Business Valuation…
The question of the century is, how much is my business worth? I talk to 10 to 15 business owners every week. What’s interesting is that if you ask them how much their business is worth, the variations in answers are extreme.
In the past few weeks these are some of the answers I got.
- Two times gross receipts.
- 15 times profit.
- 10 times annual cash flow.
- 5 X the balance sheet assets.
None of these are remotely accurate. Although they could be true, your odds of getting an accurate valuation using any of these are extremely low.
Why are business valuations so complex? Since most business owners depend on the sale of their business to retire, Why is knowing what your business is worth something that most business owners can’t answer?
Why are other assets like real estate so easy to determine value vs a business?
If you buy single-family homes in a specific neighborhood, there’s an average cost per square foot multiplied by the square footage of other houses sold in close proximity. With the cost per square foot, you’ll have a pretty accurate assessment of the value of a home in the area. Zillow built a multi-billion-dollar advertising platform on this one metric.
The area or neighborhood determines the price per SF more than anything else.
With commercial real estate, it’s not the cost per square foot but the capitalization rate (cap rate) of comparable buildings in the area.
The area determines the capitalization rate and what investors are willing to pay for income in that area.
For every dollar invested, how much capital do they receive in returns? For instance, if I invest $100,000 and receive $5000 per year in net income after all expenses, the property is said to have a 5% cap rate. When I want to determine what to offer on a commercial property, all I need to know is the gross income minus all expenses. They take what’s left and divide that by the market cap rate for like properties in that market and voila, you’ve got the property value.
So, if real estate values are so easy to determine, why is it so hard to determine the value of small businesses?
There are many reasons, but let’s focus on three main reasons: emotion, overzealous business brokers, and the lack of a universal standard covering all sizes and categories of businesses.
There are three common categories of businesses. I’ll explain each and how their valuations are determined in the category.
Small Businesses
Typically, a small business has gross revenues under 10 million and profit below 2 million.
Small businesses are valued using a multiple of the seller’s discretionary earnings (SDE).
Technically, they sell based on multiples of earnings before interest, taxes, depreciation, and amortization (EBITDA), but the valuation comes from how much the owner(s) are able to pocket from the business annually.
Most small businesses are limited because the owner actively participates in the company’s day-to-day operations.
Because of this, small businesses can be challenging to sell because the best employee is the one selling the company, and it’s difficult to replace them.
The vast majority of small businesses never sell because the sellers have an inflated view of their business’s worth, and buyers find it difficult to get lenders to loan them enough money to satisfy the seller’s emotional connection to the sale price of their business.
Depending on financing, small businesses typically trade between 1 and 4 times SDE. Most SBA-backed loans fall in the 1.5-2.7 times SDE range.
A lender has more control of the pricing in this category unless the seller is willing to mitigate some of the risks to a buyer and provide the financing.
A seller willing to finance most or all of the business’s sale price will get the highest multiple because the lender is the obstacle.
Lenders know statistically that the chance of the business surviving once you are gone is in direct correlation to how active you are in it.
The more active you are, the higher the risk of failure after you sell.
Eliminate the obstacles, risk of failure, and lender hesitancy, and you can sell quickly.
So if you own a business, and you make $1 million per year in salary, profit, company cars, insurance, and all of the other benefits you receive from the business, you might be able to get as much as 4 million from the sale of your company. Although unlikely because most buyers will need to secure financing from a lender, and the lender will deduct from your 1 million in SDE for things like your salary and benefits because the new owner will have to pay 1 to 3 people to take your place.
These “takebacks” can dramatically lower your valuation.
Banks will not lend money if they believe there’s a high probability of failure. Lenders want to see the probability of failure under 10%.
Just because your business is a money-making machine for you doesn’t mean you can transfer the machine to someone else.
If you believe you can transfer the machine provided you train the buyer, but a lender doesn’t see it that way, then you should consider financing your buyer. It shows the buyer that you believe in the business, and you believe in them.
Conversely, when a seller says “I want all cash, and I’m only going to stay on for 2 weeks after the sale”, the buyer will go somewhere else because the transaction is too one-sided. The “I want all cash” seller most often closes their doors after a life event.
Mid-Market Businesses
Mid-market businesses typically have gross revenues in the $10-100 million range.
These companies are larger than small businesses and tend to have management in place across sales and marketing, operations, and accounting and finance.
Mid-market businesses almost always have well-established systems, 50 or more employees, and ownership that has little or no involvement in the day-to-day operations of the business. Mid-market businesses trade for multiples of earnings before interest, taxes, depreciation, and amortization (EBITDA). EBITDA is similar to SDE, but the interest paid on debt, taxes, depreciation, and debt paydown (amortization) is added to the corporation’s profit.
Mid-market companies trade for higher multiples of EBITDA, usually between 5 and 15 times EBITDA,depending on management, customer concentration, systems and processes, and other variables.
Mid-market businesses are quite often acquired by private equity groups and family offices that look to leverage capital for rapid growth and high returns.
The better the company runs without ownership involvement, the higher the multiple. My partners and I focus on acquiring small businesses, improving all aspects of the business, and selling them to mid-market acquirers.
Large Enterprises
Large enterprises can be privately owned or public entities with gross revenues in excess of $100 million and valuations of 15-25 times EBIT or more. My expertise does not extend to large enterprises because these companies can have hundreds of thousands of employees and management all over the globe. Warren Buffet and Charlie Munger have made billions acquiring undervalued large enterprises and holding on to them until they trade at much higher multiples.
If you’re a small business owner considering a sale in the next 1 to 3 years, let’s talk. We’ll have a confidential conversation, and I’ll provide you with an accurate evaluation of the market value of your business. I’ll also provide you with what I call a financeability score. A financeability score is a rating we apply to a business that tells us the probability of a lender providing 80-90% financing of the business. If the score is under 60%, there’s a high probability that you will not sell your business for the cash price you think you’ll receive.We’re not business brokers. We buy great companies and offer advisory services to business owners looking to exit their businesses in the next 1 to 3 years.
Here’s why you should talk to us before speaking to a business broker. Business brokers are basically real estate agents who focus on selling businesses. I’m not knocking them; a good broker can be essential when selling a well-positioned company, but the goal of most business brokers is to get listings.
Why?
They normally charge an up-front fee of $35-50K to create a confidential information memorandum (CIM), and then they get 5-10% of the sale price.
The problem is they won’t get the listing unless they make it seem like they can get you some outlandish price for your company. You think, dang, if I could get that kind of money, I’d sell right now.
They’ll show you stats on how they sold another company “just like yours” for a 5 X multiple in 33 days.
When in reality, your company is unique, and there are no comparable companies because YOU are partially what makes your business unique.
When you speak with us, we’ll show you what we are willing to pay for your business and how we came to that valuation. We don’t lowball, we can’t, or no one will sell to us.
We work to achieve a valuation that works for you and us. If your business needs some tweaks to achieve the valuation you need to retire comfortably, we’ll show you how to make it happen. We can even advise you through the process so you can sell the business at the price you need to live happily ever after.
Are you approaching retirement and thinking about selling your company? Book a confidential call today. If we like what you’ve built, we’ll give you an honest assessment and a fair offer. We’ll even show you what to address if your business isn’t quite ready for a new owner.
A comfortable retirement might be closer than you think.
About the Author: David Mulvaney moved to Florida from Wisconsin in 1987. In 1992, he acquired a home services company with 97.5% seller financing. By 1994, Dave converted the company to 75% commercial services and sold the company in 1998 for over 10 times the original acquisition cost. Since then, Dave owns or has owned controlling interest in profitable businesses in the following sectors: manufacturing, engineering, global distribution, home services, commercial services, e-commerce, SAAS, residential, and commercial real estate. His companies have grossed over 250 million in sales over the past 33 years.
Dave buys and builds great companies and advises entrepreneurs on how to exit profitably on their terms. To Book A Call, Go Here.