The number one question I’m asked, is what is my business worth? It’s a question every business owner has on their mind. Maybe it is because they want to sell, maybe they are just curious. And it should be a simple answer, but unfortunately, it’s not.
First, we should start with the fact that businesses are valued in different ways, for different reasons. For the purposes of this post, I’m going to be talking about how businesses are valued for the purpose of selling to a third party in the main street to lower end of the lower middle market (SDE at or less than $1 million). One of the key tenants of economics and what I am also a true believer that the market will determine what an item is worth based on supply and demand. Essentially, an item is worth what a buyer is willing to pay. And businesses are no different.
Businesses are valued as a multiple of EBITDA (Earnings Before Interest Taxes Depreciation & Amortization) or SDE (Seller’s Discretionary Earnings). The main difference between the two is that SDE also add-backs one owner’s salary and benefits on top of the EBITDA number. Calculating SDE or EBITDA for every business allows each business – no matter what type – to be on equal playing field. To determine the value of the business, you calculate SDE for the last 3-5 years and then complete a weighted average (this is more art than science).
Now to determine the multiple. This may come as a shock, but your business is not worth as much as you think it is. Most companies sell for 2-6 times SDE, and those in the market we are talking about (less than $1 million SDE) sell for an average of 2 times, the range between 1 and 3 times. Often times, business owners will say, “Two times! If it’s only 2 times, I’ll just keep it!” To which our response is, yes you should. Most people do not sell a business just for the profit alone, there is some other life event that is the impetus for the sale – retirement, health, relocation, partner disputes, burn out, desire to try something new. There are a very few people that buy and sell small businesses for a profit, known to us as flippers – but they are few and far between (although this is a great opportunity I’ll talk about in another blog post).
This method I just explained is called the market method and is based directly on comparative sales of similar businesses to your size and industry. It is effectively going to the market and asking buyers what would they pay for your business. There are other methods for calculating business value including the asset method and discounted cash flow. But for the purposes of selling a small business to a third party, these are often either way overstated or way understated and get the hopes of business owners up only for them to wait for years on the market before they finally come to terms with what the market is telling them.
Another note is that we do not use projected earnings in this calculation – this valuation is based totally on past performance. Past performance is a good indication of future expectations. Buyers do not pay for potential, they pay for performance. Now if your business is set up for accelerated growth and the ‘quality’ of the company and earnings are better than others in the market, then a buyer may pay a higher multiple for a company. This is how you move from 2 times to 2.5 or even 2.75 times. How a business owner does that requires an entirely different blog post, although a good resource is our Prep to Sell program.
I hope this post helped shed some light on the business valuation process and how we determine listing prices, I know for many this may not be great news. But now that you know the reality of the space, you can go forth informed with a plan to grow your business in the way you need to achieve the exit you want.