How much is your business worth?
Knowing your business value based on your company's operational and financial condition is necessary to make sure you are asking a fair price. We partner with full service valuation firms that provide business brokers, banks, consultants, attorneys and their respective clients with business valuation services.
Every business is unique. Research is the foundation of valuing a business, which is why they invest in (and develop) the most comprehensive databases of economic and comparable transactions available. Analysts spend numerous hours researching historical transactions, reviewing court cases and conducting detailed financial analysis for every valuation assignment to assure that they provide the most accurate valuation possible.
There are multiple ways to value a business and all or some may be applicable to your business. An appraisal approach is defined as a general way at determining an indication of value using one or more appraisal methods. The American Society of Appraisers has developed appraisal standards for the Asset Based Approach, Market Approach and the Income Approach, described briefly as follows:
The Asset Based Approach to Business Value
The asset-based approach to business value, sometimes referred to as the cost approach, is an asset-oriented approach rather than a market oriented approach. Each component of a business is valued separately and summed to derive the total value of the enterprise.
Using this approach, the appraiser estimates value by estimating the cost of duplicating or replacing the individual elements of the business property being appraised, item by item, asset by asset. The tangible assets of the business are valued using this approach. It cannot be used alone, however, because many businesses have intangible value as well, to which this approach cannot be applied.
The Market Approach to Business Value
Since the objective of this report is to arrive at an opinion of the Market Value of the 100% interest in the Company, a logical method would be business values determined and tested in the marketplace. Therefore, a fundamental method for estimating the value of a closely held business is an analysis of prices paid for companies in the same or similar lines of business.
The Income Approach to Business Value
The income approach to business value is an income oriented rather than an asset or market oriented approach. This approach assumes that an investor could invest in a company with similar investment characteristics, although not necessarily the same business.
The computations using the income approach generally determine that the value of the business is equal to the expected future income of the business divided by a rate of return. This involves the principle of capitalization. In general, capitalization is merely the process of dividing the estimate of future income by the rate of return.
Because estimating the future income of a business is considered to be speculative, historical data is generally used as a starting point in several of the acceptable methods under the premise that history will repeat itself. The future cannot be ignored, however, because valuation is prophecy of the future.
The conclusion of business value reached by the appraiser will be based on value indications resulting from one or more methods performed under one or more appraisal approaches.
To be a Certified Business Appraisal an individual must receive specific education, have experience, pass a certification examination, be subject to reviews, and attend continuing education in regards to business value determination. There are four organizations and designations which provide these standards. These designations are Accredited Senior Appraiser/Accredited Member (ASA/AM) from the American Society of Appraisers, Certified Business Appraiser (CBA) from the Institute of Business Appraisers, Certified Valuation Analyst (CVA) from the National Association of Certified Valuation Analysts, and Accredited in Business Valuation (ABV) awarded to CPAs by the American Institute of Certified Public Accountants.
The Foundation of Small Business Value
“Small business” financials are very different from “big business” financials. The only people likely to see small business financials are the business owner, the business owner's accountant, and the IRS. Many business owners try to maximize their lifestyle while minimizing the taxes they pay. This often leads to creative accounting. This is fine for a business owner as he is operating the business, but it isn’t fine when he tries to sell a business. It becomes difficult to show the actual profitability of the business to a buyer if the owner becomes too creative in minimizing his earnings.
The three most common ways of expressing earnings are Net Income (Net Profit), EBITDA (Earnings Before Income Taxes and Depreciation), and SDE (Seller Discretionary Earnings).
Net Income is the bottom-line profit as shown on the tax return or income statement. Though this is the easiest to identify, it is the least informative of the three in regards to a small business. It doesn't tell the full story on how profitable the business actually is. Since this is the baseline of what is used for deciding how much tax is owed, it is often worked to be the lowest possible.
The second way to express business earnings is EBITDA. EBITDA stands for earnings before interest, taxes, depreciation, and amortization. Though it can be calculated for any business, EBITDA is really only useful when discussing larger businesses. The calculation looks at the earnings without making an adjustment for an owner/operator. In other words, this is how you would look at the profitability as an investor having someone run the day-to-day operations.
Seller's Discretionary Earnings is the most important of the three methods when discussing small businesses. This is the base of what the business valuation is calculated. It shows the most accurate earnings picture of a small business. To calculate SDE, you need to make adjustments to the income statements or tax returns. This is often called recasting, adjusting, or normalizing. Items that can be adjusted include Depreciation, Amortization, Interest, Officer Compensation, Family salaries/benefits, Officer Insurance, Officer Auto, Officer Fringe Benefits and Rent. These cannot always be added back for SDE. Sometimes the effect can be positive and other times negative. A knowledgeable business broker understands when you can adjust and when it must stay.
Don’t let these three terms confuse you. Net Income is easy to find. EBITDA and SDE are also very similar. If you calculate SDE, you can also find the EBITDA. Calculating SDE and then subtracting a wage for a full-time manager's salary and benefits gives you EBITDA.
When recasting financials, you will need to ask questions to dissect the income statements or tax returns. The easiest way to think about adjustments is to ask, "If a new owner took over the business, what expenses would be necessary to generate the current level of revenue and profitability?" For every legitimate dollar that can be added-back, a business seller will likely be paid a multiple of it when they sell a business thus increasing the business value.