Business Valuation Explained

Posted 01-23-2015 4:17 pm by

Business valuation can seem like a mystery to many business owners.  How do you determine the value of your business?  Is it a multiple of your annual revenues?  Is it a multiple of your net income?  Or is it based on comparable sales or some other method? 

The first step to business valuation is to determine the type of business that is being valued.  For instance, if the business being valued is a family-owned or privately held business, obtaining recent comparable sales data can be difficult since most privately held companies are sold confidentially.  For this reason, the comparable sales approach is not frequently used for valuing small businesses. 

The next step to business valuation is to determine the intent of potential buyers.  Are you marketing to a much larger company that is looking to acquire your business for strategic reasons?  Are you marketing to similar-sized companies that are looking to buy out their competitors?  Or are you marketing to individuals who are quitting their jobs and going into business for themselves? 

The reason it is important to determine the intent of potential buyers is that what the buyers value plays a large role in the sale price of your business.  When Google acquired YouTube for $1.65 billion, YouTube did not have the revenues or cash flow to justify a $1.65 billion sale price.  Instead, Google was a strategic buyer that wanted the number of users on the YouTube web site. 

On the other hand, the buyers of most small businesses are individuals who are quitting their jobs, plunging their life savings into the purchase, and going into business for themselves.  In this scenario, the buyers care a lot about the cash flow of the business.  Revenues do not matter to most small business buyers as cash flow does, because at the end of the day, these buyers need the cash flow to pay the bills.  For this reason, most small businesses sell based on their cash flow. 

How exactly is cash flow defined?  It is common knowledge that many business owners like to minimize the net income shown on their tax returns in order to minimize their tax liability.  To accurately portray the cash flow of a business, one needs to perform a financial recasting of the company financials.  For instance, there are expenses such as depreciation, meals and entertainment, owner’s salary, etc. that can be added back to the net income.  The total “owner benefit” is termed Owner’s Discretionary Income, or ODI. 

Most privately held companies with annual revenues of $5 million and under sell based on a multiple of the ODI.  The exact multiple can vary based on the desirability of the industry, the competitive advantage of the business, the operating history of the business, historical profitability and trends, whether the business is run with an absentee owner or owner operator, and other factors that can influence the multiple that is used. 

The key to obtaining an accurate business valuation is to seek the advice of competent advisors who specialize in selling businesses in your company size range, your industry, and your geographic location. 

Aaron Muller is a business broker in Washington State who has sold over 120 companies and facilitated over 40 SBA loans for his clients. Contact Aaron at (425) 766-3940 to inquire about selling your business.

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