses, principally interest payments + |
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“Discretionary expenses” |
These are expenses paid for by the business but that really are more of a personal benefit for the owner(s). Typical examples are owner’s medical insurance, owner automobile expenses, travel or entertainment not related to the business, etc |
| Extraordinary, non-recurring expenses |
E.g., expenses from a flood or hurricane damage, one time move of the business, very unusual law suit, etc. By contrast, a failed advertising program or recruiting expenses are not considered extraordinary. |
| Non cash expenses, i.e. amortization and depreciation |
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| Total = Seller’s Discretionary Earnings (SDE) |
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Estimates of the SDE are calculated for each of the last 3-5 years, and then an overall average is obtained, typically with more weight placed on recent years.
SDE is considered the best overall measure of the profitability of a small business. When SDE gets above $400-500K, buyers look more closely at EBITDA (Earnings Before Interested Taxes Depreciation and Amortization). EBITDA is calculated as follows:
EBITDA = SDE – (annual compensation for a manager capable of running the business).
EBITDA is the earnings a passive investor owner would receive after paying a general manager.
A Multiple of Earnings
The majority of small businesses in Hawaii and on the mainland sell for between 1.5 and 3.0 times the average SDE. Customarily included in the price are all the assets of the business (inventory, equipment, customer lists, leases, goodwill, etc.) except cash, deposits and accounts receivables. Buyers generally don’t assume any of the liabilities.
This is obviously a very general rule. The multiple can vary dramatically depending on dozens of factors, falling into the general categories of "desirability", "level of risk" and "terms of sales, as mentioned above, and elaborated later in this document. We have obtained higher values for sellers on occasion, but have also seen lower values.
The aforementioned multiples are likely to be irrelevant in any of the following situations:
- Business is near breakeven or losing money (i.e, SDE is zero or negative)
- Buyer is a "strategic" industry buyer who will be able to greatly increase earnings through synergy in marketing and operations
- Large businesses (earnings $1 million or above)
- Technology business
- Business has inventory levels far in excess of annual SDE (e.g., some jewelry stores)
Desirability
More desirable businesses sell for a premium relative to less desirable ones. Some of the factors that increase desirability include:
| Desirability Factor |
Explanation |
Higher level of SDE |
The multiple of earnings increases as earnings increases, creating a compound effect on value. Earnings should be at least $70K. Above $300K is especially desirable. |
Strategic value |
Applicable when a buyer in the same industry can greatly increase earnings through synergies found by integrating the purchased company with their operations. In some cases the increase in value can be dramatic. But the risks for sellers in approaching competitors in the same industry are also great. |
| Fun and glamour of industry, business |
E.g., a sailing charter company will be worth much more than a cleaning company with the same SDE |
Number of hour owner works, and ability to take vacations |
Very important to many buyers |
| Location |
Important for some businesses, but not for others |
| Facilities |
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Risk
Risk can have a dramatic impact on value. Some of the key risk drivers follow.
| Risk Factor |
Explanation |
Years in business and with the current owner |
The longer the better |
Quality of books and records, especially tax returns |
Extremely important; buyers need to verify earnings. |
| Profit trend |
Flat or increasing is key. If earnings are down, buyers tend to look only at the most recent down year. |
Franchise membership |
Can have a dramatic impact for market leading franchises. Impact is more modest for less successful franchises. |
| Lease length and terms |
Absolutely critical for location dependent businesses such as retail and restaurants. Longer lease with guaranteed rates are better. |
| Dependence on current owner |
If business is extremely dependent upon owner’s skills contacts, relationships, etc. value can be greatly diminished. E.g., a one man plumbing business is typically worth whatever his truck and tools can be liquidated for. |
| Stability, cyclicality, legal issues of industry |
Cyclical, volatile businesses sell for less |
| Brand recognition/ strength |
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| Level of competition |
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| Diversification of customer base; customer turnover and contractual agreements/ terms |
Dependence on a few customers will reduce value. |
| Supplier relationships and agreements |
Exclusive rights to sell increase value. Supplier should be stable if important to business. |
| Equipment/ asset condition |
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Terms of Sale
Terms of sale, or “deal structure”, can also greatly affect value. The good news is that these are factors that sellers and buyers can control. Factors here include:
| Terms of Sale / Deal Structure |
Explanation |
Seller financing |
Most sellers prefer all cash, but value is typically 20% higher if seller is willing to carry paper. See VR’s “Seller Financing FAQ” for more information. |
Training and ongoing consulting |
The more dependent a business is on the owner’s skills and relationships, the more important this is. |
| Non compete agreement |
To get maximum value, sellers need to agree not to compete with buyers for five years after sale. |
Purchase price allocation |
For asset purchase agreements, the allocation of purchase price to various asset classes can have important tax implications and affect value. |
| Sale of entity (stock, membership interest) vs. assets |
Legal structure of sale can have significant impact on value. |
Valuing Your Business
From the above discussion, you can see that valuing a business is a complex task. Going to the market with the wrong asking price can lead to disastrous results. In some special cases it’s better to have no asking price when going to market. So it’s important to get professional advice. We can suggest proven strategies for increasing the value of your business for later sale. Contact VR Business Brokers anytime for a complimentary, no-obligation consultation.
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