Breaking up is hard to do and so is selling your business. While finding the right buyer for a good price might seem to be the hardest problem you have to face, it is probably easier than giving up your baby after all you have invested over the years.
Contrary to what you might feel, you will only get the best price possible if you are able to park your emotions about how much you think the business is worth and approach this dispassionately. Regardless of your feelings about the value of your business, it is only worth what someone is willing to pay.
This document is the first part of a two part series covering practical ways to value your business. In this blog, we’ll review how to value any small business while in part two we will look at specifics for an equipment rental business.
First, there are two basic methods of valuing businesses, no matter the size
1. Going concern
The first method is to assume your business will continue operating after its sale as part of a larger organization or as a standalone acquisition owned and managed by someone other than you, although you might be asked to stay around for a limited amount of time. Calculation of the business worth can become complicated as there are many motives for selling and as many different calculation formulas. In nearly all situations, you will find yourself using this method to value your business.
There are times the business will be worth more if you dismantle it than if you continue to operate the business. An example would be a business with significant amounts of cash or real estate investments. The business may be worth more by distributing the excess cash and selling off the real estate piece meal instead of trying to earn rental income. Another example, which is perhaps more applicable to an equipment rental business, is where you have a marginally profitable or even non-profitable business. The value of the equipment and any real estate investments may be worth more than the marginal cash flow generated over the years.
If you think option 2 might apply to you, keep this in mind as you work through the calculations under option 1. You may find it more lucrative to dismantle the business rather than sell it as a going concern. It might break your heart, but you would be better off.
At this point, let’s remind ourselves again a business is only worth what someone else is willing to pay for it. Nothing else matters when selling your business. Because of this, you need to understand how potential buyers will view your business and not get caught up in the emotions or that desire for a new diesel pusher RV. This objectivity will help you to set an appropriate value and give you the knowledge you need to prepare your business for sale. Selling a business may take between one to three years, giving you time to improve your fundamentals, which can increase the sale price.
Use an earnings multiplier method to value a going concern
In plain English, this means you are looking for a multiplier to apply against your projected earnings, which are usually based on historical earnings. So, for example if you had a multiplier of 2 and earnings of $100,000, your company would be worth $200,000.
For larger companies, these multipliers are more well-known and are less risky than those for smaller companies, which might be dependent on a single product line or key executives. You might think you are truly indispensable but, if that is true, your company valuation will be less if the business needs you to function.
For smaller companies, these multipliers commonly range from 1 to 3 times adjusted earnings, which we will discuss later. Your goal is to improve your adjusted earnings and get to the higher end of multiples for your business.
Factors increasing your multiplier include:
- Showing consistent growth in sales and profit over a number of years, usually a minimum of three
- A strong reputation in the industry and community
- Strong economic climate, even if this is out of your control
- Better than average assets including real estate and equipment
- Formalizing as many of the intangible assets as possible, i.e. trademarks, branding, etc.
- Positive reason for sale as any hint of forced sale for reasons such as health of a principal can seriously reduce the value, so sell before you have to
- Strong internal systems as the user will want the business to run smoothly when you stop managing it
Three Steps to valuing your business
1. Calculate adjusted or discretionary earnings
As good as your accounting records may be, prospective buyers will not use your reported earnings to calculate the business value. Instead, they will start with those numbers and “normalize” them to get something called Seller’s Discretionary Earnings (SDE), which better represents the business’ true profit potential. The following items are some adjustments that might be made to get to SDE.
- Non-cash expenses including depreciation and amortization
- Financing expenses such as interest on short and long-term loans
- Any personal expenses included in the calculation of income
- Arbitrary expenses such as excess entertainment or travel
- Charitable donations
- Owner’s salary and benefits, although if the owner is actually managing the business, a reasonable amount may have to be added back to hire a replacement manager
- Any family salaries not required in the new business
- Any one-time expenses or revenue unlikely to recur, such as the settlement of a lawsuit
Generally, most of the adjustments will increase your SDE, and therefore your business valuation, so don’t be shy about digging out those numbers. The prospective purchasers are not the tax auditors!
2. Determine the SDE multiplier
Most people won’t know this number. You will likely need to talk to a small business broker or mergers and acquisition (M&A) specialist. It can be very specific to your unique business segment so don’t accept a generalization. There is a lot of difference between multipliers of 1 and 3. For purposes of our example later, we’ll use 2.
3. Adjust SDE for other business assets and liabilities
The SDE obtained may not include all assets or liabilities so adjustments may need to be made.
In many cases, purchasers won’t want to assume possible liabilities your business may have incurred and this results in many purchases being treated as an “asset” purchase in order to freeze any potential liability. As a result the business liabilities may be retained by the original owner, who will be responsible for settling them. Another example is the SDE may not include the value of inventory so this may need to be adjusted. Or there may be excessive real estate holdings. You get it. There can be many possible adjustments but the following example is a good starting point.
For a business with a three year average of $200,000 net income with the following details:
- Annual depreciation and amortization of $25,000
- Annual mortgage interest of $25,000
- Personal expenses of $25,000
- Owner’s compensation of $125,000
- New business manager’s salary of $100,000
The calculation of SDE would be:
- Net income of $200,000
- Plus: $25,000 + $25,000 + $25,000 + $125,000 = $200,000
- Minus: $100,000
SDE = $200,000 + $200,000 – $100,000 = $300,000
For a business with an SDE of $300,000 with the following details:
- Multiplier of 2
- Net real estate of $400,000
- Accounts receivable of $100,000 excluded from multiplier
- Cash of $50,000 excluded from multiplier
- Accounts payable of $75,000 excluded from multiplier
The calculation of the adjusted valuation would be:
- SDE of $300,000 x 2 = $600,000
- Plus: $400,000+$100,000+$50,000 = $550,000
- Minus: $75,000
Final calculation = $600,000 + $550,000 – $75,000 = $1,075,000
Other adjustments are possible but this is a starting point. Talk to your accountant and see what you can come up. Doing this every year can give you both a starting point and a report card on how you are doing as you look forward to selling your business someday.
There are online calculators useful for business valuation and one example is BizEquity. This website also has useful information about selling businesses but there are many examples. I personally have not had any contact with this company, so cannot .
You can hire professional appraisers but it is important to find one who understands the nuances of your business. Otherwise, they may not know the correct multiplier or the necessary adjustments. As an example, service businesses often rate lower than those with a more concrete business such as manufacturing as it doesn’t take much for the business to disintegrate if key customers or staff are lost.
The Shark Tank show isn’t just about entertainment
It is important to remember these guys are playing with their own money and time. Business owners can get kicked off the show very quickly if they don’t have a realistic idea of what their company is worth and why. Valuing your company at $1,000,000 because you have invested $100,000 in an idea but have no actual sales is likely unrealistic. It is really sad when someone shows up who has a passion for something, has sold their house and all they own to invest in the idea but has no sales. The possible deals you see creating the most excitement from the investors are those with confirmed sales and growth. Often times, the value isn’t those actual sales numbers. These savvy investors know sales and profits can be grown exponentially by taking advantage of their experience and investment funds.
Make sure you know what your company is worth and why.
Don’t forget about tax planning
You need to talk to the experts about this, preferably several years in advanced, so you can maximize your net proceeds after tax. Some owners are sensitive about this because they confuse tax planning with tax dodging. You are entitled to minimize your tax burden using all legal measures. You don’t have to pull a “Wesley Snipes”, who somehow decided he could declare himself a tax-free zone. It didn’t work out too well for him. Don’t let it scare you. Honest tax planning is good.
This concludes part one of our valuation blog. Stay tuned for part two where we apply this methodology to equipment rental companies.