How To Value Your Small Business (And Increase It’s Potential Sale Price)
Business valuations are unique in that they take into account a wide range of factors, including financial performance, market conditions, industry trends, and the distinct characteristics of the business itself. Each business is unique and therefore, determining its value can be a complex process which should be done by a professional team of business advisors. However, with the right approach and with the help of experienced professionals, it is possible to determine a close approximation of your business’s value so you can make better informed decisions about your business and it’s future.
In this article, we will explore the different factors that go into determining the value of a business and provide practical tips on how to potentially increase the value of your small business.
5 Reasons Why Knowing Your Business’s Value is Extremely Important
Knowing the value of a business is important as it helps in determining the right price for selling the business, negotiating with potential buyers, raising capital, planning for the future, benchmarking performance, and estate planning. Additionally, it allows them to secure loans or investments, plan for retirement, identify areas for improvement and transfer of ownership to their family members.
Selling a business: Knowing the value of a business can be crucial when it comes to selling it. A business owner will be able to determine the right price to sell their business, and they will be able to better negotiate with potential buyers. Additionally, a business owner who knows the value of their business will be better prepared to answer questions from potential buyers and provide the necessary financial information.
Raising capital: Knowing the value of a business can also be important when it comes to raising capital. A business owner can use the value of their business as collateral to secure loans or investments. Additionally, a business owner can use the value of their business to negotiate better terms with investors and lenders.
Planning for the future: Knowing the value of a business can also be important for planning for the future. A business owner can use the value of their business to plan for retirement or to determine how much money they can afford to invest in future growth opportunities.
Benchmarking: Knowing the value of a business can also be a useful tool for benchmarking performance against industry standards and competitor's businesses. This can help business owners identify areas where they can improve performance and increase the value of the business.
Estate planning: Knowing the value of a business can also be important for estate planning. A business owner can use the value of their business to plan for the transfer of ownership to their family members or to determine how much money they will need to provide for their family after they pass away.
Although we’ll be writing something in the future in more detail about why you should know the value of your business, let’s discuss how you can determine what it might actually be worth.
EBITDA
EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is one of the most important metrics to consider when valuing a business. This metric is used to measure a company's earnings and financial performance by removing the effects of financing and accounting decisions from the revenue equation (these things typically change when the business is sold). EBITDA provides a clear picture of a company's profitability, making it a valuable tool for both buyers and sellers when determining the overall potential value of a business.
EBITDA is particularly important for businesses that have significant investments in real estate, property, plant, and equipment, as it excludes the non-cash expenses related to depreciation and amortization. This allows buyers to see the true cash flow generated by the business, which is a key factor in determining the overall value. Additionally, EBITDA can be used to compare the performance of companies within the same industry, as it provides a more accurate picture of a company's current underlying operational financial performance.
It's also worth noting that EBITDA actually should be analyzed in the context of the company's industry and the market conditions. For example, a company in a historically growth related industry with high EBITDA margins may be worth more than a company in a mature industry with lower EBITDA margins. Additionally, EBITDA might be compared to other businesses in the same industry to determine how it stacks up against its peers.
How to Calculate EBITDA:
EBITDA = Revenue - Cost of Goods Sold (COGS) - Operating Expenses + Other Income - Depreciation – Amortization
Revenue is the total amount of money the company generates from its sales.
COGS is the direct cost of producing the goods or services sold by the company.
Operating expenses include all the expenses incurred to run the business such as rent, utilities, salaries, and other general and administrative expenses.
Other income includes any income from sources other than the primary business operations.
Depreciation is the non-cash expense that reflects the wear and tear of assets over time.
Amortization is the non-cash expense that reflects the cost of intangible assets such as patents and trademarks over time.
EBITDA is traditionally not a GAAP (Generally Accepted Accounting Principles) or IFRS (International Financial Reporting Standards) financial measure and can be different depending on the company's accounting policies. EBITDA is often used as a financial measure to evaluate a company's performance, but it should be used alongside other financial metrics such as net income, gross margin, or operating margin to get a more complete picture of the company's financial performance.
Gross Multiples
Another key metric to consider when valuing a business is gross multiples. Gross multiples are ratios that compare a company's revenue or EBITDA to its valuation. This can provide a quick and easy “back-of-the-napkin math” way to compare the value of different companies in the same industry. For example, if a business has a gross multiple of 5x, it would be valued at 5 times its EBITDA. In the case of the manufacturing company mentioned in the example, with an annual EBITDA of $5mm, the value of the business would be $25mm based on a 5x multiple. Some industries have multiples in the double digit range.
It's important to note that these calculations can get more granular depending on the company, industry, and current market conditions. For example, businesses that have higher margins, consistent revenue growth, or significant intellectual property may be valued at a higher multiple compared to a business with lower margins and a more sporadic or uncertain revenue stream. Additionally, the multiple chosen is not always a fixed number and can vary depending on the buyer or seller's perspective, the industry, or the company's financial performance.
Gross multiples can be a quick way to compare the value of different companies, but they are not the only measure to consider while evaluating a business. It's important to take into account other factors such as the company's management team, growth potential and industry trends as well as the company's overall financial performance.
Machine-Like Operations
In addition to EBITDA and gross multiples, the value of a business that has machine-like operating characteristics is also very important. These businesses are characterized by their ability to operate with minimal input from their owners or managers. They have a predictable and consistent revenue stream derived from a diversified customer/contract base, and their operations are not heavily dependent on the skills and expertise of a small handful of specific individuals. As a result, these businesses are considered to be less risky and more valuable because they are less likely to experience a significant decline in value if the owner or someone in a key management position leaves the company.
In order to increase those high operating characteristics, successful business owners establish goals and implement procedures to maximize the efficiency of their organization. Think of a McDonalds or Chic-Fil-A – Someone is at the counter taking the order, who then sends the order to the kitchen where a cook prepares the food who completes their task and passes the product onto the next person, who passes it on to the next person and so on until the order is finished. Each station is timed to the second, leaving no room for error which helps reduce over cooking or under cooking, resulting in the same product every time. Having timed processes, skilled workers and a strong company culture elevates the value of the company to one that is “best in class” and can potentially fetch top dollar from buyers.
The 4 C’s
We can’t talk about culture without talking about The 4 C’s. There are 4 what we call “intangible capitals” that make up 80% of a business’s value. As previously stated, these intangibles help to eliminate the small, time sucking tasks that generally plague small business owners from optimal performance. These 4 C's are a framework that can be used to evaluate the value of a business:
Customer Capital: This refers to the types of customers the business serves and whether it has a diversified base of customers. A business with multiple income sources from different types of customers is considered more valuable than one that relies on a few key customers.
Structural Capital: This refers to the assets that the business owns that drive revenues. Things like big machinery, proprietary products or services, IP, processes, real estate etc. Business owned assets give the company a competitive advantage.
Human Capital: This refers to the workforce of the business; a good, reliable and intelligent team of like-minded individuals is crucial for the business’ success and ideally needs to place before considering a sale.
Social Capital: This refers to the company culture. If a company has a phenomenal company culture, employees will more likely stay with the business regardless of who owns it. The stronger the relationships between the people who drive the business’s success, the better chance the value of the business will be maintained through a transition of ownership.
It is important to note that these 4 C's are not the only factors that affect the value of a business and that other factors such as market conditions, industry trends, business model, etc., also play a role. However, by understanding and managing these 4 C's, a business owner can make their business more attractive to potential buyers and increase the chances of a successful sale at a favorable price.
Conclusion
EBITDA, gross multiples, and machine-like operating characteristics are all important metrics to consider when valuing a business. By looking at the big picture, buyers and sellers can make informed decisions about the value of a business and negotiate fair and reasonable terms for a sale. As a business owner, it is important to be aware of these metrics, and work with professional business advisors to improve them in an effort to increase the value of your business.