Selling a business is no easy feat, and neither is buying one. There is an enormous level of detail to take into consideration and the process can take years and years if you’re not careful.
This is why we have constructed this guide so you don’t waste any time and can learn to comprehensively value a business whether you are looking to buy or sell.
Understanding The Business Valuation Mechanism
Many business owners make the mistake of believing that their business is worth more than it is. This makes sense – the business owner is going to reinforce the ideas and concepts that he/she believes to be the most relevant and efficient. Also, the business owner may have spent years building the business, and there is certainly going to be a level of sentiment and nostalgia kicking in.
This is one of the reasons why the business valuation process is so important. It brings in a level of objectivity and logic which makes it easier for both parties. Of course, there is still a huge level of customization and negotiation to be undertaken between the buyer and the seller. There are ways to arrange the sale so that both parties leave satisfied.
Many mechanisms exist for the buying and selling of a business. There is a degree of contention among analysts about correct business valuation. But, generally speaking, it is quite straightforward. Diligence, record keeping, and organization are the main keywords here. Below, the different methods of business valuation are compared.
Different Methods of Business Valuation
There are three kinds of primary business valuation – Income-Based (discounted cash flow or capitalization of earnings), Asset-Based, or Market-Based. They are described below, along with a table indicating what kinds of business they are best suited for, benefits, and pitfalls.
In many cases, you will be using a combination of the below techniques, and the asset-based valuation will always play a role, to greater or lesser degrees. There isn’t just one standardized method for valuing a business. And there are different levels of sophistication, depending on how much you want to spend on the process.
#1 – Discounted Cash Flow
This is best suited for newer businesses that have a high-profit potential but little to go on right now. It is calculated by estimating the present value of a business’s future cash flows. It is known as an Income-Based business valuation model. ‘Debt Free’ and ‘Direct to Equity’ are the two primary forms of Discounted Cash flow analysis. Discounted Cash Flow (‘DCF’) is similar to using an Earnings Multiplier, another common valuation method. But they are technically distinct.
#2 – Capitalization Of Earnings
Capitalization of Earnings is another kind of Income-Based business valuation. However, it anticipates future earnings based on current profits. This makes it more suitable for larger, more established businesses that have a stable revenue coming in the door. For this process to work, the business must have a strong accounting methodology and the reviewer needs to understand the business in detail.
The Capitalization of Earnings Income-Based models does have limitations. The rate for small businesses is around 20%, which is an acceptable Return on Investment for a potential buyer. The ROI is not inclusive of the salary for the owner.
#3 – Asset-Based Valuations
This is most suitable for businesses that have a large number of fixed assets, such as real estate or construction businesses. It is also suitable for large businesses that are looking to liquidate holdings. The Asset-Based valuation is among the most straightforward. You simply subtract the total assets (both tangible and intangible) minus the total liabilities.
When you are buying or selling a business, you are going to be taking this approach anyway, in some fashion. You will always subtract assets from liabilities. The difference is that it can comprise the entirety of a business valuation in certain instances, instead of just a piece. If you are only interested in the future earnings potential of a business it becomes less relevant. A digital subscription business would be a prime example where assets are non-existent or less important.
The Asset-Based method will give you the liquidation value, which is what would be obtained if the business was sold today. This is similar to the book value on a balance sheet, except for the fact the liquidation value will be a little less, given the circumstances.
#4 – Market-Based Valuation
The Market-Based valuation is suitable for practically all businesses, provided you can get reliable information. You compare your business to other kinds of business in the same market. This can give you a good range for what to expect. However, it is quite general and there are always going to be specific details in any given business. Experienced buyers will look at all of your financial statements in-depth to get a good indication.
|Discounted Cash Flow
|Best For||New businesses, non-tangible businesses such as startups or businesses selling digital products.||Established businesses.||Established businesses.||All industries with significant data (e.g real estate, restaurant, etc)|
|Variants||Debt-free, direct to equity, earnings multipliers.||N/A||Book value, liquidation value, net worth, etc.||N/A|
|Benefits||Can work without current data or income/assets.||Simple direct formula. Accurate with enough data.||Very simple and accurate.||Easy to calculate. Great for giving a ‘ballpark’ range or figure.|
|Pitfalls||Easy to make mistakes on future earnings. Relies on many assumptions.||Easy to make mistakes on future earnings. Relies on many assumptions.||Only suitable for businesses with significant assets. Book value might not relate to actual market value.||Only useful when there are lots of comparable data. May not highlight business-specific pitfalls.|
Other Business Valuation Models
There are other ways to value a business than the categories mentioned above. For instance, you might consider the Earnings Multiplier. You can use these in tandem with the other approaches above, as they are relatively easy to calculate.
- Earnings Multiplier – This is similar to the discounted cash flow. It takes projected future profits into account. Profits are a reliable indicator of the viability of a business. It also takes current interest rates into account to adjust the profit against what could potentially be returned if money was invested.
- Revenue Method – This is a little less reliable in comparison to the Earnings Multiplier. It is used to determine the maximum value of a business, taking the industry and economic environment into account. While the liquidation value determines the minimum value you can expect for a small business, the Revenue Method gives you a maximum ceiling of what you can expect. Remember that revenue does not equal profit, just sales. You can increase revenue while decreasing net profits due to operational inefficiencies. It happens.
- Market Capitalization – By far the easiest and most straightforward mechanism. Multiply the total number of shares by the share price to get the total market capitalization. Unfortunately, this only applies to corporations, not small businesses. It is the most accurate sign of current value but can be misleading in terms of where the company is going and what the trend is.
Core Financial Concepts in Business Valuation
To comprehend small business valuation in-depth, then there are some financial terms you need to become familiar with. Some terms are more important than others. Learn to identify the key metrics and to look into business documents in detail. Even if it looks good on paper, some digging can reveal that the business is not as good as it appears. You need a blend of technical knowledge with hard-earned intuition and common sense.
There are many methods to manipulate financial documents so that the business looks to be in perfect standing. Many of these methods are legal but ‘Grey Hat’. It’s a terrible idea to buy or sell a business without understanding the terms below in depth. And the entire picture needs to be seen. You need to investigate how all of the financial metrics relate to one another to get a good idea of the overall business model. The following terms must be understood to correctly evaluate a business proposition.
- Accounts Payable – One of the most basic yet pivotal financial accounting terms. The Accounts Payable (‘AP’) is the total amount that you owe to creditors, lenders, and suppliers.
- Accounts Receivable – The opposite of AP, Accounts Receivable (‘AR’) is the total owed to your business for goods and services rendered.
- Cash Flow Statement – This will show you how much money the business is bringing in, and from what sources. If the business has a lot of cash, but only from selling its asset the past couple of years or from loans, then it’s not a good sign, regardless of how much cash is going through it.
- EBITDA– This stands for ‘Earnings Before Interest, Taxes, Depreciation, and Amortization’. It is essentially the core profit of a business before all of the necessary deductions.
- EBITDA Multiple – The higher you multiple, the higher your business will be worth. This is a perceived estimate based on your industry, not your business. More appropriate for large businesses.
- Gross Profit – Profit after Cost of Goods Sold (‘COGS’) has been taken from total revenue/sales.
- Growth of Earnings – This financial metric can be found in the income statement. It denotes how quickly the business is growing its earnings. The earnings are how much profit is made each year. The slow but steady growth of earnings over the last 5 years is one of the most positive signs of a strong business.
- Growth of Revenue/Net Income – Not to be confused with the Growth of Earnings. A business can have increasing revenue with a decreasing net profit. A business can also have a decreasing revenue but an increasing net profit.
- Income Statement – Displays the profitability of a business over a given period. This is sometimes called the Profit and Loss (‘P&L’) statement.
- Net Worth – The net worth of a company is its total assets minus its total liabilities. This is a pivotal figure when buying or selling a small business.
- Net Profit – Profit after COGS and all other expenses have been taken into account. This is the overall profit of a business. Perhaps the most relevant bottom-line metric of them all. If you had to choose only one metric, it would be this one, but on a multi-year basis. Any business can have a good year or may have profited from the sale of key assets. Earnings and net profits are the same things.
- Operating Cash Flow – This is a very important figure, found on the Cash Flow Statement. It denotes the amount of cash available for Operations (i.e. to run the business). To make this even more accurate, subtract the operating cash flow from the cost of purchasing equipment. This will give you pure ‘free’ cash to grow the business.
- Returns – Look to see what the returns of the business are for its available capital. Look to return on assets, return on capital, and return on equity. Great companies can see a 30% return on capital a year. Return on assets is an indication of the operational efficiency of a business. It’s good (but rare) to see a business that can generate decent returns from its assets.
- SDE – This stands for ‘Seller’s Discretionary Earnings’. SDE is similar to EBITDA, but the major difference is that it includes owner salary and benefits. This makes it more common for small business enterprises, while bigger businesses and corporations are more likely to use EBITDA. A small business owner will more frequently incur personal expenses.
- SDE Multiple – The higher you’re multiplying, the higher your business will be worth. This is a perceived estimate based on your industry, not your business. More appropriate for small businesses.
- Working Capital Ratio – This is the most critical metric. Working capital is the amount of capital a business has to meet short term debt. Most businesses go bankrupt because of a lack of liquidity as opposed to a lack of profitability. A ratio of 1.5 and above is generally regarded as strong, but it largely depends on the industry.
Why Are You Buying/Selling The Business?
Before you think about buying or selling, it’s best to understand your psychology and the psychology of the potential buyer/or selling. Why are you selling? How much do you expect? Why are you buying, and what are you looking for? Why is the other person buying or selling the business, and what are they likely looking for?
You need to be realistic. If you are serious about getting the best price you can for your small business, you have, at the very least, 12 months of work to do. There is an incredible level of detail involved in selling a business. Buying a business is a little easier, as you are shopping for businesses that are already in order (unless you intend to be a ‘fixer-upper’).
If you have a specific plan in mind, then it will make negotiations easier. For instance, you might be prepared to overlook certain aspects when taking a long-term approach, that would not be overlooked if you are expecting to ‘flip’ the business in a year or two. A lot depends on your assumptions and expectations.
Essential Steps to Prepare Your Business For Valuation
If you are selling a business, it will take you at least a year to get everything in order including the business listing, the documents, meeting potential buyers, performing the valuation, etc. Be methodical in your approach and realistic in your expectations.
Step #1 – Decide on Method of Business Valuation
The mode of business valuation will largely depend on your model and size. If you do not have much in the way of fixed assets, then the Asset-Based approach is not going to work. For new small businesses without a brick and mortar shop, the Discounted Cash Flow and future earnings approach will be most relevant.
For established businesses, an Asset-Based approach might be more appropriate. You will use a mixture of different approaches, but one will be the best fit and take priority. This should be obvious, based on your mode of operation.
Step #2 – Decide on External Help
If your business is large and established, it makes more sense to get some professional assistance. But even if you have a small business, a professional business valuation can save you a lot of time. You won’t have to justify your business valuation to the seller, as you have an independent third-party without any vested interests.
Step #3 – Understand Your Industry
What is the comparable sale price for similar businesses in your industry? What is the average working capital ratio for businesses in your industry? Is it a buyer or a seller’s market? The industry you are in will play a huge role in what is appropriate in terms of business valuation.
Step #4 – Organize The Financials
Regardless of your mode of business valuation, any potential investor is going to want to pour over all of your financials from the date you started your company to the date you are selling it. The last 5 years are going to be the most relevant. But make sure that you have all of your income statements, balance sheets, and cash flows statements for the past 5 years at least.
Step #5 – Improve the Financials
The aim is not to ‘manipulate’ anything, as this will be more trouble than its worth. What you want to do is analyze the financials to spot any inefficiencies. From here, you can work on improving your financial affairs and command a better price for the eventual sale.
Step #6 – Take Stock of Resources (Assets & Liabilities)
Add up all of your assets and liabilities. Tangible assets mainly include real estate, machinery, cash, and inventory. Intangible assets include branding, intellectual property, customer base, loyalty, copyrights, and trademarks. Liabilities will include loans, accounts payable, expenses, and other debts. All of this should be reflected in your financial statements anyway.
Documents Needed to Sell A Business
If you are looking to sell (or want to buy) a business, then these are the minimum documents to look for:
- Profit & loss statements for the current and past 5 years.
- Current balance sheet.
- Cash flow statement.
- Business tax returns for the past 5 years.
- Copy of the current lease.
- Insurance policies.
- Non-disclosure/confidentiality agreement.
- Personal financial statement for the buyer to complete.
- Executive summary or overview of the business.
- Detailed profile describing the business.
- Potential supplementary documentation to validate financial documents.
- Professional certificates.
- Supplier and distributor contracts.
- Employment agreements.
- Offer to purchase agreement.
- Note for any seller financing.
If you are buying a business, inspect all of these documents. You will also need to create a detailed business plan. This is for you, so you know what you are looking for in your future business and where you want to take it. Take the time to learn how to write a business plan like a professional. It will help.
If selling the business, you still need to create a business plan. This will provide clarity and context for potential buyers. It will also help you to justify the asking price and outline the business strengths and weaknesses.
How To Ensure That The Sellers Valuation Is Done Correctly
If you are buying a business, then you need to know:
- How to evaluate a business properly
- That the seller’s information is correct.
Having a working knowledge of business valuation is key here. The following are some of the ways to verify that the valuation is accurate and not misleading.
Use a Business Valuation Calculator
There are simple online tools that you can use to determine the fair price of a business. Most business valuation calculators operate on the Income-based valuation model. This can give you a quick indication as to whether or not the price is right.
Do not be naive when buying or selling a business. “Trust, but verify” is the mantra. You could shorten this to simply ‘Verify, always”. In the digital age, keep in mind how easy it is to alter financial documents and online credentials. Do your research into the owners of the business and its history.
If selling, know your buyer. Many times after a sale has been agreed it falls through because the buyer cannot procure the funds. Ensure they have the capital at hand – otherwise, it could be a giant waste of time.
Ask an Expert
A business broker can help you to ascertain if what the seller has done is correct. It always helps to ask for additional guidance, even if you are very knowledgeable about the industry. They may spot something that you have missed. And they deal with the buying and selling of businesses in your industry daily, so they will know what they are talking about. A one-off consultation is not too expensive.
Be An Expert
As a potential buyer, you should be familiar with the industry and what makes for a good business. Run over the financial documents for the past 5 years to see exactly how good it is. The financial concepts above should serve as a base for further knowledge. Know the financial metrics in depth.
How long has the person been in business? Why did they use this particular valuation method? What are the underlying assumptions? Why are they selling? Find out all that you can about the business and how the valuation was done. You should also enquire as to why the owner did not get a professional evaluation if that is the case. It is less important to know buyer motivations, but still relevant.
Meet Them In Person, Often
If possible, try to meet the owner and get a feel for the type of person that he/she is. You are involved in an identical industry, so you should have a lot in common. All things considered, it should be an enjoyable affair – don’t go in with the mentality of squeezing them for every penny. The keyword is symbiosis, not domination.
Business Valuation In a Nutshell
When performing a business valuation, the 3 most important financial documents are:
- The Balance Sheet.
- The Income Statement.
- The Cash Flow Statement.
Understand these statements in depth. Familiarize yourself with them at all costs, if you have not already. The most important metrics to understand that will give you a quick yet accurate analysis of the viability of any small business include:
- Book Value.
- Gross & Net Profit.
- Growth of Earnings.
- Working Capital Ratio.
- SDE Multiplier.
While there are many business valuation mechanisms, it is a better bet to understand all the important metrics of a business and to make up your analysis from there. This will give you a more in-depth understanding. The choice of business valuation is more of a function of the business type itself.
Aside from this, you can look into purchasing a professional business valuation for objectivity. It can help to clarify things. Based on the complexity and size of the business, they can range in price from $6,000 to $30,000. But they could end up saving you money, and not just time.
Business valuation sounds more complex than it is. Preparing your business for sale is the most difficult step. By understanding some key concepts, along with prior expertise, you should be able to ascertain the buying or selling price of business relatively quickly. Just keep your expectations realistic, do the math, and get organized.
What is the best method of Business Valuation?
There is no ‘best’ method of business valuation. You want to get as many valuation vectors as possible to understand what the business is worth. Provided the financial documents are accurate, you should be able to judge its worth from your expertise if you are buying. If selling, a third-party business valuation could be the way to go.
How to do a business valuation?
There are many different methods. The easiest way is to hire a professional. Failing this, you can perform a quick business valuation using a Market Capitalization approach, Market-Based approach, or Asset-Based approach. LLCs and corporations are required to file annual reports with all of their information, and also to file with the SEC. You can get data on all public businesses.
What does valuation mean in business?
How much the business is worth. There are many types of ‘valuation’. It could be based on income, assets, market capitalization, liquidation value, etc. The most appropriate valuation depends on your unique business model and assumptions for the future.
Emotional bias is likely to have what kind of effect on a seller’s valuation of a business?
It will likely result in a strong overvaluation of the business. It is very difficult for a person who has started and run a business for decades to be objective in the valuation process. They have too much ‘skin in the game’.
What is ‘SDE’ in business valuation?
SDE is one of the most relevant terms in business valuation, especially for a small business. It is the total earnings before interest, tax, deprecation, and amortization. The SDE multiplier will also determine the future profit potential of the business to a large degree. It includes the salary of the owner.
What statement best characterizes a business valuation?
The balance sheet best characterizes a business valuation. It denotes what a business is worth in the sense of ‘book value’. This is total assets minus liabilities, basically what the company is worth at the present moment without any real ‘projections’ or ‘estimations’. However, the income statement and cash flow statement must be taken into account for more granular information.
How long does it take to get a professional business valuation?
One of the major benefits of a professional business valuation is time. The professionals will be able to complete it quickly, provided they get the documentation from you. The business valuation can be completed in as little as 48 hours, as they have the expertise and the software. Complex business evaluations involving site inspections, huge supplier/distributor chains, customer loyalty analysis, etc will take a lot longer.
How much does it cost to get a professional business valuation?
The costs can vary greatly. It mainly depends on the type of business valuation, as well as the depth of business valuation. The average cost for a small business could be in the region of around $10,000 to $15,000.
How quickly can I prepare my business for sale?
You can get the documents and listing in order within a few weeks if you are focused. But to optimize the business and the financials will take at least 12 months. It all depends on how thoroughly you intend to optimize your business. You should have it prepared within 12 months, all things considered.
Is there a way to speed up the buying and selling of a business?
Get a professional business valuation and a good broker. It will cost you money, and save you time. Another obvious way would be to be prepared to pay more or sell for less. In other words, the tradeoff between time and money is not exactly avoidable.