A Get Down to It Guide to Business Valuation
You probably know about home valuation or websites and appraisal if you already own a home. You know that the appraisal to value the home looked at every conceivable aspect of its construction and mechanicals.
A business valuation works similar to that, but it considers much more than the physical structure in which you house the business. It does include your physical structures such as office buildings, but also the financials of the company, your business equipment, your customer values, etc.
Just as we previously covered with home valuation and appraisal, many methods of valuation exist. When valuing a business, you should run every scenario of valuation, but you also need to pick one and stick with it. If you need to value many businesses, for example, you work at an investment firm or you’re a venture capitalist, this increases in importance. Sticking with one method and applying it to every valuation means you will compare like and like.
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While a plethora of methods exist for valuation, the three most common include seller’s discretionary earnings (SDE), EBITDA, and the assets-based approach. Each of these provides a different approach and a better application. You also have the option of using a business valuation calculator which provides an estimated value based upon industry, current profit, and current sales. I will admit, the fun and easy way that I mentioned in the header refers to the calculator. You only need two figures to calculate this and your industry and that, as my buddy Dr. Dave Titley says, “is super easy.”
Okay. Let me be honest. The rest of the ways to calculate range from not so horribly tough to do to why haven’t you just hired a CPA or certified appraiser?
Basically, I am saying you need to be decent-ish at math and organized to do this. While SDE does not require math genius, it does require patience. Extreme patience. Also, if you do not know what you are doing, the complication of the business valuation process can result in mistakes. The valuation results you obtain might not match the actual business sale price. If you still want to calculate things the long way, we’ll start with SDE.
Seller’s Discretionary Earnings (SDE)
SDE provides a relatively simple method ideal for valuing a small business. It requires three main steps.
Step One:
You need to normalize your business earnings first to get an accurate appraisal. This provides you the raw SDE number. Get ready for a mouthful.
The latter does not refer to once a year expense. They are only paid the once and there is no expectation they will continue in the future. You calculate this before expenses because that reflects how much your business actually produces in revenue. So, do not use the quickie way of obtaining this number which is snagging the income line from your business’ tax return. If you do that, you end up with all your deductions pulled out and you will determine an incorrect SDE. Your SDE shows your potential buyers what they could earn.
The List of What You Add Together to Your Net Income to Calculate SDE
- 1. Owner's salaries
- 2. Perks and benefits owners receive such as per diem, personal vehicle payments, etc.
- 3. Non-essential family member employees on the payroll,
- 4. Amortization, depreciation, and other non-cash expenses
- 5. Leisure business activities such as golf games that double as business meetings
- 6. Charitable donations
- 7. Personal/business expenses such as a vehicle you will keep that also got used as a business vehicle
- 8. Non-essential business travel
- 9. Other one-time expenses such as a lawsuit settlement
To make it simpler, use a business valuation worksheet. It will prompt you for all data that needs to get included.
Step Two
Determine your SDE multiplier. You will probably be pretty happy to know that your business will sell for more than your SDE. In fact, you will most likely get one to four times the SDE as your sale price. You could use an industry-standard multiplier or a business multiplier specific to the business type. The multipliers cannot be interchanged. They are not equal. You must make a decision on which one you need to use. Here are the criteria for that.
Choosing Your SDE Multiplier
Your industry,
Market risk in the geographic region,
Size of the business,
Tangible and intangible assets,
Owner risk/business independence,
Other variables as needed.
The most influential SDE multiplier factors include industry outlook and owner risk/business independence. This means the business’s genuine ability to function without you or the other owners. If a transference of leadership would cause little to no fluctuation in the business’ operation, it has independence from its owner. If the business requires you or another owner to function, then it exhibits high owner risk.
You need to use the criteria to determine whether the business-specific or industry SDE multiplier works better for your business. The BizBuySell’s media insights quarterly report provides SDE multiples for industries based upon business sizes.
Step Three
You now add your assets and subtract the liabilities that you did not already include in the SDE in Step One. You typically keep the liabilities in a business sale.
Your tangible assets include physical goods such as real property, accounts receivable, and cash on hand. These items do not get included in the multiplier calculation.
Intangible assets consist of non-physical goods with business-specific value such as the patents, trademarks, reputation, and goodwill of the company.
The liabilities include the debt or obligations of the business. You can sometimes sell the liabilities, too, but rarely. Business sales typically are asset sales. These usually include the business’ current debt and past-due debt. You also need to indicate when the business pays its suppliers on time. You can determine assets and liabilities relatively quickly with a Dunn & Bradstreet report.
Step Four: Do the Math
Now, you need to plug your numbers into the formula to achieve your final sales figure. Here is the formula:
EBITDA Approach
You might have heard of this one before if you watch television crime shows. It figured as a clue in an episode of Law & Order: Criminal Intent. It was the CPA with a penchant for diamond dog collars. CPAs love EBITDA. You can use this for a business with earnings of less than $1 million, but it works better for a business with more than $1 million in earnings.
In the L & O episode, the dog got named EBITDA. For your edification that stands for “earnings before interest, taxes, depreciation, and amortization.” It is a line in the TV show and a line on your business income statement.
EBITDA works to remove fuzzy variables. Your valuation otherwise would depend on things you’re your accounting method and the business’ tax strategy plus if it gets debt or equity financed. EBITDA takes a bite out of the variables and provides a standardized earnings figure. From that number, you create the EBITDA multiple that lets you calculate the business’ sale price.
Sorry, but you need a new multiplier if you, or when you, use this method. Remember that if you are determining a sale price for your own business.
The amortization and depreciation discounts can cause the EBITDA formula to miss upgrades or asset replacements needed by the company or overestimate a business’s ability to cover its liabilities. You need to use a method of cash flow analysis to balance it. Many CPAs use discounted cash flow (DCF).
I was not kidding that this stuff gets rather technical and complex. It is not for the faint of heart. Most people hire a consultant to do the math for them. Let’s face it. Each of these methods includes a lot of financial research, a ton of math, and some digging online to find the right multipliers.
You can do the math if you like, but, hey, why not go the quick route and have a CPA do this? Okay, maybe you are reading this thinking, well, ‘Carlie, I’m studying to be a CPA. I can do this. I know I can!’
Okay, here comes your third method for calculating business valuation.
Asset-Based Approach
The asset-based approach works great for small businesses and uses no multiplier. It includes tangible assets and intangible. The former includes items like inventory while the latter includes location and reputation.
Asset-based Key Data Points
The formula for an asset-based valuation is simple. The business or prospective buyer should take all of the business’ tangible and intangible assets and subtract all liabilities. As simple as this calculation is, it just provides a rough estimate to determine if the seller listed a realistic asking price.