Approaches to valuing your business when you’re ready to sell [Transcript]
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[Plan Your Future Today]
[Kimberly Deas, BCI, Business Transfer Specialist]
[Murphy Business & Financial Services]
As a business owner there are many different ways to value your business and we’re going to be looking at several of those here. So let’s start with the ways that business owners commonly value their business. The first way, and I’ve seen this a lot, is business owners look at how much time and effort they put into their business. You might have run your business for 10, 15, 20 years thinking about all the events you’ve missed, maybe all of the kids’ plays and the soccer practice and the games and thinking about how much money you put in. Maybe you paid, six, seven, $800,000 for your franchise years ago, and you’ve built it for 10 years. It must be worth at least that, right? Well, the truth is time and effort put into a business does not equate to the value of the business unfortunately. So let’s look at a couple other methods of how to value a business.
The next method that people often will look at is what their friend’s business sold for. It’s very easy or common, and it might not even be a friend, it might be an article in a magazine. And we see this happen a lot of times where someone will come to us and they’ll say, “Well, my friend just sold their business for $3 million and they were about the same size as me.” Well, what we don’t know is the dynamics of that business. So the Rumor method, although it’s simple, it’s not accurate. Because here’s what often happens, let’s say your friend’s business is the same size as yours. Let’s say you’re a million dollar business, they were a million dollar business. And let’s just say they got one times revenue. You might think, “Well, my business is worth one times revenue.” But the truth is your business might be worth a lot more because even though one times revenue is a true number, that may not be how the value was calculated.
And I’ll give you an example. I recently had a business, it was doing about 1.2 million in revenue. When we did the net profit, it was about $600,000 of net profit. We gave that business a three multiple because of the size of the business, the growth of the business, stability. That would have been a one point $1.8 million business. If she would have taken one times revenue, she would have undervalued the business drastically. So it’s important not to base it on rumor, but to actually do the analysis and see what the business is worth. And again, many times we’ll hear that businesses are sold for so much times revenue. One times, 50% of, 60% of. That may be true for that business, but that’s not how they calculated the value of the business. The value is often calculated on net profit.
So Rules of Thumb are also another way that businesses get valued in kind of the rumor area. People often say, “Well I know businesses of my type are two times revenue, three times” … or excuse me, “two times profit, three times earnings.” Well, those are good rules of thumb, but the problem becomes is what if those businesses were all increasing and your business is declining? Would a business that’s declining have the same value as a business that’s rapidly growing? Well, the answer is no. So it’s important that someone does the analysis to determine the appropriate valuation and the appropriate methodology for your specific circumstances.
So the next way that oftentimes people will try to value a business is they’ll look at the balance sheet, and I was guilty of this. Many years ago, I looked at the balance sheet, it said my net worth was negative $33,000. And believing that information I gave the business to my partner, I later found out that was a $2 million mistake. So balance sheets, although they seem reliable, they are accurate information, they are not the best way to produce a fair market value of a business. So when people look at balance sheets, that’s merely just a book value. It’s not necessarily the fair market value.
Now there’s something called an asset approach and this is the first of the professional methodologies that we’re going to talk about. And the asset approach is really an adjusted balance sheet. So what you do is you take your balance sheet. Now you’ve already appreciated some of the items, and let’s just say you’ve got $100,000 of furniture fixtures and equipment. Well, you’ve taken a depreciation of maybe 60, 70, $80,000. Does that mean the equipment’s only worth $20,000? The answer is no because if you were to have to rebuy back that equipment at that same condition, you would pay a lot more than $20,000. Usually it’s about half of what you originally paid for it. So call it about $50,000.
So the asset approach is to really total up all of the assets at what you would have to buy them back at today, minus your debt. So if you still had a loan on some equipment, you’d have to pay off the loan first before you got the total asset value. But basically adjusting the balance sheet to determine the fair market value of the assets or the liquidation value. And I have to mention liquidation value because once a business is shut down, it’s no longer a going concern. And as long as it’s no longer a going concern, you now fall into the liquidation value. And liquidation value can be as little as 10% of the fair market value or as much as 100%, it’s all going to depend on your type of business.
We recently had a baseball cap business that had $100,000 of baseball caps. As soon as the business shut down, excuse me, before the business shut down the baseball caps were valued at about $100,000. That’s what she paid for them, she would be able to resell them for about two times that and she would have about $200,000. As soon as the business shut down the liquidation value went to about $20,000. So depending on the business’s circumstance, whether you’re going concern or whether you’re in shut down and in liquidation mode, will determine the value of the assets.
Now another methodology is the professional approaches and we just talked briefly about the asset approach and there’s three professional approaches we’re going to review. So the asset approach we talked about, we’re going to talk about the income approach and we’re going to talk about the market approach as well. So let’s talk about the market approach next. The market approach goes out to the market, and there’s many databases with transactions of similar businesses that have been sold, and they look for the multiples. And often the multiples are that of revenue or of seller’s discretionary earnings. Now it’s often abbreviated SDE and what seller’s discretionary earnings are, are the adjusted net profit. So we take the net profit of the company and we add back certain things like interest, depreciation, amortization, and any one time expenses, anything that a new owner would not have reoccurring. And then of course, we make those adjustments and this produces what’s called an SDE.
For our smaller businesses, this is what we operate from is an SDE, seller’s discretionary earnings. Now as a larger company, anything over a million dollars of EBITDA or earnings before interest, tax, depreciation, and amortization, they’re going to value on EBITDA, not on SDE. And the reason why is as you get over a million dollars of EBITDA, the owner’s salary becomes irrelevant. As the numbers get bigger, the owner’s salary gets smaller. It becomes irrelevant in the calculation. So as our smaller businesses, we typically see somewhere between one and three times SDE for businesses under 2 million of revenue. So, and again, we want to make sure that we pay attention to these because markets do go up and down. And what’s interesting to note there is that ratios stay consistent over time. So as the market goes up, what we see is revenues go up, profit goes up. As the market goes down, we see revenues go down and profit go down. So in the market approach, the market approach automatically adjusts for whether it’s an up market or a down market.
So if we take a look at two businesses, which would you pay more money for? The one that has $2 million in sales and $120,000 of net profit or the one that has $2 million in sales and $400,000 of net profit. And for most people, they’re going to tell me they’re going to pay more for the $400,000 of net profit. So it’s important that as we review your business and as you get your business appraised that you want to remember you and your neighbor might have the same size business, but your profits might be very, very different.
So the last approach we’re going to review is the income approach and the income approach is what a buyer’s doing is they’re buying future revenues. And what they look at is what do they expect to see going on in the future? The two most common methods here is capitalization and discounted cash flow. This is truly based on a return on investment. Now this methodology is not used as commonly in smaller businesses, but it is used very frequently in larger businesses. So if we look at the three main professional approaches, we have the asset approach, we have the income approach, and we have the market approach. And those are the most common ways to value businesses here in our area.
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