Learning how to value a business is the process of calculating what a business is worth and could potentially sell for. The calculation factors in seller’s discretionary earnings (SDE) times an industry multiplier, tangible and intangible assets, and current liabilities. An accurate business valuation can be used to negotiate a price when you sell your business.
If you’re learning how to value a business as part of the buying process, the same information applies. If funding is still an open question, consider a Rollover for Small Business (ROBS) with Guidant Financial. A ROBS allows you to use up to $50k out of your 401(k) or IRA to purchase a small business while avoiding all the usual early withdrawal penalties and taxes.
How to Value a Business Yourself
Completing a business valuation on your own can be complicated and it may not even represent the exact price you’ll actually sell your business for. If you’re just looking for an estimate regarding the potential value of your business in a sale, you can use our free business valuation calculator. It will estimate the value of your business based on your industry, current sales, and current profit.
You can also calculate the value of your business manually by following the three steps below. This valuation will still be an estimate, but it will be a bit closer than a basic calculator can provide. Regardless, it’s important to benchmark your initial sale price with a reasonable value for your business.
The 3 steps to determine the value of a business are:
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 your 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 you likely claim many deductions that lower your business income on your 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 what the business’s earnings would be with a new buyer. This is done by adding back in expenses listed on your tax return that aren’t necessary to run your business. This includes your salary as the business owner and any one-time expenses that aren’t expected to recur in the future.
Here are some examples of things that would be added back into the net income reported on your business’s tax return to calculate SDE:
- Your salary, or total salary of all owners
- Any perks you or other owners receive(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, like 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
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.
2. Find Out Your SDE Multiplier
Businesses typically sell for somewhere between 1 and 4 times their 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:
- Geographic trends (market risk)
- Company size
- The business’ tangible and intangible assets
- Independence from the owner (owner risk)
- And many other variables.
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.
The biggest factors influencing the SDE multiple is usually owner risk and industry outlook. If the business is highly dependent on you or another owner, it cannot be easily transferred to new ownership and the business’ valuation will suffer. If you’re 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.
3. Add 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 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. These are generally not included in the SDE multiple. All tangible assets should be added into the valuation separately (as shown in the examples below) if you are purchasing them.
Intangible assets are non-physical goods that have a value for a specific business purpose, like reputation, trademarks, patents, and goodwill. These assets are included in the SDE multiple, because they are typically only sold if your business’s assets are sold.
A business’s current liabilities 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 from the sale. However, it gets more complicated when discussing things like an open line of credit facility that the business needs in order 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:
Business’s Estimated Value =
(SDE) * (Industry Multiple) + (Real Estate) + (Accounts Receivable) + (Cash on Hand) + (Other Assets Not in SDE or Multiplier) – (Business Liabilities)
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, we’ve put one together one for you. We’ll walk through an example of how to value a family restaurant versus a franchise, which will better illustrate how a business valuation works.
We chose to compare a franchise and an independent restaurant because while on the surface they are similar due to both being 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
- Annual Revenue (Total cash generated by sales): $528,747
- Annual Seller’s Discretionary Earnings (SDE) (The number you get after recasting the business’ earnings with add-backs): $80,799
- Real Estate (Estimated worth of property and buildings owned by business): $234,000
- Furniture, Fixtures, and Equipment (FFE) (Refrigerators, fryers, booths, counters, etc): $31,950
- Inventory/Stock (Food, napkins, ketchup, etc): $3,500
- Liabilities (debt, interest, etc.): $40,000
Business 2: Subway Franchise Located in New Jersey
- Annual Revenue: $373,200
- Annual SDE: $76,272
- FFE: $150,000
- Inventory/Stock: $4,500
- Liabilities: $30,000
Calculate an Average Value to Get Started
Once you have the SDE for your business, you can use it to calculate a ballpark value. You will further refine this later, but to get an average, you multiply SDE by a business sale price multiplier. Using statistics from restaurants sold between 2014 – 2017, 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:
Joe’s Family Restaurant and Cafe: ($80,799 x 1.98) = $159,982
Subway Franchise: ($76,272 x 1.98) = $151,018
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
In most cases, small businesses are given a business-specific multiplier of 1 – 4. The multiplier can be impacted by your geographic location, the risk of your industry, or a number of things related to your business.
Here are the 3 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 your multiplier. However, you might get a higher multiplier if you 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.
How to Value a Business Example: Joe’s Restaurant vs. Subway
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 value of intangible assets often determines whether or not your business transitions successfully to a new owner.
How to Value a Business Example: 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. You get credit for the brand, for example, which could be recognized nationwide like Subway.
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. They could be more highly regarded in different geographic locations, but there’s real value in using the brand everywhere it’s recognized.
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 follow.
Older Employees May Retire
Employees who were hired by Joe and are loyal to him may decide to leave when he does. If they agree to stay, however, it may only be for a short period of time (less than 1 year). If these employees hold crucial positions in the business, such as manager or head cook, the buyer 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 you as the owner of the business, making it less likely to transfer successfully to a new owner. This is often referred to as “owner risk.” Selling a business like this requires you to get out in front of these potential problems before you find a buyer.
Owner risk is one of the biggest factors influencing business value. If a business has so much owner risk it cannot survive the transition to new ownership, then all other aspects of a business’s value are pointless.
2. 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 because of the speed and ease of its service. Fast food is trending towards healthier food, but this is a major part of Subway’s brand recognition. As far as industry trends are concerned, Subway has good prospects.
Geographically, New Jersey is staying pretty steady economically. Given this information, Subway’s multiplier is probably above the industry average of 1.98. However, 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.
Although Joe’s restaurant has had success in the past, the future might be as bright. David Coffman of Business Valuations & Strategies PC explained that restaurant success is trending away from independently owned businesses and towards franchises due to their brand recognition. That makes the industry outlook shaky, at best.
Geographically, Missouri is actually doing pretty well, with dropping unemployment rates and a rise in entertainment and leisure jobs. Joe’s business-specific multiplier might be a bit above the industry average of 1.98 due to the state’s positive economic trends, but buyers might be weary of the future business potential because it’s not a recognized brand name.
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. This is typically around 30-60 % of the overall business value or purchase price. If a small business doesn’t offer seller financing, it will take longer to sell and its value is typically decreased.
3. Real Estate and Lease Terms
The last factor that can influence how to value a business is the property or land that your business occupies and/or owns. If your business leases a building, the amount of time remaining on the lease is an important factor. If your lease ends in less than 3 years, it could lower the multiple of your 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 to the SDE value of the business. Some small business owners hold on to the ownership of real estate when they sell their business and agree to lease the property back to the new owner on a long-term lease agreement.
In this case, Joe’s restaurant owns its own property and buildings estimated at $234,000 in value. That number is added to 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 a list of the most common things that 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, can affect the multiple. This is why it’s important to consult experienced professionals like Business Exits to help you get an accurate valuation of your business.
Final Values/Multipliers In Our Example
Joe’s Restaurant – 2.0 Multiplier
Total Estimated Value: $355,598 = ($161,598 Estimated Business Value) + ($234,000 Estimated Real Estate Value) – ($40,000 Liabilities)
Our business valuation expert 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
Total Estimated Value: $183,561 = ($213,561 Estimated Business Value) – ($30,000 Liabilities)
Subway’s business-specific multiplier well exceeds the industry average multiplier of 1.96. The industry is trending toward franchises, and 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.
7 Tips to Maximize Your Business Valuation
Now that you understand how to value a business on your own, you’ll want to maximize that value before you sell. There are both short and long term tips that can help you improve your business valuation and help you the largest sum possible for your business.
1. Prepare For a Sale
It’s important to properly prepare for your business valuation like you’re getting ready to sell your business. You can do this in many ways, such as getting a 3rd party CPA to help you get your books in order or paying off your debt. The important thing is that your business is ready to maximize its sale value.
Jock Purtle, Founder of Business Exits, says:
“It’s important to get your financials in order before you sell. Not having strong book keeping or accounting is without doubt the #1 deal killer when selling small businesses.”
You can learn what documents to prepare for the sale of your business getting your questions about selling your business answered in our previous article.
2. Look Beyond The Past & Provide Projections
One major problem with using an SDE multiple to value a business is that the number is backward-looking. When valuing a business, it is important to look at the future, even if you’re the seller. You will want to present a case to potential buyers that your 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 or opportunities for the business going forward. The best way to do this is to provide projections based on how the business could perform in the future in best case and worst case scenarios. It could help the buyer understand what your expectations are for the business and give them a level of comfort that it will continue to perform at or better than current performance levels.
3. 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 with loyal 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 business’s sale price.
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.
If you have time to engage in a promotional strategy it could 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 and get ready to sell.”
4. Take Emotion Out of the Business Valuation Process
Most experts we’ve talked to say 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.
Having a number like SDE to support the valuation helps take all emotion out of the valuation process and results in a more accurate estimate of the business’s worth. Plus a valuation from a professional adds credibility to your asking price.
5. Decide if You Need Professional Assistance
Before setting out to value a business you must to decide how you’re going to conduct the valuation. You can either value the business on your own (with the assistance of your accountants and attorneys), or you can hire a professional appraiser or business broker.
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 $5,000+ for appraising a small business that’s worth $500k or less.
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.
Hiring a Business Valuation Company or Appraiser
Although hiring an appraiser can be expensive, there are certain advantages to doing so. The main advantage is that a professional appraiser will audit the business’s financials to make sure they are correct. Plus, you’ll get a valuation that is much more accurate and personalized to your business.
Having an experienced professional value your business gives you indisputable evidence of what your business is worth. While a business is only worth what someone will pay for it, this is harder for a buyer to negotiate your sales price down than it would be if you just provided a valuation you did yourself.
6. 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. This tip is especially important if you think your business is similar to Joe’s restaurant from our example above.
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.
7. Start Paying 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 you value your company and try to sell it.
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. The easier you make it for them to see the value of your business 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.” That being said, while using the SDE method of valuation should give you a good estimate of your business’s worth, we recommend using professional help for more accurate numbers.