As a business owner, if you are considering selling your business in the short or medium terms, it is important that you have an understanding of the market value of your business. And also knowing what factors have an impact on the value of the business, in both a positive and a negative way.
Knowing these things can help you make decisions on what actions you need to take before the business is listed for sale.
This article focusses on the common approach that most businesses are sold, and that is to what are known as Financial Buyers. These buyers are wanting to purchase your business’s future stream of profits, so their evaluation of your business´s value focuses on its profitability, and the likelihood of those profits flowing into the future.
Because buying your business is probably riskier than putting money in the bank or in government bonds, a financial buyer will demand a much higher return on their investment and therefore will usually make an offer that is within the normal range of multiples being paid for businesses like yours.
The topic of multiples will be discussed later in the article including how an assessment is made on what multiples apply.
In contrast to the Financial Buyer, A Strategic Buyer determines what to offer by estimating the value of your business to them if they owned it. This can take into account how the busines would juxtapose onto their business. They may have a large distribution network that if they owned the products sold by your business, they could massively increase sales. Alternatively, they may be interested in acquiring the distribution channel of the business they want to buy. They may also wish to get a foothold into a new geographical location that the business is currently well-placed in.
A more in-depth discussion of the strategic buyer and how a strategic acquisition compared to a financial acquisition can mean a much higher price is paid for a business is outlined in another article.
In respect to a financial purchase there are two approaches we offer to determine the value of a business.
- A no cost Market Appraisal of the market value of the business, which provides a price range designed to give the business owner an indication of value.
- A comprehensive Business Valuation undertaken by a licensed business valuer that includes a detailed document and a valuation report. This valuation service will vary in price depending upon the size and complexity of the business.
The process to determine the market value of a business begins with obtaining some basic information starting with the financial statements of the business for the past three years and some general information about the business.
When we work with you, we will provide you with a Valuation Questionnaire. This will give you a guide to source all the information needed for a valuation.
The following is an overview of the general valuation process.
- Determine the true business earnings of the business. This is done by undertaking a rigorous assessment of the Profit and Loss, Balance Sheet and Tax Returns for the previous 3 years. We also undertake a basic review of the business and the industry it operates in.
For small businesses that have profits less than $500,000 the term, “Owners Profit”, “Seller’s Discretionary Earnings” (SDE) or Proprietors Earnings Before Interest, Taxation, Depreciation and Amortisation (PEBITDA) is used.
This is the profit before one of the owners is paid a salary. Allowances need to be made if 2 or 3 owners are to be paid market salaries within the business expenses.
For larger businesses with profits over $500,000 either a PEBITDA or EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) standard of profit is used.
For profits that exceed $1,000,000 then EBITDA is the most common industry standard used as the measure of Company earnings. When EBITDA is used this is done after adjustments, to allow for all owners to be paid fair commercial replacement salaries within the business expenses.
The multiple of SDE increases as the size of SDE increases. Small businesses with SDE less than $100,000 sell for multiples in a range of 1.2 to 2.4, when SDE is greater than $100,000 we expect to see the multiples in a range of 2 to 3, and as SDE reaches and exceeds roughly $500,000 we see the range extend to 2.5 to to 3.5 or more.
Two things happen as SDE approaches and exceed $1M; first, we are likely to redefine our SDE and begin using EBITDA (for the same business EBITDA is a smaller number than SDE), and the expected multiples grow to 3.5 to 5.5. We see multiples of 5 or larger as our EBITDA reaches and exceeds $2M.
While there may be range of multiples for any given SDE, we find that most opportunities sell near the middle of the range with very few actually selling at either extreme. Given the particular attributes of any opportunity it is relatively easy to understand where the business will fall with in the range of multiples.
With respect to a business with profits less than $500,000, the SDE/PEBITDA is calculated by starting with the business’s pre-tax income from the Profit and Loss Statement. Then to that are added the non-cash expenses i.e. depreciation, interest expense and amortisation. Then the business owner’s compensation and any benefits are then added back, plus other entries in the expenses such as contributions, donations, one-time non-recurring expenses, and other personal or non-business related expenses.
The aim is to identify the true cash flow or profit that would have accrued to an owner in each of the past three years.
Examples of adjustments to identify include:
- A seller of the business who also owns the land that the business is on pays a monthly rent of $5,000 per month, however when the business is sold he would charge the buyer a market rent of $6,000 per month. The seller would need to deduct $1,000 from the SDE to ‘normalise’ the earnings so they reflect the circumstances that a new owner would face.
- If the seller is paying a family member $100,000 per year to work in the business, but the new owner could replace the family member of the seller $60,000 per year, then $40,000 should be added to the SDE.
The process of identifying SDE/PEBITDA is often referred to as “adjusting / recasting / normalising” the financial statements.
When we work with a business owner we provide a worksheet to work through the process of identifying the addbacks on the Profit and Loss Statements.
Keep in mind that lending institutions and almost all buyers will compare the Income Tax Returns with the Financial Statements (including audited statements) and they will expect explanations of any significant variations between the Tax Returns and the Financial Statements.
With the SDE/PEBITDA identified the next step is to identify what is included or not included in the sale based on what appears on the Balance Sheet. There needs to be a clear understanding of what assets and liabilities are included in the sale, and such things can be a part of a sale negotiation. In a traditional asset sale of the business, the seller would retain any cash in the business and the company would be transferred free and clear of any long-term debt. Aspects of the business such as accounts receivable, accounts payable, personal assets and inventory may all be included, or some may be excluded depending upon the negotiations of the transaction.
Once the true earnings (SDE/PEBITDA) and included assets are identified, the next step is to apply valuation formulas to the amounts calculated. There are a number of complex valuation formulas including those specific to certain industries (i.e. rules of thumb). Some of the more common valuation formulas include Capitalisation of Net Earnings and Discounted Future Cash Flow.
Typically, though across the majority of businesses, valuation formulas tend to be a multiple of Earnings or SDE/PEBITDA. As an example, if a business has a SDE/PEBITDA of $400,000 and a multiple of 2.8 is applied, this would value the business at $1,120,000.
This multiple can vary depending upon the size, location and industry of the business, though in general the multiple gets larger as the business’s SDE/PEBITDA gets larger.
To give us an indication of what multiple to apply we have a comprehensive checklist of business factors we go through and then we apply a risk rating against each one. These are then averaged out and that amount is applied to the SDE/PEBITDA.
Our next step is to verify the valuation result by comparing the value of the business to the sale price of other comparable businesses within the State. We use the ROI’s from the reputable Business Values Newsletter.
A business’s market price will fall between a range of values. Overall, the buyer’s perception of your business’s overall strengths will be a determining factor in their opinion of value.
We outline a list of factors that can positively and negatively affect the market value of your business in another article. While each buyer will have their own opinion as to which factors are more important to them, improving as many of these factors as possible will generally result in a higher overall price for the business.
---
Disclaimer
This article is provided with the compliments of Alan Dinnie. It is genuinely intended to offer readers information to make better decisions and to give insight into various aspects of business in general, and more particularly related to the sale and purchase and management of businesses.
All material presented herein is intended for informational purposes only. Information is compiled from sources deemed reliable but may be subject to errors and omissions. No statement is made as to the accuracy of any description. Alan Dinnie makes no warranties or representations regarding the information and excludes any liability which may arise because of the use of this information. This information is the copyright of Alan Dinnie.
Nothing herein shall be construed as legal, accounting, or other professional advice outside the realm of real estate and business brokerage.
I trust you enjoy the article and that it provides you with useful information.
To your business success
.jpg)
.jpg)
