business valuation

After spending years building your small business, it can be hard to quantify the time and energy you’ve poured into it and the sacrifices you’ve made to get where you are now. Your company probably seems priceless to you, but there inevitably will come a time when you must calculate precisely how much your business is worth.

Perhaps you’re preparing for retirement or for a transition to a new owner—whether it involves a single private owner or a sale to employees. Having a exit plan or a succession plan is a good first step, but you’ll also need to understand the value of your assets and the tax implications of transferring them to the next generation. This will require an accurate valuation.

The value of your company is subjective. Buyers and sellers don’t always agree on what’s valuable and what isn’t, which is why hiring a valuation consultant or a CPA who has experience valuing businesses is a good idea. That said, it’s not overly difficult to come up with a reasonable ballpark valuation on your own—you’ll just need to avoid some of the common misconceptions first-time sellers have.

Know what you’re working with

Most business owners pour their hearts and souls into their companies, and they logically expect to be compensated for that when it’s time to sell. Unfortunately, many founders find it difficult to swallow the realities of the market for buying and selling small businesses.

In nearly every case, small businesses are bought and sold based on the cash flow they produce—with prices adjusted up or down to reflect other qualitative features. Rather than focusing only on cash flow, however, most intermediaries use a figure called “SDE,” or seller discretionary earnings, as the core data point of a valuation.

SDE is similar to cash flow, but it has one important caveat: The owner’s nonessential expenses are “added back” to arrive at a comprehensive figure of the new owner’s total compensation.

Let’s say you own a corporation that earns $150,000 a year in EBITDA and pay yourself about $100,000 in salary and benefits as the CEO/owner. In theory, all (or some) of this salary should be “added back” to the EBITDA number to arrive at an SDE of about $250,000.

This is the amount of money that a new owner acquiring the business could expect to earn if he or she worked in the business. (An owner not planning to work in the business might only accept a certain percentage of that salary number.)

While this seems straightforward on its face, it can get convoluted in practice. To illustrate, let’s say that you’ve attended annual training courses for the past few years to stay abreast of industry trends. You could certainly make the argument that a new owner wouldn’t need to do the same. But is this realistic? A new owner is likely to face the same market environment that you do, and add-backs like this can become a point of contention that ultimately derails acquisitions.

While these ideas may seem foreign at first, it’s possible to become as well-versed in small business valuation as your intermediary might be. Keep reading for a few simple, actionable steps to help get you there.

1. Read industry reports

IBBA’s Market Pulse Report offers valuable insight into the multiples business owners might expect to sell their business for—and the published quarterly data is free to the public. A quick Google search can lead you to plenty of other up-to-date reports as well as provide you with historical data for context.

Look online today, and you might suddenly be eager to explore selling: 2018 was a record-breaking year for small business owners selling their companies, according to research from BizBuySell, with a 4 percent increase in transactions over the previous record set in 2017 and a 31 percent increase over 2016’s numbers.

Furthermore, the same report indicates that 70 percent of business brokers expect to see more transactions in 2019 than before. A deep understanding of the M&A landscape and your respective industry can help you arrive at an informed valuation.

2. Talk to your CPA

Aside from you, your CPA has better insight than anyone into your company’s financials. If your CPA has been trained in valuation or follows industry trends, he or she should be able to provide you with an approximate price range based on your business’s trajectory. Perhaps more importantly, your CPA should be able to advise you on the most tax-advantaged way to structure a future transaction—as well as any steps you might need to take to prepare.

If you plan to seriously explore selling, work with your CPA to start getting your books in order. Potential buyers will heavily scrutinize your past three to five years of financials, so make sure all your finances are prepared correctly.

3. Organize your documents

There are a number of critical documents you’ll need to have in order to arrive at an accurate valuation. For starters, you’ll need to specify exactly what is available for sale. The simplest transactions, and those that most investors prefer, will always arise from selling your business as a going concern—in other words, selling the entirety of your business’s assets, contracts, and receivables in a single transaction.

Regardless of how your deal is structured, a proper valuation will require you to account for everything the business owns, ranging from the tangible (hard assets on your balance sheet like trucks and machinery) to the intangible (things like goodwill, patents, proprietary processes, brands, or trademarks). The relative quality and value of these assets can have a significant effect on your business’s ultimate valuation, so you need to keep an accurate record of everything.

Ultimately, we’re all just guessing

I once heard an interesting viewpoint on valuation that illustrates its simultaneous complexity and simplicity. I was speaking with a peer at a conference, and this person said, “We can model out everything, run the numbers, and look at industry reports. But ultimately, any asset’s value is established at the moment a transaction occurs—and not a second before.”

This is something that business owners should keep in mind. Although arriving at a valuation is a quantitative exercise, it’s still largely an art. Like it or not, the buyer on the other end of the transaction ultimately establishes your business’s true value in the marketplace.

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Jim Moran

Jim Moran is the founder and managing partner of ValueStreet Equity Partners, a San Diego-based firm investing exclusively in small businesses. His entrepreneurial endeavors began in 2006 and culminated with the founding of a small business that grew to more than $30 million a year in sales. After exiting his business in 2016, James founded ValueStreet to pursue the work he loves on a larger scale. He holds a B.A. from Skidmore College in Saratoga Springs, New York, and he lives in San Diego with his wife and son.