How To Value a Business for Sale

As a business owner, there are many times during the life of your business where you will need to estimate the value of your company. Whether you’re ready to sell and exit the business now, or you’re planning to grow it for a few more years before offering it for sale, either way, understanding its current sale value is the first step in planning for your future and the future of your business. A business valuation assesses the current condition and value of your business and provides information that guides your business planning, exit planning, planning for pre-sale improvements, and sale timing decisions.

By estimating the value of your business — creating at least a back of-the-envelope estimated price — you will have the information you need to determine whether your business today meets the financial objectives you are aiming for in a sale and, if not, to determine the extent of improvements required and the amount of time necessary to achieve them.

The asset, income, and market approaches to valuation are the most common valuation methods and depending on the business being valued, industry size, and circumstances of the sale, one may be more suitable to use than another.

• The asset approach estimates the fair market value of the physical assets of a business that could be converted to cash. This assessment is especially important to owners of distressed businesses who are likely to liquidate tangible assets. It is also important when substantiating the price of the business during sale negotiations and due diligence.
• The income approach values a business based upon its expected future performance and cash flows, which are calculated by projecting current business earnings and then adjusting for changes in anticipated future growth rates, cost structure, and other factors that affect earnings.
• The market approach projects estimated value of a business based on sale prices of comparable businesses. It involves accessing and analyzing data from recent transactions and dividing sale prices by business revenues or earnings to arrive at the multiple at which the sales of comparable businesses have closed.

How To Value a Business: Asset-Based Valuations

An asset-based valuation establishes the fair market or sale value of the tangible, physical assets of your business. The asset valuation includes all assets of the business, including fixtures, furnishings, equipment, inventory, real estate, and other physical assets. This valuation method does not include the value of intangible assets such as brand recognition and reputation, websites and online presence, client lists and relations, skilled workforce, trademarks, patents and trade secrets, and intellectual property that will transfer to a new owner. Intangible assets are included when assessing goodwill value and almost always require assistance from professional valuation experts.

A valuation of assets is essential throughout the sale process:

• During exit planning, the asset valuation provides a sense of the total value of all physical assets that could be converted to cash. If, after completing a business valuation, the sale value of physical assets is very similar to the price likely to be received through a business sale, liquidation — simply selling assets and closing shop — becomes the most expedient exit route. Liquidation also becomes the necessary exit route for owners of businesses that are not in condition to attract a buyer at the time the owner wants or needs to make an immediate exit.
• During business sale negotiations, the asset valuation substantiates a component of the business pricing strategy. It presents an asset inventory and a sound projection of what it would cost the buyer to otherwise purchase the furnishings, fixtures, equipment, and other physical assets of your business, in their current condition and at their current market value.
• During the due diligence phase of a business sale, the asset valuation confirms all assets being transferred and whether each asset is owned outright or financed, and whether specific assets are accompanied by service agreements or other obligations.

How To Conduct an Asset-Based Valuation

Begin by listing all physical assets of your business. Make an inventory by going room by room, department by department, or location by location. Or group assets by type, such as office furniture, office equipment, production equipment, office furnishings, leasehold improvements, automobiles, and so on, also noting the location of each asset.

For each asset, record the date of acquisition, original cost, replacement cost, and current fair market value, which is the sale value of the asset in its current condition. Take notes regarding ownership, such as the amount of the purchase price outstanding, the cost of accompanying service agreements, and other costs of ownership.

Be aware that the resulting asset valuation will differ from the asset value shown on your business balance sheet for two reasons:

• The balance sheet reflects the book value or carrying value of assets based on acquisition cost minus depreciation, while the asset valuation reflects the fair market value of assets, which, in some cases, could be even more than their initial price.
• The balance sheet reflects the depreciated value only of assets acquired at prices above a minimum value, while the asset valuation includes the market value of all physical assets minus any liabilities associated with those assets.

Also, be aware that there are situations that may require asset valuations by an independent certified appraiser. For example, if production equipment assets are being used as collateral for a bank loan, the valuation will require assessment by an independent certified machinery appraiser. Likewise, other high-value assets may require fair and impartial appraisals that can hold up under scrutiny with courts, banks, and financial institutions.

The Income Valuation Approach

The income approach estimates the value of future business cash flows or income. It is especially important when valuing startups or turnarounds for which past financial performance is not a good indicator of future potential. The approach involves either a capitalization of earnings method or a discounted cash flow method to project growth, with both benefitting from professional valuation and accounting advice.

• Capitalization of earnings measures the value of a business by determining the net present value (NPV) of expected future profits or cash flows. This involves dividing the expected future earnings of the business by the capitalization rate, which is the rate of return the buyer can expect to earn on the investment made to purchase the business. The capitalization rate is determined in part by the company’s perceived risks. This method is often used by businesses with stronger future growth and profit projections than past performance indicates.
• Discounted cash flow (DCF) estimates the value of a business based on its projected future earnings. First, the expected cash flow of the business is projected over a duration of time, usually one year. That projection is then discounted based on risk, using a percentage which is either derived from weighted average cost of capital (WACC) or a build-up rate determined by the market.

How To Value a Business: Market-Based Valuations

The market approach estimates the value of a business based on data from similarly sized and recently sold businesses in a geographic area or business sector. It involves multiplying the earnings of your business by the valuation multiple at which similar businesses have sold or are selling.

What is Comparable Data?

Often referred to as comps, comparable data is usually sourced through online databases tracking recently listed and sold businesses. Comp criteria can be targeted by industry, geographic location, financial performance, sale price, and other filters. This allows a comparison of information only from businesses that are similar to yours in terms of industry classification, geographical location, size (revenue, assets, employees), earnings, and other financial metrics.

How to Use Comparable Data When Determining the Value of Your Business

Knowledge of the price-to-revenues or price-to-earnings ratios at which businesses similar to yours have recently closed provides a benchmark for the valuation multipliers you might use to arrive at a ballpark estimate of your business value.

The goal is to compare businesses like yours in terms of industry classification, geographical location, size (in terms of revenue, assets, employees), earnings, and other financial metrics.

For example, the owner of a California pizzeria could compile a valuation analysis for comparable pizzerias sold in California. Based on the report results, the owner could divide the sale price of each recently sold pizzeria by its gross revenue or earnings to see the range of pricing multiples at which comparable businesses have recently sold.

The owner would then study the report data in search of information reflecting the condition of each business, based on such indicators as expenses, rent, or other data. Considering how the condition of recently sold pizzerias compare with the condition of the owner’s pizzeria would help determine if it ranks in the higher – or the lower – quartile of businesses in terms of condition, and therefore whether its valuation would be based on the higher – or lower – multiples achieved through recent sales.

Understanding the Difference Between Price-to-Revenues and Price-to-Earnings Ratios

When reviewing data for comparable market sales, two of the most common ratios used are revenue multiples (often referred to as sales multiples) and earnings multiples.

Revenue Multiples

Revenue multiples are based on the gross revenue shown on the annual business income statement. They involve a fixed figure, and therefore some experts feel applying a multiple to annual gross revenue is the most reliable approach. However, because annual revenues cannot reflect how much money the business actually earns, most experts caution that basing the price multiple on revenues does not reflect the health of the business. Revenues do not reflect whether the business is mismanaged or if it has higher-than-average expenses.

Earnings Multiples

Earnings multiples are based on how much the business earns annually for the benefit of its owner. Owner earnings differ from the annual profit shown on the business year-end income statement or its federal tax return. When pricing small businesses, profit and earnings are defined as follows:

Profit, the bottom line on the business income statement, reflects all business revenue less all legally deductible business expenses to arrive at the lowest possible taxable income.

Annual owner earnings, also called owner’s cash flow or seller’s discretionary earnings (SDE), also include all business revenue, but from there deductions reflected on the income statement are revised to arrive at a total showing how much the business actually generates for the benefit of its owner in a normal year.

Preparing a Statement of Seller’s Discretionary Earnings (SDE)

Owner-operated businesses measure the full financial benefit that a business generates for its owner with the seller’s discretionary earnings metric. To calculate SDE, the year-end income statement is recast with the following adjustments:

1. Add back expenses that were deducted for interest, depreciation, taxes, and amortization, resulting in what accountants call business EBIDTA (earnings before interest depreciation, taxes, and amortization).

2. Add back expenses that benefitted the owner directly, such as owner’s salary and benefits, insurance, and auto use.

3. Add back discretionary expenses and contributions or donations that another owner might choose not to incur.

4. Add back non-recurring expenses to “normalize” earnings by excluding unusual and one-time transactions of the business.

5. If SDE has differed greatly over recent years, work with your accountant to create and present what is called a weighted average.

Calculating the Earnings Multiple

The earnings multiple used in most small business valuations is a number between 1 and 5. Businesses with weakest potential and highest risk have the lowest multiples, and businesses with strongest potential and lowest risk have the highest multiples.

When applied to the SDE of the business, the multiple results in an early estimate of business value. For example, a business with an SDE of $500,000 and a multiple of 3 has an estimated value of $1,500,000, while a business with SDE of $500,000 and a multiple of 4 has an estimated value of $2,000,000.

To determine the multiple for your business, begin by studying comparable-data benchmarks. They provide the most basic ballpark estimates of earnings multiples for businesses matching your size, geographic location, or business sector.

You can begin to estimate the earnings multiple for your business by assessing factors likely to signal attractiveness or risk to buyers.

No one valuation approach answers the question, “What’s my business worth?” Instead, a combination of approaches contributes to the answer based on the value of your business assets, sale prices of comparable businesses, and the annual earnings and strength of your business as a going concern. Valuing a business requires a multilayered approach, so combining methods is important to help you determine the true worth of your business. 

To get an estimate of the value of your business, use the BizQuest Valuation Calculator to see a valuation range based on business earnings and the average market valuation multiple in your industry.