You’ve spent years growing your business, pouring in blood, sweat, and tears to make it successful.
Now, the time has come for you to pass the baton to new leadership and you’re wondering how to establish the value for your business. One of the first questions that might pop into your head is: “Do I get paid for past performance or future potential?”
At the end of the day, every buyer is purchasing the future cash flow your business will provide. The key is determining if these future earnings should be valued at their historical level or at the level you expect them to be in the future.
In this article, we will go over how the size of your company, its growth trajectory, and your buyer will dictate whether you estimate value with past earnings, future earnings, or a combination of both.
Let’s jump right in!
Should You Value a Business Based on Past or Future Earnings?
1. The Size of the Company
As the size of the company goes up, the chances it will be valued based on future performance goes up.
Smaller companies, with revenue less than $1 million, are almost always valued based on past performance.
Businesses with revenue between $1 million and $10 million can be valued using either past performance or future performance depending on company specifics. However, it’s most common for businesses under $10 million in earnings to be valued based on past performance.
“But what about my business’s potential? The buyers could easily do ____ to increase earnings.”
Owners often suggest buyers start new product lines, expand geographically, or add additional employees to grow revenue and ask why this does not factor into the valuation.
One reason is most buyers will ask why the seller chose to not do those things if they would increase revenue and are easy to do.
Another reason is that the potential future cash flow is the result of the buyer’s investment in expansion and most buyers expect to have a pathway to grow the business.
Most buyers within the $500,000 - $5 million price range are individuals using Small Business Administration (SBA) 7(a) financing. With this type of loan, lenders are required to evaluate the deal on historical financial information.
For companies doing more than $15 million in revenue, it is typical to evaluate the company, market, and industry in much more detail than a company doing $10 million in revenue. Often, buyers of these companies will create projections that take the changes they want to make into account before submitting an offer.
Publicly traded companies, for example, are valued by analysts on future performance expectations. Their past performance is talked about in terms of a price-to-earnings ratio while their value is often established using a discounted cash flow analysis or DCF.
MIDSTREET TIPThis excludes startups and e-commerce businesses, which have their own valuation methodologies. These companies can experience dramatic growth and are usually valued on expected earnings.
2. The Growth Trajectory of the Business
Just like the size of your business will affect how you value it, so will its growth trajectory. If your company is growing quickly or shrinking, you will use future earnings.
If your company is growing rapidly (more than 10% per year) and it will most likely keep growing, you’ll want to value your business using future performance. If your business is declining by a significant amount, you would also use future performance.
When accounting for growth, valuation analysts will also consider research and development and capital expenditures. They will estimate how much needs to be spent maintaining existing products and equipment and how much spending is required to grow. Then, they will remove this spending from your seller’s discretionary earnings, or SDE.
If your company has already invested money into products that will create a substantial increase in revenue, they should account for those future profits.
3. The Potential Buyers of the Business
In the due diligence stage of selling your business, buyers will perform their own valuation based on their plans. Depending on the type of buyer and their experience with valuing businesses, they will use either past or future earnings.
Most private equity groups (PEG’s) and strategic buyers will use future earnings but talk about valuation in regards to multiples. Meaning they will create projections to use internally but negotiate with you by talking about multiples. Individual buyers will almost always use multiples, which tend to be based on past performance.
If the person valuing the business uses the correct inputs (correctly adjusted financials, the right comparable sales, and so on), they will usually come up with a similar value, no matter what valuation method they are using.
NOTEPrivate equity groups will usually start with EBITDA, but then use the discounted cash flow method later on in the deal. This method allows them to see how much they can truly make from the investment.
Which Valuation Method Should You Use?
We always say business valuation is an art and a science - and this is a good example.
If you are thinking about selling and want a business valuation, it’s important to get one that uses the right technique for your business.
If your company should be valued on its historical earnings, you’ll want a valuation that uses a multiple of earnings. The two most common multiples for small businesses are based on SDE and EBITDA.
If your business is best valued using future performance, you can still use a multiple of SDE or EBITDA. It is also possible to use other valuation techniques like the discounted cash flow method or capitalization of earnings method.
That being said, the method used to value your business isn’t as important as quality information. All valuation methods should produce similar results when properly performed.
Make Sure to Get an Accurate Value for Your Business
To get started, identify the size of your business, the growth trajectory, and the type of buyer you want/expect. Once you have these key details nailed down, you will better understand how you should value your company.
It’s important to use the correct earnings (past or future) to find the correct value for your business. Knowing the value of your business is one of the first steps to prepare - regardless of if you want to sell today or in 5 years.
If you have questions about which technique to use don’t hesitate to reach out. We’re happy to discuss your specific situation and help you identify the right approach. If you would like to learn more about valuing your business, read our blog “What is a Business Valuation?”