You put years or even decades of hard work into growing your business. When it comes time to sell, you want to receive a fair price that reflects your effort and dedication. Unfortunately, many business owners do not know how to properly value their business. It is no surprise that many for-sale businesses sit on the market for extended periods of time or indefinitely. The biggest mistake that these business owners make is not taken all the necessary factors into consideration when determining a sale price. There are several crucial components that must be reviewed when you are valuing your business.
Estimating the Cash Flow of Your Business
One factor to consider when valuing your business for sale is your cash flow or profits. Buyers want to know how well your company is able to generate a profit stream and showing your cash flow is one way to accomplish this. When the business owner is able to calculate the stream of cash over a course of five years or more, the worth of the business can be determined.
Seller’s discretionary cash flow (SDCF) is the method used to determine the earnings of a company. SDCF is most effective for companies that are owner-operated, such as a small business or certain franchises. A SDCF follows a simple formula. Start with your business earnings before taxes, then add expenses unrelated to operating costs.
Next, subtract income that does not result from business operations, such as personal expenses. Then add any atypical expenses, expenses resulting from depreciation or amortization, interest payments, and the total compensation of the owner. Subtract any atypical or one-time-only income. This should provide you with an estimate of how much your business is making. Multiply your SDCF by a market multiple to determine a market price for your business.
Determining Value Based on Market Approach
Market approach refers to the method of business valuation based on the purchases and sales of similar businesses in the same industry. This model can be highly useful if you are able to gather enough data to compare your business accurately. When comparing your business to another that has recently sold, consider if your business is similar in size and if you offer many of the same services or features. This can sometimes be tricky as very few companies in the U.S. are publicly traded, meaning this information is often kept private.
Business valuation methods that are based on the market approach fall into one of three main categories. The empirical category involves the use of comparative business sale data. The second category relies on public company data. The third category, heuristic, uses the professional opinions of expert practitioners. Each method has its own strengths and weaknesses and multiple methods may be used to get sufficient results. No matter which you choose, it is important to gather and study as much relevant business sale data as possible.
Using the Multiplier Method to Estimate Value
The profit multiplier method is a common tool used by businesses to determine value based on a company’s earnings. This figure is then adjusted using other variables that may change the sale price based on various factors. The multiplier is generally based on a specific industry’s average sales figures. If you own a retail business, the company’s inventory and gross sales are combined and then multiplied by the average figure in the industry. The standard multiplier when using a gross sale figure typically spans 0.25 to 1.0 but may be higher.
If you use your pretax profits with this method, the standard multiplier will usually be 1, 2, 3, 4, or 5. You can usually find the most current industry multipliers by performing a little research. Sources such as financial publications, trade associations, and brokers are often a good place to start. If you want to calculate the profit multiplier basis, simply multiply the industry standard by your annual profit. While this business valuation method can provide great insight, it does have some flaws. The biggest being its inability to factor in other critical details such as the overall profitability of the business.
Properly Structuring a Business Deal
How you value your business deal and terms has a direct impact on your sale. Ideally, you want to present terms that benefits both you and the buyer with certain incentives. Of course, sellers want to get as much as possible for their business and buyers want to pay as little as possible. To find middle ground, a business deal can be developed that both parties accept. Remember that businesses do not always sell for 100 percent cash up-front. Other terms may be considered to allow the buyer and seller to meet somewhere between the asking price and offer price.
In some instances, a seller will agree to accept installments instead of cash up-front. After providing payments for a specified amount of time, the seller will generally receive a higher amount than the initial asking price. Another option is an earn-out. When a seller agrees to an earn-out, a portion of the purchase price is considered contingent on the business’s achievement of certain operational or financial benchmarks. The seller will then receive payments based on these earn-out provisions. These provisions are usually taxable but the tax burden can be spread out over a number of years.
Learn More About Business Valuation
Valuing your business is not as easy as setting a price based on what you think your company is worth. It is important to take many factors into consideration, such as your cash flow and the market approach. If you are able to, it is best to seek professional advice from a business broker with vast experience in business valuation. An industry expert can help you better analyze your finances, find trends in the market, and estimate your company’s future profits. For more information on how to value a business for sale, contact the business brokers at BBG Broker today.