Valuation Critical When Selling Business
The most important factor to consider in selling their business for the majority of business owners is the potential purchase price they can realistically receive from the sale. No two businesses are exactly alike, and a professional business broker must evaluate a business properly in order to determine its potential worth. Let’s explore the various factors and methodologies used when determining how much a business is worth.
Business Worth Ultimately Depends on Adjusted Owner Benefit
Most buyers typically ask themselves one simple question: How much money can I make from owning the business that I am purchasing? The answer depends on how much money the business makes today for the current owner (the seller), and how much money the business will make in the future for the buyer.
What is Adjusted Owner Benefit?
- Adjusted Owner benefit is the total amount of monetary benefit that an owner derives from a business.
- The owner benefit may accrue from a variety of different sources such as taxable profits, the owner’s salary, and any personal expenses of the owner that flow through the financial statement.
- There are many hidden assets that comprise owner benefit, such as expenses or salary paid to non-working family members of the owner.
- Importantly, adjusted owner benefit is different from EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) because EBITDA does not include the owner’s salary, irregular expenses, or personal expenses that flow through the financial statement.
- For small business sales, it is critical to use adjusted owner benefit rather than what the net profit appears to be from a tax return or profit and loss statement.
- Only the adjusted owner benefit will tell the true picture of the profitability of a business.
A Multiple of Adjusted Owner Benefit Determines What A Business is Worth
Generally speaking, small businesses sell for a multiple of 2-4 times the adjusted owner benefit. For example, if the adjusted owner benefit is found to be $200,000, then the general valuation range of the business is $400,000-$800,000 (or 2-4 x $200,000). The buyer of the business would thus expect to receive his or her investment back in two to four years. As we will see, this range depends on several factors. If the factors accelerate the buyer’s return on investment (by shortening the time in which the buyer may expect to receive their investment back), then the valuation multiple will increase.
Factors Affecting Valuation of Business Sales
Quality of Financials Affect Business Valuation
First, the quality of the seller’s financials will greatly affect the business valuation multiple assigned to the owner benefit. Without transparent financials (such as tax returns or profit and loss statements) that coherently explain and prove the actual owner benefit of the seller, it is difficult for a buyer to believe (and thus pay for) the owner benefit that is being represented. Moreover, if the financials show that the owner benefit is increasing over time, then the valuation range will increase.
Physical Assets Affect Business Valuation
Next, the physical assets of the business (at depreciated value) must be factored in to the valuation multiple. Physical assets include owned equipment as well as leasehold improvements that will benefit the buyer. In some cases, physical assets comprise the bulk of the valuation if there are minimal or non-existent profits. The seller should have an asset list that includes all the equipment conveyed in the sale.
Lease Affects Business Valuation
If the business has leasehold rights which are memorialized in a commercial lease, then the quality and length of the lease will greatly affect the worth of the business. Particularly in retail businesses – especially restaurants – a buyer will be much more willing to pay a higher multiple of adjusted owner benefit if they are secure in the knowledge that they have a favorable long term lease where their rent is at least below ten percent of total sales.
Seller’s Role in Business Affects Business Valuation
Another major factor affecting the valuation range is the degree on which the seller of the business is involved in the day to day operations of the business. The more involved the owner is in the business, then the lower the valuation range. This is because a buyer is typically fearful that the seller’s involvement and role in the business (especially their personal relationships with customers, employees, or suppliers) may be hard to replace. Further, a buyer would need to incur costs to replace the seller’s role in the business. Buyers will thus discount the adjusted owner benefit since it may not be the same after the seller is no longer running the business.
Competitive Advantages Affects Business Valuation
Finally, the competitive advantages (if any) of the business greatly affects its valuation multiple. A business will be assigned a higher valuation multiple when it can provide a better service or sell a better product at a lower cost than its competitors. If the business is insulated from competition (healthcare companies for example have valuable government licenses that creating barriers to entry of new competitors) then that too will have a higher valuation. Competitive advantages are reflected in the financials of a business through high margins, a fast growth rate, and consistent profits over many years.
Every business owner should understand what their business is worth and why. A professional business broker’s most important role is to properly analyze and value a business by properly defining the adjusted owner benefit, and weighing all of the various factors affecting the multiple assigned to the adjusted owner benefit.
Give Martin at Five Star Business Brokers of Palm Beach County a call today for a FREE evaluation of your business.