What's Your Business Worth?
As a business owner, I’m guessing you have a number in your head, the one that you have decided your business is worth.
Perhaps you’ve done some tax planning and had a specialist conduct a formal valuation of your business. Or maybe you heard a valuation rule of thumb at a cocktail reception for your trade association. It might have sounded like: “Our types of businesses are selling for 1x revenue these days.” Or it could just be an anecdote you heard from a friend of a friend who is familiar with what a competitor sold for recently. Doing some back-of-the-envelope math based upon his story, you established a basis for your company’s value.
However you got there, you’ve developed what is often called the “seller’s expectation”.
Is your seller’s expectation important? Yes, in so far as it often establishes a psychological floor for you.
That said, your expectations and what a buyer will actually be willing to pay for your company (“buyer’s expectations”) are most likely divergent. As a business owner, you have a choice:
Ignore this reality, put your head in the sand, and press on, armed with your hope that everything will work out in the end, or
Educate yourself and work to bridge any gap between seller’s expectations and buyer’s expectations.
If you feel uneducated and unconfident about your business’s valuation, join the club. You are a business owner, not a business transactions specialist.
While anecdotes can serve as legitimate inputs to establishing the value of your firm, let’s walk a few steps down path #2 and learn about how buyer’s approach value in today’s marketplace.
Range of Value
In today’s business transaction market, established businesses are generally valued on the basis of a multiple of profits. The most frequent profit measure used is EBITDA (i.e. Earnings Before Interest, Taxes, Depreciation, and Amortization) . For small businesses this might be SDE (i.e. Seller’s Discretionary Earnings).
So the starting point for most business owners would be to calculate EBITDA and/or SDE, as neither of these measures appear on a financial statement. Learn more about EBITDA here.
Next, we have the multiple. Here is where we review a sample of comparable transactions to discover the relevant multiple range. There are several subscription providers of private transaction data. For illustrative purposes, we might find that machine tool businesses have historically sold for between 2.5x to 6.5x EBITDA. So when we value a particular company in this industry with $1 million in annual EBITDA, the potential range of value runs from $2.5 million to $6.5 million.
In most cases we end up with a pretty wide range like this. So how do we hone in on the right value?
Placing Your Business in the Range of Value
With the range of value determined, we now have to determine where to place your business. This requires both art and science, but it follows a pretty simple principle: better companies trade at higher multiples and lesser companies trade at lower multiples, or not at all.
Taking our example from above, assume our machine tool business has industry-leading EBITDA margins of 20%, so on sales of $5 million it generates the $1 million in EBITDA referenced above. The average firm in the industry has 10% EBITDA margins. This factor alone means it will likely sell for a higher than average multiple, since high profits suggest a better-run business.
On the other hand, let’s assume that this same business, while very profitable, receives 90% of its business from a single customer. This would be a huge negative, which would suggest that this business will trade at a lower-than-average multiple, or not at all.
In this simple example, we have hit on two of the dozens of value drivers that enhance or detract from business value. Placing a business in the range of value requires analysis and nuance. But when done correctly it offers a game plan for enhancing business value moving forward.
Ultimately, a business is worth what a buyer is willing to pay. But this is the type of analysis that most buyers in the market today use to establish their willingness to pay.
Are you interested to know what your business is worth and, more importantly, what you can do about it? Talk to Doescher Group and consider an Exit Audit, which can set you on a path to accelerating the value of your business.
