So, you’re starting to consider selling your business. Congratulations!
The fact that you’re here doing research indicates you believe in doing things the right way, and we couldn’t agree more.
Knowing how your business is valued and who you should hire to help you sell it are some of the first pieces of information you’ll need to get the ball rolling.
Lucky for you, MidStreet has helped hundreds of business owners sell their businesses and plan for the future.
So, if you’re ready to sell your business and step into retirement, or you’d like to stay involved in your business and take some chips off the table, you’re in the right place.
In this blog, we’ll break down the best ways to value a business in 2023, the factors that will impact your business valuation, and who you should hire to walk you through the selling process.
Excited? Us too.
Let’s get started!
How NOT to Value Your Business
Before we get into the best ways to value a business, let’s debunk some of the myths you may have heard from other professionals who might have had the right intentions, but the wrong ideas.
Valuing a Business Based on Its Revenue
If you’ve been Googling how to value a business, you’ve probably come across CPA firms or appraisers who suggest a business should be valued based on a percentage of its revenue (usually ≈40%) plus inventory.
Unfortunately, this is a commonly distributed piece of information that can lead to your business being listed for years without selling. Or, it can cause you to receive a purchase price that is lower than what a buyer would be willing to pay.
Businesses with similar revenues can vary greatly in their profitability, which can make a valuation based on revenue vastly inaccurate.
Consider this example:
ABC Co. and XYZ Co. are each doing $10 million in revenue, and each have $300,000 in inventory.
ABC Co. has only been operating for 3 years, so they haven’t established any substantial negotiating leverage with suppliers. They also underprice their work and overpay employees, so their profit margins are 12.5%, meaning the company’s net profit would be ≈$1,250,000.
XYZ Co., on the other hand, has a strong customer base willing to pay higher prices for XYZ's excellent service and quality products. XYZ Co. also pays employees a fair market rate and has great leverage with suppliers because they’ve been in business for 20 years.
Because of this, they enjoy a much higher profit margin of 21%, making their net profit ≈$2,100,000.
Using the 40% of revenue plus inventory valuation method, both companies would be valued at $4.3 million, even though one earns $850,000 more in net profit than the other.
See the problem?
We’ve even seen companies who were losing money valued at greater than $1 million using the percentage of revenue method.
Multiple of Net Profit
Another unreliable way of valuing a business is applying a multiple to its net profit. This valuation method is unreliable because it includes your salary as an expense, which may be vastly higher or lower than the market rate.
A multiple of net profit can also be slanted by your company’s accounting practices.
Additionally, a multiple of net profit isn’t a common valuation technique, so using it can make it virtually impossible to find comparable sales reports.
Both multiple of revenue and multiple of net profit are unreliable valuation methods, and will often result in the inability to sell your business, or you leaving money on the table.
Because of this, we prefer to use a valuation method based on a multiple of your business’s earnings.
How to Value a Business: Multiple of Earnings
The multiple of earnings method is by and large the most reliable way to value most small-midsize businesses for several reasons.
Perhaps the most important reason is that most small-midsize businesses are valued based on a multiple of seller’s discretionary earnings (SDE) or a multiple of Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA).
Because this is how most businesses are valued, comparable sales reports are available to help give you a better idea of what buyers are willing to pay for a business similar to yours in size and location.
The multiple of earnings method also allows your earnings to be adjusted by adding back standard, non-recurring, and discretionary expenses which would have otherwise negatively impacted your business valuation and purchase price.
Let’s take a look at the two earnings metrics your business valuation should be based on: SDE or EBITDA.
Multiple of SDE
If you are the owner-operator of a small business doing less than $1 million in earnings, your business will most likely be valued using a multiple of SDE.
SDE X Multiple = Purchase Price
An SDE valuation begins with your business’s net profit and adds back certain expenses like taxes, depreciation, your salary, and other items.
This is done because as you’ve worked with your accounting team to take advantage of legitimate tax deductions, you’ve kept your bottom line as low as possible.
This creates an issue when it comes time to sell your business because certain expenses like personal phone and fuel, one-time repairs, legal fees etc. don’t represent cash expenses necessary to run the business.
Other standard add-backs, like interest and owner's payroll tax, are added back not because a buyer won’t have these expenses, but because these expenses will be different under a new owner.
Lastly, your salary as owner-operator will be added back to represent the financial benefit a new owner would gain from owning and operating your business.
Calculating SDE also makes your earnings comparable to other companies valued using SDE who may have different tax structures, interest rates, or depreciation schedules.
After your company’s SDE is determined, comparable sales reports (comps) will be used to determine what range of multiples should be applied, which will result in a range of purchase prices for your business.
For example, the range of SDE multiples for a lawn care company doing $350,000 in SDE might be 2.7-3.5. This means that a buyer could realistically pay $945,000-$1.2 million to acquire that company.
Multiple of EBITDA
An EBITDA valuation is used to value larger companies in which the buyer will not be actively operating the company, but will rather act as a majority shareholder.
Because these buyers are generally more interested in larger companies, an EBITDA valuation is the most common valuation method for companies with over $1 million in earnings.
Just like in an SDE valuation, interest expenses, taxes, depreciation expenses, and amortization expenses are add-backs in an EBITDA valuation. The main difference is that in an EBITDA valuation, rather than adding back the full owner’s salary, excess owner’s salary is added back instead.
This is done assuming the buyer will hire a manager to fulfill your role as owner-operator. That manager will be paid a fair-market salary, which is usually lower than what you have been paying yourself, meaning your company’s earnings will have to be adjusted accordingly.
For example, if you were paying yourself an annual salary of $150,000, but a manager could be paid $100,000 to fulfill your role, the difference of $50,000 would be added back to your earnings as "excessive owner's salary"
to help determine your company’s EBITDA.
Conversely, if you’ve only been paying yourself a $75,000 salary, but the fair market salary is $100,000, $25,000 would be subtracted from your company’s earnings to represent the additional expense necessary to pay a manager to fulfill your role. This is a far less common scenario, but it has happened.
Once EBITDA has been calculated, an EBITDA multiple will be applied to determine a purchase-price range.
EBITDA X Multiple = Purchase Price
EBITDA multiples are generally higher than SDE multiples. This is because a company's SDE is higher than its EBITDA due to the full owner’s salary add-back.
Just like with an SDE valuation, EBITDA is calculated to make the earnings of your business comparable to other businesses with similar earnings.
What Impacts Your Multiple?
Now that you know your business's purchase price will likely be based on a multiple of SDE or EBITDA, you may be wondering what will determine if your business earns a high or low multiple.
The difference between 3 times SDE vs 3.5 times SDE could be a few hundred thousand dollars.
What would cause a buyer to offer a higher or lower multiple depends highly on your industry and the size of your business.
There are, however, a few general factors that will typically impact a business’s SDE or EBITDA multiple regardless of industry.
NOTEWhen it comes to multiples, the amount of risk associated with an acquisition directly is the determining factor. High risk = lower multiple, low risk = higher multiple.
Let’s take a look at some of these factors to help you prepare your business to receive the highest multiple possible.
The number one factor impacting the multiple you’ll receive for your business is its earnings.
Remember: when a buyer is determining what they’ll offer for your business, they’re really gauging how much risk is involved with the acquisition.
No matter the industry, buyers are often willing to pay more for a business with higher earnings because it reduces their risk and substantially increases the potential return on their investment.
The industry you’re operating in can also have a huge impact on the multiple you’ll receive for you business.
Some industries are consistently more sought out than others, like healthcare (4.8-8.1 times EBITDA) and manufacturing (4.7-9.3 times EBITDA). Businesses in these industries are generally seen as recession proof, and are therefore perceived as less risky businesses to own.
Buyers may also be willing to pay more for a business in an industry that is starting to boom, like Cybersecurity (4.9-12.8 times EBITDA) or Fintech (5.8-16.4 times EBITDA). These buyers will generally want to take advantage of current trends, and monetize before trends shift.
Other industries become hot during periods of consolidation and private equity involvement. The disaster restoration industry, for example, has recently been consolidating, and owners of disaster restoration companies are receiving premium multiples from strategic and private equity buyers.
IT and Managed Services are also experiencing greater private equity involvement and higher multiples (4.5-12.2 times EBITDA).
Although you can’t change your business’s industry, you can stay informed on what industries are going through a consolidation phase or greater private equity and strategic interest, and take advantage should yours fall into those categories.
Earnings that are guaranteed are earnings that are worth more to a buyer.
Certain business models lend themselves to recurring revenue, such as home service businesses with recurring maintenance contracts, and property management businesses with contracts on auto-renew.
Regardless of your industry, if a substantial amount of your business’s earnings come from recurring revenue, buyers will usually be willing to offer a higher multiple.
Generally speaking, businesses that don’t rely too heavily on the owner will receive a higher multiple than those in which the owner performs the business’s most important functions.
Imagine you're a buyer interested in purchasing a company.
Company A has an owner who is in the office 20 hours a week and is responsible for holding monthly meetings with managers and making big picture decisions. There are a few key employees in place who take care of most of the company’s operational needs.
Company B has an owner who works 55 hour weeks and is responsible for quoting projects, interfacing with customers, purchasing inventory, and managing employees. Company B has good employees, but none of them have been given a real leadership role, and haven’t received any training beyond their current responsibilities.
It’s not very difficult to decide which company you’d pay more to acquire.
Company B isn't a tougher sell just because of the owner’s heavy work load. There’s also a greater chance the business will experience declines in performance as a new owner learns to manage all the previous owner’s responsibilities.
Company A, on the other hand, would require much less of a new owner because it already has managers in place who can fulfill most of the operational functions necessary for the business to run.
If the owner of Company B sounds more like you than the owner of Company A, it’s time to start training your long-time and trustworthy employees to manage some of your responsibilities.
Having employees in place who help manage the business’s operations will help convince a buyer that the business can maintain its success once you make your exit, and assure them they are buying a business rather than a job.
You’ve heard it before: location, location, location!
As you’re probably aware, it’s usually a plus if a business is located in a growing metropolitan area, although location is more important in some industries than others.
Retailers, for example, rely heavily on exposure and traffic to attract the majority of their customers. Home service businesses also benefit greatly from being located in densely populated areas because it allows them greater access to residential and commercial contracts.
But even in industries wherein location doesn’t have as big of an impact on the business’s success, such as with certain manufacturers or suppliers, buyers will still consider the business’s location because it’s where they’ll be moving after the acquisition.
When the business is located in a growing city with highly rated schools, dining, entertainment, etc., buyers may be willing to pay more for the opportunity to relocate.
Processes in Place
The processes, procedures, and systems your business operates with are extremely important. They can also be difficult to implement if you and your employees are used to a different way of doing things.
The key factor here is creating a system of processes that allows the business to run smoothly despite changes in ownership or employee turnover.
It can be hard for business owners to see the value in creating this kind of system if they’ve successfully run the business without defined processes and systems for years.
Because they’ve never needed a strictly systemized approach for the business to succeed, these owners can be lost for words when they start getting questions about the company’s processes and procedures.
As you can probably imagine, buyers will have a hard time successfully transitioning into your business if all the systems and processes are in stuck in your head.
A good ERP system like SAP or Oracle automates and manages some of the company’s core business processes is highly encouraged.
This will take a lot of the weight off a new owner’s shoulders and increase their confidence that they can step in and successfully manage the company.
Clean Books and Records
Last but not least, clean books and records can help to nudge your multiple in the right direction. This falls a little lower on the list of valuation impacts because with the right professionals in place, a company’s disorganized books and records can generally be cleaned up (although this will come at a cost).
However, poor accounting practices and disorganized records can make it much harder to determine the actual earnings of a company or where its earnings come from. This can create disputes between buyers and sellers that extend the timeline of a deal or make an acquisition much less attractive.
Once again, the multiple you receive for your business is directly related to the risk associated with acquiring it.
Selling Your Business
Now that you know how your business will be valued and what affects its valuation multiple, you may be curious about what steps you should take to sell it.
The first step is to get a business valuation. We recommend speaking with a handful of experienced business brokers or M&A advisors and choose one you trust to value your business.
It’s always a good idea to ask any professionals you employ, such as a CPA or attorney, for referrals to brokers or advisors they’ve worked with in the past. If they have transaction experience, they’ve likely built a network of people you can trust to sell your business.
To help you navigate your discussions with potential brokers or advisors, we’ve created this downloadable checklist of questions to ask to make sure you’re hiring someone with the knowledge and experience to handle the deal.
Business Broker Checklist
How Much Does it Cost to Sell Your Business?
Many brokers and advisors offer free business valuations to develop a relationship with you if they think they can sell your business.
How much you’ll pay a broker or advisor in success fees, however, all depends on the size of the deal and the way they structure their fees.
Smaller businesses with less than $1 million in earnings are usually sold by business brokers to individual buyers. Business broker success fees are generally around 10% of your business’s purchase price. This should be comforting to you because it means there is an incentive for the broker you hire to find the highest possible offer for your business.
In smaller deals, you may be required to pay a broker a minimum commission (usually $10-15,000) if 10% of your business’s purchase price is below a certain threshold.
For more on business broker pricing and fees, click here.
MIDSTREET TIPBe sure to understand the listing agreement you sign to determine if there is a minimum commission, and look out for clauses that could result in you paying a broker even if your business never sells.
Larger businesses doing more than $1 million in earnings can be sold by a business broker or M&A advisor, but an M&A advisor becomes a more likely candidate as earnings get higher.
Most M&A advisors will use one of the following fee structures:
- A percentage of the purchase price (i.e. 5%) with a higher commission rate applied to any amount exceeding a target purchase price (i.e. 5% on a target valuation of $10 million and 8% on any amount exceeding $10 million).
- A flat success fee percentage.
- A Lehman formula or close variant (i.e. 10% on the first million, 8% on the second, 6% on the third, with any amount exceeding $5 million earning 2%).
Other fees charged by some advisors include expense reimbursement (i.e. travel and accommodation expenses) and work fees (i.e. an up-front or monthly retainer fee, usually deducted from the success fee once the business is sold).
For more on M&A Advisor Fees, check out this resource.
Types of Buyers for Your Business
Businesses are generally sold to one of three types of buyers: individuals, strategic buyers, and private equity buyers.
Which of buyers will purchase your business depends greatly on your goals for the deal as well as your business’s size and industry.
Individual buyers are usually active in smaller transactions with purchase prices less than $4 million.
Most individual buyers are looking to buy their first business, and typically use the SBA 7(a) loan program to finance the deal.
If your goal is to stay in the business and keep a minority stake, an individual buyer won’t be your best option. The SBA stipulates that the seller of a business cannot be employed by the business in any capacity for more than one year after the acquisition.
Individual buyers will usually take over as owner operator and have a less demanding due diligence process. This can make them a great option if you’re seeking a smooth transaction process and a buyer who will help maintain your legacy.
Strategic buyers are businesses within your industry that grow by acquiring other businesses.
Strategic buyers are sometimes willing to offer the highest purchase price for your business because they see potential revenue synergies your business can help them realize, which can allow their company to grow more quickly than would be possible organically.
These buyers will require a very thorough due diligence process which can take months to complete, so you’ll need to have your books and records as clean as possible before they start making requests.
A strategic could offer you the opportunity to keep a minority stake in the company if you’re willing to stay on after the acquisition and help them achieve growth, although this isn’t always the case.
If purchase price is the top priority for you when selling your business, and you don’t mind a lengthy selling process, a strategic buyer could be your best option.
Private Equity Buyers
Private equity buyers are buyers who want to acquire your business, grow it, and sell it for a higher purchase price in 3-7 years.
Private equity groups will often require you to roll over some of your equity from the sale back into the business (at least 20%, sometimes more)and retain a managerial role to help the business grow.
This can be extremely advantageous if you don’t mind spending another few years in the business. Private equity groups have the ability to double or even triple a business’s value over the course of its cycle through their portfolio. That means your 20% rollover could turn into a second pay day worth 40-60% the initial purchase price you received for your business.
If your business is acquired as an add-on, that means the private equity group sees the acquisition as a potential benefit to one of their current companies, or “platforms.”
If your business is acquired as a platform, that means it is likely one of the private equity group’s first acquisitions in your industry or market, and they will use your business as a “platform” for acquiring and growing other businesses.
When private equity groups are interested in acquiring your business, make sure you spend some time assuring you and the soon-to-be majority stakeholders of your company are on the same page from a cultural and operational standpoint.
Even though you’ll keep a managerial role and have a say in the way the company is run, the private equity group will have the final word.
You’re going to be spending a lot of time with them, so you want to avoid as many conflicts as possible.
Valuing and Selling Your Business
Learning about how your business will be valued and sold is one of the first, but most important steps you can take once you’ve decided you’d like to sell.
With this knowledge you can prepare your business to receive the highest multiple possible, keep your valuation expectations realistic, hire the right professionals, and develop your criteria for potential buyers.
Remember, the more risk a buyer associates with acquiring your business, the lower the multiple they’ll be willing offer you for it.
It’s never too early to focus your attention on systemizing your operation, attaining more recurring revenue, cleaning up your financials, and all the other things mentioned above that will make your business more attractive to a buyer.
If you’re ready to sell your business today, or you’d like to make sure you’re ready in the next few years, don’t hesitate to contact us today. We’d love to learn more about your business and help guide you through the process of selling it to the right buyer.