If you’re a business owner, there’s a good chance you’ve given some thought to how much your business is worth.
Even if you aren’t ready to sell your business today, you may still want to know its value to give you a better idea of how you should plan for the future.
So, how are businesses valued?
In short, the best way to value a business is to use a multiple of earnings method, which determines your business's value by first calculating its SDE or EBITDA and then applying the appropriate multiple for your business's size and industry.
At MidStreet, we’ve conducted hundreds of business valuations over the years. We’ve seen some owners use their valuations as a starting point for making changes in the business, while others got their valuations and decided it was time to sell.
Whether you want to get a valuation because you’re ready to sell, or you just want to know where you stand, this blog will help you understand how businesses are valued, who performs valuations, and the factors that impact your business’s value.
Let’s get started.
Types of Valuations
Before we get into how a business is valued, we need to discuss the different kinds of valuations and which type is right for you.
The kind of valuation you'll want depends entirely on your needs, whether they're legal or transactional.
If you’re going through a divorce, partnership dispute, or other litigation, then you’ll want a legal business valuation.
A legal valuation is best performed by a certified appraiser or professional certified in legal valuations. Legal valuations tend to cost between $10,000 and $20,000 for businesses doing between $1 million and $25 million in revenue.
These valuations use quantitative methods to analyze the last five to eight years of your business’s performance and are meant to represent your business’s value in court.
Since legal valuations don’t analyze the financial benefit of owning a business, they aren’t a good representation of what your business could sell for.
For the rest of this blog, we’ll assume that you want to know how much someone would pay for your business, in which case you’ll need a fair market valuation.
Fair Market Valuation
Fair market valuations can be performed for various reasons. Whether you’re tax planning, seeking potential investors, or planning to exit the business, a fair market valuation is the best representation of your business’s value.
Fair market valuations look at your business from a qualitative standpoint (how a buyer would view it) instead of a quantitative standpoint (how a court would view it).
These valuations are best performed by an M&A advisor or business broker. Since brokers and advisors regularly value and sell businesses, they can generally give you the most realistic range of values for your business.
Fair market valuations vary greatly in cost depending on the size of the company, the complexity of the valuation, and the timeline of your valuation.
Some firms will perform a valuation for free in order to build a relationship with you, while others may charge a valuation fee between $3,000 - $30,000 to minimize their risk if your business doesn’t sell.
Business Value Misconceptions
Perhaps the biggest misconception we see business owners have about the value of their business is that an accurate valuation method involves a 1-1.5 multiple of their revenue.
This is an awful way to value businesses, and if someone tells you otherwise, you should run for the hills.
Consider this: a company with $20 million in revenue might generate only $1 million in annual earnings. Using the multiple of revenue method, that company would be worth $20-30 million.
As you can imagine, no one is going to pay $20 million to make $1 million each year.
Another common misconception is that a large portion of a business’s value is in its hard assets like furniture, fixtures, and equipment (FF&E) and inventory.
It’s important to remember that the goal of a fair market valuation isn’t just to assign an individual value to each of your business’s assets. The idea is to determine the financial benefit of owning those assets.
Sure, your inventory, and FF&E have dollar amounts tied to them. But isn’t your business worth more than the sum of its parts?
If your business is profitable, then the answer is yes.
When someone is buying your business, they aren’t just buying your assets. They’re buying the ability to make money using those assets, which is why simply adding together their values isn't an accurate representation of what your business is worth.
The biggest factor in your business's valuation is your historic performance, which will hopefully indicate the financial benefit to a buyer owning your business in the future.
Best Valuation Method: A Multiple of Earnings
To a buyer, the most accurate representation of your business’s value is a multiple of its earnings. Earnings can be calculated as seller’s discretionary earnings (SDE) or earnings before interest, taxes, depreciation, and amortization (EBITDA).
Whether your business is best valued using a multiple of SDE or a multiple of EBITDA depends on a few variables like your business’s size and the type of buyers you attract.
To help you better understand which one will be used for your business, let’s take a look at each and discuss when they’re used.
SDE is typically used to value smaller companies that are owner-operated and have less than $1 million in earnings.
Since the owner serves as an owner/operator, it can be difficult to separate what they earn compared to the earnings of the business. For this reason, we add them together in one number: SDE.
For example, if a business has an SDE of $300,000, a buyer will have $300,000 to spend on living, taxes, interest, and capital expenditures.
This means that if a buyer is used to living on a salary of $120,000, then they can look at the business as earning $180,000, which can be used for debt service, savings, and any other needs the business may have.
To calculate SDE, a valuation expert will start with your net profit and add back certain expenses (like an owner’s salary, benefits, non-recurring expenses). Once these “add-backs” have been configured, the resulting number will be your business’s SDE.
If you want to learn more about how SDE is calculated, check out our blog “Sellers Discretionary Earnings (SDE) Explained with Examples.” In it, we do a much deeper dive into the different kinds of add-backs, and provide an example SDE calculation.
EBITDA is normally used for larger companies with earnings greater than $1 million. Instead of representing an owner/operator’s benefit to owning a business, EBITDA shows an investor/buyer how well your business performs.
This investor won’t actively run the company, but will instead hire a manager to oversee daily operations.
If you're an owner/operator selling to an investor/buyer, the salary you've been paying yourself will be adjusted to a fair-market manager's salary, which will be reflected in your company's EBITDA.
After this adjustment, EBITDA will be calculated using the following formula:
To learn more, check out our blog “What is EBITDA? (with formula)” for an in depth look at how EBITDA is calculated, how it’s different from cashflow, and if EBITDA is the right metric for your business valuation.
After you’ve calculated your business’s SDE or EBITDA, it’s time to apply an industry multiple that has been adjusted for your business in order to estimate its value.
The multiple you get will depend on a few different factors, which we’ll discuss shortly.
Since SDE and EBITDA represent annual earnings, and a business’s value is reflective of its earnings potential, an industry multiple helps to represent just that: the financial benefit to owning a business in the coming years.
Industry multiples are found by looking at the comparable sales (or comps) of other companies within your industry similar to your business in both size and location.
Whoever you hire to perform a business valuation will use these comps to determine a range of possible multiples.
While the multiple that will be applied to your business's SDE or EBITDA can vary greatly, the range of multiples applied to a business with $1 million or less in earnings is frequently between 3-4 times SDE. The multiple for businesses with earnings greater than $1 million is often between 4-6 times EBITDA.
This range of multiples helps to give you an idea of the maximum and minimum purchase price you could receive when you sell your business.
For a more granular look at what goes into a business valuation and an example scenario for calculating a purchase price range, download our sample business valuation below.
This document includes a complete sample valuation with a full breakdown of recast financials, key terms and definitions, and a detailed example of the buyer test method.
Download our Sample Small Business Valuation Report Here:
What Affects Your Multiple?
While the number one thing affecting your business’s value is its earnings, there are other factors that can get you more attention from buyers, and potentially a higher multiple.
One factor that can impact the multiple you receive is your business's industry. Depending on shifts in the economy, technological advancements, and other influences, certain industries are more desirable than others.
If you’re in an industry that isn’t heavily impacted by shifts in the economy, or if your industry is on the rise, then that could increase the multiple that buyers are willing to pay.
The amount of contract work or recurring revenue your business has can also affect your multiple. When work is guaranteed, a buyer sees this as a safer investment, which can get you a higher multiple.
Likewise, if you have little to no contract work, or your customer relationships are sporadic in nature, it could mean that you get a lower multiple.
Customer concentration can also affect the multiple a buyer is willing to offer. One customer making up 20% or more of your sales can mean you have a customer concentration problem. Losing this customer would mean losing 20% of your sales, so buyers will see this as a higher risk, meaning you could get a lower multiple.
Buyers may be willing to pay a higher multiple if your books reflect consistent growth over the last 3-5 years. Remember, past performance is generally the best indicator of future performance, so the more consistently you’ve grown, the more of an opportunity buyers will see in owning your business.
Other things that could potentially affect your multiple are:
- Several buyers bidding for your business: in a bidding war, multiples can increase as buyers compete for your business.
- Your involvement as an owner/operator: the less involved you are, the more confident a buyer will be that the company won't be negatively affected once you walk.
- Your business’s location: locations in or near a major city draw more interest and higher multiples.
Understanding Business Valuations
If you’re interested in selling your business, then a fair market business valuation is the right type of valuation for you.
The best professionals you can hire to perform a fair market valuation will be M&A advisors and business brokers, although there are some CPAs and other valuation experts who may be experienced enough with fair market valuations to consider.
If you’re still not quite sure which kind of valuation is right for you or who to hire, check out our blog “What Is a Business Valuation (And Which Type Is Right for You.” In it, we discuss each type of valuation in depth so that you can decide which one best fits your needs.
You’re also encouraged to read “The Top 5 Business Valuation Companies in the US” and “8 Common Problems with Business Valuations” for more information about who to hire for your business valuation, and what problems you want to keep an eye out for.
If you’re interested in getting a free valuation, contact us today. We perform hundreds of valuations each year and will be glad to offer you our services.