Avoid Three Common Mistakes When Valuing A Business

Business Valuations

The value of a business is generally a multiple of its profits (or adjusted owner benefit) generated by the current owner of the business. The mean valuation multiple for businesses is about 2.5x its annual adjusted owner benefit but varies significantly by industry and by the specific attributes of the business. An accurate business valuation must incorporate the properly adjusted owner benefit – or true economic profits derived by the owner- and must apply a valuation multiple that reflects the owner’s role in the business. Three common mistakes made when valuing a business include not normalizing or undercounting the adjusted owner benefit, valuing the business solely as a multiple of its revenue, and not factoring in how transitioning the goodwill of the business to the buyer from the seller may affect the valuation multiple.

Avoid Undercounting Adjusted Owner Benefit

The most common mistake for many small business owners when it comes time to value their business is undercounting their level of reported profits. The level of reported profits on which their business valuation is based should fully reflect the true economic profits derived by a working owner. A properly determined level of adjusted owner benefit starts with the EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) or the pre-tax cash flow from the most recent financial statement. Then one must add back any personal expenses of the owner that may have flowed through the financial statement, the owner’s salary, and any non-recurring expenses not applicable to a buyer. Most business owners do not realize that these ‘add-backs’ are of economic benefit to them and should be considered part of their reported profits or adjusted owner benefit.

Example of Undercounting Adjusted Owner Benefit

  • Let us suppose that Ned is selling his auto body shop.
  • Ned decides that his shop generates $200K of profits per year, and bases his own valuation accordingly.
  • After not being able to sell his shop on his own, Ned consults with a professional business broker.
  • The broker realizes that Ned has about $50K of personal expenses (such as personal vehicle payments, personal cell phone payments, and personal travel costs) that flowed through the most recent tax return or financial statement.
  • Once such expenses are substantiated as having flowed through the financials statement, they are properly considered to be part of Ned’s adjusted owner benefit.
  • The valuation of the auto shop should correspondingly rise by 25%, or the percentage increase of Ned’s actual owner benefit of $250K compared to Ned’s owner benefit determination of $200K.

Valuation Based Solely on Revenue

Valuing a business solely on its revenue is a common mistake made by those who assume that the revenues or gross sales of a business is the sole criteria on which to base a business valuation. This flawed methodology ignores the gross margins of a business and well as the operating margins of a business. The gross margin of a business is the percentage of revenue left over after paying for labor and material (cost of goods sold) to produce products or services. A business that cheaply produce goods or services by virtue of a better supply chain and more efficient production process will have higher gross margins than its competitors. The operating margin of a business is the pre-tax profits divided by sales, or what is left over after operational costs such as rent, overhead, administrative payroll, utilities, advertising, and insurance are paid. Two businesses with identical gross sales may have starkly different operating margins which leads to starkly different business valuations.

Example of Valuing Businesses Based Solely on Revenue

  • Consider the valuation of two chains of female retail clothing stores, each of which do business in adjacent markets in South Florida.
  • Both chains of apparel stores have three locations with the same level of $3M per year in gross sales (or $1m/year per store).
  • Should these two businesses be valued the same based on a multiple of their $3M/year of sales?
  • A closer inspection of the two businesses reveals that the first business has a gross margin of 45% due to strong supplier relationships and a mix of inventory which favors higher margin items.
  • The second business has 30% gross margins because of a different product mix (with low mark-up) and onerous terms from suppliers.
  • Further, the first business has an operating margin of 20% because its management has trained an efficient and productive staff, negotiated favorable rental terms on its three leases, and has instituted a cost efficient social media marketing campaign.
  • By contrast, the second business has an operating margin of only 5% as it is has a bloated and inefficient cost structure.
  • These two businesses must be valued based on their net profits or adjusted owner benefit rather than solely on their revenue in order to account for the competitive advantages of the first business.
  • Some businesses, however, such as pool routes or small landscaping routes may be valued based solely on revenue.
  • This situation is rare and only applies when the real value of the business is the customer route and its monthly recurring revenue
  • Buyers for such businesses establish their own cost structure after the sale in order to service the customer route.
  • Any efficiencies and cost advantages inherent in the operating structure of the seller’s business are of little use to the buyer and do not affect the valuation.

Transitioning Goodwill to Buyer

A final common mistake to avoid when valuing businesses is not factoring in how the difficulties of transferring the goodwill of a business – or its brand name, customer loyalty, and reputation – may affect its valuation multiple. When the seller plays an important role in running a business, the profits generated by the seller may not be the same as the profits generated by the buyer. This is especially the case if the seller has personal relationships with key customers or suppliers who may not continue to do business with the buyer after the sale. The more difficult the transition of the goodwill from the seller to the buyer, then the lower the valuation. It is always recommended that business owners develop a clear transitional plan prior to selling their business in order to address this issue.

When valuing a business, avoid the common mistakes of undercounting profits, basing a business valuation solely on revenue, and ignoring the importance of transitioning the goodwill of the business to the buyer. With the assistance of a professional business broker, business owners should be able to sell their business confidentially and for the maximum purchase price.

Give Martin at Five Star Business Brokers of Palm Beach County a call today at 561-827-1181 for a FREE evaluation of your business.