A business valuation is a calculation of what a business could potentially sell for. It factors in the seller’s discretionary earnings with a multiplier that varies by industry, both tangible and intangible assets, and the business’s current liabilities. A true business valuation can be used to negotiate a price during the sale of a business.
Preparing to buy a business can be difficult, and the last thing you want to have to worry about is what the debt you take on will do to the financials of the business post-closing. Using a ROBS, you can take funds in a qualified retirement account and use those funds to purchase your business. You can get a free consultation about the whole process by reaching out to a Guidant representative today.
How to Value Business in 3 Steps
While the business is generally worth whatever someone is willing to pay for it, we’re going to identify industry acceptable means for determining the reasonable value of a business. You can typically determine a business’s value by following three main steps:
Step 1: Calculate Seller’s Discretionary Earnings (SDE)
Most experts agree that the starting point for valuing a small business is to normalize or recast the business’s earnings to get a number called the Seller’s Discretionary Earnings (SDE). SDE is the pre-tax earnings of the business before non-cash expenses, owner’s compensation, interest expense and income, or one-time expenses that aren’t expected to continue in the future.
Small businesses report expenses on their tax returns with an eye towards reducing their tax burden. This means they typically claim many deductions that lower the business’s income on the tax return. For this reason, using income numbers from a business’s tax return can underestimate how much revenue the business actually produces.
SDE gives you a better idea of the business’s true profit potential by calculating the business’s net income by adding back in expenses listed on the tax return that are not necessary to run the business. It also adds back in the owner’s salary and any one-time expenses that are not expected to recur in the future.
According to Wayne Quilitz, President of business brokerage firm Murphy Business and Financial Corporation, here are some examples of things that would be added back into the net income reported on the business’s tax return to calculate SDE:
- Owner’s salary
- Owner’s perks (like personal travel or personal vehicle payments)
- Family members on payroll holding non-essential positions
- Non-cash expenses such as depreciation and amortization
- Leisure activities, such as business golf outings
- Charitable donations
- Any personal expenses, such as the purchase of a personal vehicle, that were noted as expenses on the business tax return
- Business travel that’s not essential to running the business.
- One-time expenses that are unlikely to recur after the sale of the business, such as the settlement of a lawsuit
In general, one-time expenses, and anything that’s not essential to running the business, should be added back to the business’s income in order to calculate SDE.
We’ve put together an easy to use worksheet to help you determine what your business’s SDE and estimated value is. You can download the worksheet, which includes these three steps, below.
Click Here to download our free, printable, and handy Business Valuation Worksheet
Step 2: Find Out the SDE Multiplier
Generally, businesses sell for somewhere between 1 and 4 times SDE. This is called the SDE multiple or multiplier. Finding the right SDE multiple is really more of an art than a science because it varies based on industry and geographic trends (market risk), company size, the business’ tangible and intangible assets, independence from the owner (owner risk), and many other variables.
The biggest factors influencing the SDE multiple is usually owner risk and industry outlook. If the business is highly dependent on the owner, it cannot be easily transferred to new ownership, and the business’ valuation will suffer. If you’re buying or selling a business in an industry and/or area that is expected to grow in the near future, the SDE multiple will be higher.
You can find out the approximate SDE multiple to use by looking at BizBuySell’s media insights quarterly report. BizBuySell provides multiples for different industries based on reported business revenue and cash flow. For a more personalized estimate of the multiple, you can also consult a business broker or appraiser.
Step 3: Add Other Business Assets & Subtract Business Liabilities
The final step of how to value a business is to account for business assets and liabilities that aren’t already included in the SDE. Most small business sales take the legal structure of an “asset sale,” which means the purchaser is buying the tangible and intangible things that make the business what it is. Typically the seller retains liabilities, but deal terms will vary from sale to sale.
Tangible assets are actual physical goods, owned by the business, that you can put a value on. Some examples include real estate (if the business owns any property), accounts/receivables, and cash on hand, and they are generally not included in the SDE multiple. All intangible assets should be added into the valuation separately (as shown in the examples below) if you are purchasing them.
Intangible assets of a business are non-physical goods that have a value for a specific business purpose, like reputation, trademarks, patents, and goodwill. These assets are typically included in the SDE multiple, because they are only typically sold if the business’s assets are sold.
The current liabilities of the business are debt or other obligations the business has that it must pay for in the future. Many sales have been lost by sellers unwilling to keep the liabilities they created for the business. An asset sale typically is structured where the seller pays off the business liabilities with proceeds of the sale. However, it gets more complicated when discussing things like an open line of credit facility that the business needs to continue operations.
One way to determine what the potential liabilities are for a business is to run a business information report through Dun & Bradstreet. This can be purchased on virtually any company, by anyone, for $121.99 and will give you information such as:
- Current debt
- How often the business currently pays their suppliers on time
- Any debt they’re past due on
It’s a cheap way to get information about the business, or to confirm that you’re not missing any important liabilities. It’s important to note that this may not include all liabilities, but it should give you a good estimate.
Final Business Valuation Formula
Now you can distribute all of your balance sheet lines into the appropriate category and use the formula below to come to an estimated business value:
SDE * Industry Multiple
+ Real estate
+ Cash on hand
+ Any other assets not included in the SDE multiple
– Business liabilities
= Business’ Estimated Value
For a quick business valuation estimate on a business you’re buying or selling, you can use our Business Valuation Calculator.
If you’re looking for an expert to guide you through the buying or selling of a small business, Murphy Business & Financial Corporation is a nationwide business broker. Set up a free consultation with a highly trained Murphy business broker today.
How to Value a Business Example: Family Restaurant vs. Franchise Restaurant
If the explanation above was enough to get you started, you can stop here, but if you’d like an in-depth example of how to value a business, read on. Instead of boring you with a detailed academic explanation of business valuation, we’ll walk through an example of how to value a family restaurant versus a franchise.
We chose to compare a franchise and an independent restaurant because while on the surface they are similar as they both are in the food industry, they have different valuations. An independent business, for many industries, has more risks and therefore typically gives a lower valuation than a franchise business.
Business 1: Joe’s Family Restaurant and Cafe Located in Missouri
- $528,747 – Annual Revenue (Total cash generated by sales)
- $80,799 – Annual Seller’s Discretionary Earnings (SDE) (The number you get after recasting the business’ earnings with add-backs)
- $234,000 – Real Estate (Estimated worth of property and buildings owned by business)
- $31,950 – Furniture, Fixtures, and Equipment (FFE) (Refrigerators, fryers, booths, counters, etc)
- $3,500 – Inventory/Stock (Food, napkins, ketchup, etc)
- $40,000 – Liabilities (debt, interest, etc.)
Business 2: Subway Franchise Located in New Jersey
- $373,200 – Annual Revenue
- $76,272 – Annual SDE
- $150,000 – FFE
- $4,500 – Inventory/Stock
- $30,000 – Liabilities
Calculating an Average Value to Get Started
Once you have the SDE for a small business, you can use it to calculate a ballpark value for the business. You will further refine this ballpark later, but to get an average, you multiply SDE by a business sale price multiplier. Using statistics from restaurants sold in 20174, bizbuysell.com determined that the average multiplier for the restaurant industry is 1.98.
Using this figure, we can calculate an average value based on industry norms for Joe’s Family Restaurant and Cafe and for the Subway franchise.
$159,982 – Joe’s Family Restaurant and Cafe ($80,799 x 1.98)
$151,018 – Subway Franchise ($76,272 x 1.98)
If you stopped here, you would think that Joe’s is worth more than Subway. There’s more work to be done, however. The multiplier that you use, and hence the final valuation, will depend on multiple factors.
Factors That Influence the Multiplier/Base Value
Calculating the average value of a business using the SDE multiplier method can be a good first step. In the restaurant industry, the average SDE multiplier is 1.98, as mentioned above. Using this multiplier, Joe’s Restaurant has a slightly higher value than Subway.
However, there are lots of different factors that affect whether a specific business’ multiplier is above or below the industry standard. Think of the industry standard multiplier and the specific business multiplier as two separate numbers, one giving you a general value based on industry averages and another giving you a more specific value based on variable factors of each individual business. In most cases, small businesses are given a business specific multiplier of 1 – 4.
Here are the main factors that influence a specific business’s multiplier/business value:
Assets add value to a business. The more assets a business has, the more it will be worth on the market and the higher the multiplier that will be used for the valuation.
Tangible assets refer to all of a business’s material assets. This includes but is not limited to the following:
- Real Estate
- Inventory (sometimes included in asking price sometimes priced separately)
- Company Vehicles
Note: You must take into account the asset’s depreciation when assessing the value of many of these physical assets.
Tangible assets typically don’t have a major effect on a business’s multiplier. However, owners sometimes want a higher multiplier if they have recently purchased new equipment. Let’s say a restaurant has just purchased a whole new set of fryers and stoves. That means that equipment will not have to be updated in the near future, cutting down on future costs, which can raise the current value.
Joe’s Restaurant vs. Subway
Let’s get back to our example. Subway has around $119,000 more in tangible assets than Joe’s restaurant. The odds are that Subway’s multiplier will be higher than the industry standard of 1.98 due to its high level of physical assets. Joe’s restaurant, on the contrary, has nothing special in tangible assets, so the industry standard is still a pretty good benchmark for its valuation at this point.
Intangible assets are all of the positive aspects of the business that are not material in nature. These include but are not limited to a business’s:
- Independence From the Current Owner
Intangible assets are the biggest influencer of a business’s individual SDE multiplier. A wealth of intangible assets means a much higher multiple. A lack of non-physical assets means a much lower multiple. This is because the wealth or lack of intangible assets often determines whether or not a business transitions successfully to a new owner.
Joe’s Restaurant vs. Subway
In many industries, buying a franchise is considered a much safer bet than buying an independent restaurant, because of the wealth of non-physical assets that inherently come with a franchise.
Getting back to our example:
Subway Franchise Non-Physical Assets
- Nationally Known Brand
- History of Financial Success
- Informed Marketing Strategy
- Standardized Operating Procedures
The intangible assets above benefit every Subway franchisee, regardless of location, demographic, or owner charisma.
Joe’s Non-Physical Assets
- 35 years of success
- Loyal local customer base
- Good reputation in community
The fact that Joe’s restaurant has been relatively successful as a business for 35 years is great. However, there is no guarantee that the restaurant will be successful once Joe leaves. That is a big risk to a potential buyer because of these risks:
- Customers May Start Going to Another Location: Many times, local customers choose one establishment over another because they have a personal relationship with the owner. If Joe leaves, customers may as well.
- Older Employees May Retire: If there are employees who were hired by Joe and are loyal to him, they may decide to leave when he goes. Or, if they agree to stay, it may only be for another 6 months or a year. If these employees hold crucial positions in the business, such as manager or head cook, you could lose some of the most valuable team members that made Joe’s Restaurant such a success.
- Supplier Relationships May End or Deals May Change: If Joe had relationships with his suppliers, they may have been giving him an extra good deal, like lenient credit terms. When Joe leaves, those deals may dry up, or the suppliers may see it as an opportunity to back out altogether, which means lots of extra work, effort, and time to find new suppliers.
In other words, the intangible assets associated with Joe’s restaurant are much more closely connected to the owner of the business, making it less likely to transfer successfully to a new owner. This is often referred to as “owner risk.”
Owner risk is one of the biggest, if not the biggest, factors influencing business value. If a business has so much owner risk it cannot survive the transition to new ownership, than all other aspects of a business’s value are pointless.
Future Prospects of the Business
Industry and geographic trends also influence how to value a business. This is often referred to as “market risk.” If an industry is booming and trending towards your particular business, the higher your multiplier will be. In the same way, the more the population growth and popularity of a business area is growing, the higher your business’s specific multiplier will be.
The truth is, people are never going to stop eating fast food. Fast food is trending towards healthier food, but this is a major part of Subway’s brand recognition. So, as far as industry trends are concerned, Subway has good prospects.
Geographically, New Jersey is staying pretty steady economically (Of course, specific geographic regions within a state can often have very different trends than the state as a whole, so it is also important to research local area trends). Given this information, Subway’s multiplier is probably above the industry average of 1.98.
Although Joe’s restaurant has had success in the past, David Coffman of Business Valuations & Strategies PC explained that restaurant success is trending away from independently owned businesses and toward franchises. So, the industry outlook is shaky, at best. Geographically, Missouri is actually doing pretty well, with dropping unemployment rates and a rise in entertainment and leisure jobs. So, Joe’s business specific multiplier might be a bit above the industry average of 1.98 due to the state’s positive economic trends.
The availability of seller financing also has an impact on the sales price multiplier. In nearly 80% of cases, a business has some kind of seller financing option available to the seller, typically around 30-60 % of the business value. If a business does not offer seller financing, it will take longer to sell and its value is typically decreased.
In our example, both Joe’s and Subway offer seller financing, so the value is not affected.
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Real Estate and Lease Terms
The last main factor that can influence how to value a business is the property and land that the business occupies and/or owns. If a business leases a building, the amount of time remaining on the lease is an important factor. If the lease still has 3-5 years on its term, that will work in the seller’s favor. If your lease ends in less than 3 years, that can at times lower the multiple of a business because the new owner will have to renegotiate the lease.
If a business actually owns its own property and building, then the value of that real estate is estimated separately and added onto the SDE value of the business.
In this case, Joe’s restaurant owns its own property and buildings estimated at $234,000 in value. That number is added onto the value of the final SDE x multiplier value.
Subway’s lease term still has 4 years left on it, so the value is not significantly affected.
Other Factors That Affect the Multiplier
The factors we’ve covered above are not an exhaustive list of what can affect the SDE multiplier. Any number of things, from the business being in a desirable or undesirable location to the business having a diverse or narrow customer base to the business having many or few liabilities, can affect the multiple. The specific details of every transaction are different. Here is some more guidance on coming up with the right multiplier.
Final Values/Multipliers In Our Example
Joe’s Restaurant – 2.0 Multiplier
Estimated Business Value = $161,598
Estimated Real Estate Value = $234,000
Liabilities = $40,000
Total Estimated Value = $355,598
David Coffman helped us put together these values. Although Joe’s restaurant has had reasonable success in the past, the industry is trending away from independently owned restaurants. Also, the likelihood of new owner success is questionable because Joe’s is a family owned business with a long reputation in the local community. Nevertheless, due to Missouri’s positive economic climate, Joe’s business specific multiplier is a little higher than industry standard, at around 2.0. Although it does not have a very high multiplier, the real estate value actually makes the investment a pretty good one.
Subway Franchise – 2.8 Multiplier
Estimated Business Value = $213,561
Liabilities = $30,000
Total Estimated Value = $183,561
Subway’s business specific multiplier well exceeds the industry average multiplier of 1.96. There are several reasons for this. First, the industry is trending toward franchises, meaning market risk associated with the business low. Second, since Subway is a franchise, the transition to a new owner is less risky.
Considering all of these positive factors, Subway’s business specific multiplier is almost a whole point above the average industry multiplier of 1.98. Ultimately, the estimated business value of Subway is significantly higher than that of Joe’s Family Restaurant and Cafe.
Six Tips to Maximize Your Business Valuation
Now that you understand how to value a business, sellers will want to maximize that value before they sell. There are both short and long term tips that can help you improve your business valuation and help you sell your business for the largest sum possible.
1. Look Beyond The Past & Create A Business Plan
One major problem with using an SDE multiple to value a business is the number is backwards looking. When valuing a business it is important to look at the future for both potential buyers and sellers. A seller will want to present a case that the business’s revenues and profits will grow and the business should have a higher multiple as a result.
A buyer also wants to consider factors that might be challenges and opportunities for the business going forward. The best way to do this is through a detailed business plan. We recommend LivePlan for creating business plans. LivePlan comes with a money back guarantee, so you can essentially try it out for free.
2. Review and Improve Your Promotion Strategy
It’s important to control the public’s perception of your company before you try to sell it. Perception often is reality in business, and a business that has the eye of their customers will almost always sell for more than one that doesn’t. Additionally, improving your market share and promotional strategies prior to selling can give a nice immediate increase to your value.
Katy Herr, Founder of Audacia Strategies where she helps businesses prepare for valuations, says:
“You wouldn’t sell your house without clearing the clutter, giving it a fresh coat of paint, and engaging a crackerjack realtor. Business valuations are similar. First, review your external face to the market (website, sales materials, business cards). Are they dated? Do they positively reflect your business? Take the time to make your promotional materials work for you.
Second, if you have time, engage in a promotional strategy to raise the visibility of your firm and demonstrate market leadership and awareness. By elevating public perception of your business you improve your market positioning, customer awareness, and you may also increase your new business pipeline. All important factors as you enter into a business valuation.”
3. Take Emotion Out of the Business Valuation Process
Most experts we talked to said that sellers set the asking price for their business too high. Michael Karu, a CPA at Levine, Jacobs & Company, explains that this is because “sellers often think they are the only ones who can properly run their businesses.” They place too much value on the amount of time and effort that they have put into the business, even if the financials don’t support such a high valuation.
On the flip side, most buyers have unrealistic views of how they will be able to run the business. To their detriment, says Karu, most buyers believe that they can successfully turn around any losing venture. It can be easy to place blame on current management for a failing business, but buyers should keep in mind that certain things about the business, such as location and competitors, cannot be changed even when they take over. These things need to be accounted for when pricing the business.
Having a number like SDE to drive the valuation helps take emotion out of the valuation process and results in a more accurate estimate of the business’s worth.
4. Decide if You Need Professional Assistance
Before setting out to value a business, you have to decide how you’re going to conduct the valuation. Buyers and sellers can either value the business on their own (with the assistance of their accountants and attorneys), or they can hire a professional appraiser.
Value a Small Business on Your Own
The main benefit of valuing a business on your own is that it saves you money. The experts we spoke to quoted different price ranges for appraisals, but a good ballpark is $8,000 for appraising a small business that’s worth under $500K.
Valuing a business on your own is also faster. A professional appraisal takes 2-4 weeks, while you can get a valuation within a few hours on your own.
If you do decide to value a business on your own, we strongly recommend using online software such as BizEquity for guidance. BizEquity will walk you through the business valuation by asking you questions about the business. It’s easy to use and costs $500 for a comprehensive business valuation report (sample report available here).
Hiring a Business Valuation Company or Appraiser
Although hiring an appraiser can be expensive, there are certain advantages to doing so. The main advantage, says Naman Shah, a Market Lead for BizEquity, is that a professional appraiser will audit the business’s financials to make sure they are correct. When using software like BizEquity, the final valuation will only be accurate as the numbers you enter.
Another advantage of using an appraiser is that it can result in a more personalized valuation. A tool like BizEquity takes into account intangible factors (often called “goodwill”) when valuing a business, such as reputation of the business and how important the owner is to its continued success. However, an appraiser will be better able to manipulate intangible factors to come up with a valuation that’s agreeable to both the seller and buyer.
If you decide you’d like to hire an appraiser, we recommend starting with BizEquity. They offer certified appraisals for $2,000-$3,000, which is a great deal compared to what some appraisers charge. You can also find an appraiser on the American Society of Appraisers website.
5. Lock Up Key Employees & Contracts
Make sure that you have key employees committed going forward, in case the buyer needs them to stay. This can give all potential buyers a comfort level that the company will continue to operate the way it has been.
Brandon Crossley, CEO of financial projections software company Poindexter, says:
“Be proactive and get letters of intent from both your key employees and your key suppliers or vendors. Don’t wait until you have a buyer or until your contracts expire. Show all potential buyers that all of your important pieces want to remain with the company for the foreseeable future.”
Also work on getting all of your key contracts locked up for as long as possible. If you have important contracts coming up for renegotiation in the next year, then try to get them extended or renegotiated now. I’ve seen deals fall apart because important contracts were put up for bid during the sales process and the seller thought it would be easy to extend.
6. Pay More Taxes
While most business owners spend tax season finding every business expense they can possibly claim in order to reduce their tax bill, that may not be the right move before a valuation.
Shawn Hyde, CBA, CVA, CMEA, & Business Appraiser at Canyon Valuations, says:
“Consider paying more in income taxes. This has two particular benefits. One, the fewer adjustments an appraiser has to make, the more favorable a potential buyer looks at the operation. Two, businesses are sold based on a multiple of earnings. That means for every dollar on the bottom line, one may pay 40% of it in income taxes, but that same dollar may count two to five or even more times in value when selling.”
Padding your expense line to lower your taxes won’t help you get a higher sale price. Kevin Vandenboss, former Business Broker solidifies this point further, saying “Some business owners don’t report cash sales, or charge things like vacations, meals, and even home improvements to the business. Think of it this way, for every dollar of profit you’re hiding to save 25% on taxes, you’re losing out on $2 or $3 in the value of your business.”
Paying more taxes will also make it easy to show any potential buyers what the company is making right from your tax return, which is a value that’s hard to argue against. Many potential buyers analyze more than one business at a time to find the right match for them, and the easier you make the discovery process the more likely they take a closer look at yours.
Bottom Line: How to Value a Business
Several of the valuation professionals we talked to stated that “business valuation is more of an art than a science.” Many of these professionals said that it could be good to compare several methods of valuation. That being said, using the SDE method of valuation should give you a pretty good estimate of a business’ worth.
If you’re buying a business then you want to read about how to get a loan to buy a business. Another good resource would be Guidant Financial. If you are starting a business and looking for startup financing, you can actually use your retirement account to fund your startup without paying any taxes or early-withdraw penalties. Guidant offers free consultations if you want more information.