Understanding Your Business’s Enterprise Value When Preparing for a Sale

As a business owner, understanding your company’s enterprise value is one of the first steps in preparing your business for sale. Enterprise value (EV) represents the total worth of your company, taking into account not just your business’s equity value, but also its debt and cash.

Valuation Methods

When valuing a business, owners typically rely on three primary valuation approaches:

• Market Approach: This method compares your business to similar companies that have recently been sold. By analyzing the selling prices and key metrics of comparable businesses, you can gain insight into what your business might be worth on the open market.
• Income Approach: The income approach estimates your business's future cash flows and applies a discount or capitalization rate to arrive at a present value. This method is well-suited for established businesses with predictable cash flows and helps to capture the company's earning potential.
• Asset Approach: The asset approach values your company based on its tangible assets, including equipment, real estate, and inventory. This method can be especially relevant for businesses with distressed businesses who are looking to liquidate tangible assets.

While these three approaches form the foundation of most small business valuations, there are additional metrics that can provide valuable insights into a company's enterprise value:

• Market Capitalization: For publicly traded companies, market capitalization (the total value of outstanding shares) is a key component of enterprise value. While not directly applicable to privately held small businesses, understanding market capitalization can help owners compare their valuation to industry peers.
• Discounted Cash Flow (DCF) Analysis: DCF analysis is a more sophisticated version of the income approach. It involves forecasting a company's future cash flows and discounting them back to their present value using a discount rate that reflects the investment's risk. DCF can help small business owners understand the long-term value of their company and make informed decisions about growth and exit strategies.
• Comparable Company Analysis (CCA): CCA is an extension of the market approach that compares a business to similar publicly traded companies. By analyzing the enterprise value multiples (such as EV/EBITDA or EV/Revenue) of comparable companies, small business owners can gain additional benchmarks for their own valuation.

While market capitalization, discounted cash flow, and comparable company analysis may not be the primary focus for most small business valuations, understanding these concepts can help owners gain a more comprehensive view of their company's worth and make informed decisions when preparing for a sale. By combining these insights with the foundational market, income, and asset approaches, owners can arrive at a robust enterprise value that accurately reflects their business's unique strengths and potential.

How to Calculate Enterprise Value

As a business owner, you can calculate your company's enterprise value using a simplified formula that considers your business's total value, debt, and cash.

1. Determine the value of your business using one or more of the valuation methods discussed earlier (market, income, or asset approach). This value represents the equity value of your company.
2. Add the total amount of debt your company owes, including both short-term and long-term debt. This step is important because a potential buyer would assume these obligations when acquiring your business.
3. Subtract your company's cash and cash equivalents from the total obtained in step 2. Cash and cash equivalents include money in your business bank accounts and any highly liquid investments that can be easily converted to cash.
4. If applicable, consider adding the value of any minority interests or preferred shares that have a claim on your company's value. These may include silent partners or investors with special rights. Additionally, if your business has investments in other companies that are not part of your core operations, subtract the value of those investments.

The result of this calculation represents your small business's enterprise value. This value provides a comprehensive view of your company's worth, considering not just the value of your business itself, but also the debt and cash that would be included in a potential sale.

Here’s an example of how to calculate enterprise value: Alex owned a successful manufacturing business with $3 million in annual revenue and $500,000 in earnings before interest, taxes, depreciation, and amortization (EBITDA). When he decided to sell, his business broker used a combination of valuation methods to determine the company's enterprise value.

First, the broker used the market approach, comparing Alex's business to similar manufacturing companies that had recently sold. Based on a revenue multiple of .75x and an EBITDA multiple of 3x, the market approach yielded a range of potential values for the business.

Next, the broker employed the asset approach, valuing the company's tangible assets like equipment and inventory, as well as intangible assets such as patents and customer relationships. This provided a floor value for the business based on its physical and intellectual property.

Finally, the broker used the income approach, forecasting the company's future cash flows and applying a discount rate to arrive at a present value. This method took into account the business's growth potential and risk profile.

By triangulating these three approaches, the broker arrived at an enterprise value of $3 million for Alex's manufacturing business. This value took into account not just the company's assets and revenue, but also its debt and cash on hand.

Armed with this enterprise value, Alex and their broker were able to effectively market the business to potential buyers and negotiate from a position of strength. They highlighted the company's strong cash flows, valuable assets, and growth potential to justify the asking price.

Ultimately, Alex received multiple offers and was able to sell the business for $3.2 million, a premium to its enterprise value. By understanding the company's true worth through the lens of enterprise value, Alex was able to achieve a successful exit and maximize their return.

Enterprise value is more than just a single number—it's a comprehensive measure of a company's worth that considers multiple valuation approaches and financial factors. For small to mid-market business owners looking to sell, understanding enterprise value is key to setting realistic expectations, marketing effectively to buyers, and negotiating the best possible deal. Potential buyers will use your enterprise value as a starting point to assess the attractiveness of your business as an investment opportunity.

Keep in mind that while this simplified formula can give you a general idea of your enterprise value, it's always a good idea to consult with a professional business appraiser or broker when valuing your business for a sale. They can help you refine your valuation based on your specific circumstances and industry trends.

The Role of Debt and Cash in Enterprise Value

A company’s debt and cash help determine a business's enterprise value.

• Debt represents the company’s financial obligations.
• Free cash flow reflects the company's liquidity and ability to meet its obligations.

When calculating enterprise value, debt is added to capture the company's total financial obligations and liabilities, while a company’s cash is subtracted to reflect its available resources. Understanding the balance sheet makes it easier to assess a company's financial health and its ability to generate returns for investors.

What Are Enterprise Value Ratios?

Enterprise value ratios are important financial metrics that gauge a company's valuation in relation to its financial performance. Common financial ratios like EV/EBITDA and EV/Revenue offer valuable insights:

• EV/EBITDA compares enterprise value to earnings before interest, taxes, depreciation, and amortization.
• EV/Revenue contrasts enterprise value with total revenue.

These ratios help investors and analysts assess valuation multiples, facilitating comparisons with industry peers and spotting investment potential.

Using Enterprise Value as a Benchmark

Industry benchmarking involves comparing a company's performance and valuation metrics to those of its industry peers. By benchmarking enterprise value ratios and other financial indicators against industry averages, businesses can identify areas of strength and weakness, understand market trends, and make informed decisions. Benchmarking helps stakeholders assess a business’s growth potential.

Understanding the key drivers of enterprise value is essential for maximizing shareholder value and driving business growth. Common value drivers include:

• Revenue growth
• Profit margins
• Operational efficiency
• Market position
• Industry dynamics

Business owners and buyers alike can use enterprise value as a benchmark when evaluating sale offers and opportunities. By comparing the enterprise value of their business to similar companies in the market, owners can assess the fairness of sale offers and negotiate from a position of strength.

Additionally, buyers can use enterprise value benchmarks to identify undervalued acquisition targets and evaluate the potential return on investment.

BizQuest Valuation Tools

To learn more about business valuation, visit BizQuest’s Valuation Research Resources designed to help business owners and buyers make informed decisions. Our valuation tools include a Valuation Calculator and Average Business Valuation Multiples designed to help you understand the key drivers of value and identify areas for improvement.