3 Ways to Assess the Value of Your Business

Valuation methods

There are many ways to estimate the value of a closely held business, and they all seem complicated. But, in reality, the process isn’t much different than pricing a used car.

Figuring out a price for a car is fairly simple. First, keeping in mind the price that was originally paid for the car and factoring in the number of years that it’s been owned, you determine the overall condition of the car by looking at the mileage, tires and belts, interior and exterior paint, etc. Then, you go online to check Kelley Blue Book and see the prices at which others are selling that same year, make, and model car in a similar condition.

Plus, if there were documentation to show that the car had been maintained expertly—consistent receipts for oil changes, mileage checkups, repairs—you’d probably bump up the price and might even jump on the opportunity to buy more quickly.

Calculating a business valuation estimate is similar. First, you need to look at factors that affect the condition of a business:

  • Gross revenue,
  • Seller’s Discretionary Earnings (SDE),
  • Financial history.

You compare and double check the financial statements. Then, you look at what others have paid for similar businesses in similar conditions.

However, business value has one thing cars and homes don’t have: goodwill. In fact, as I said previously, the primary source of value of a small business is its customer base, and valuing a business is about existing customer relationships. You can’t put a precise numerical value to goodwill, but you can estimate it fairly well by looking at the three factors above.

Unfortunately, a valuation—whether for a car, home, or business—isn’t an exact science. It is an opinion that is informed by data. But just because this isn’t a hard and fast number, doesn’t mean we shouldn’t calculate the estimate. Developing an asking price that’s based on sound methodology is fundamental to a successful negotiation and a profitable purchase.

There are three basic methods of pre-transaction valuation:

  • Asset Based Valuation,
  • Earning Based Valuation,
  • Market Based Valuation.

Each involves detailed analysis and calculation. Let’s look at each of these!

Asset Based Valuation

Generally, Asset Based Valuation is used to determine the bottom end price (i.e. liquidation value) for a business. For simplicity’s sake, you might think of this as a sum total of the fair market values for each of a business’ assets.

Unfortunately, with this method it’s difficult to value the soft assets of the business (e.g. trademarks, goodwill, etc.). Again, goodwill is the name, reputation, and relationship between the business and its customers. It’s the difference between a going concern business and a bunch of desks, computers, and equipment sitting in a storage unit. It is critical to business value because it translates into a consistent, growing, and profitable business that generates cash flow.

So, this method usually fails to make a reasonable estimate of the value of the business because it doesn’t accurately value all of the business assets. An asset based approach is appropriate if:

  • The business is going out of business,
  • The business has little to no earnings history,
  • The business relies heavily on competitive contracts,
  • A large portion of the business’ assets are made up of liquid assets or other investments,
  • The fair market value of the operating assets exceeds the value of the business as a going concern.

Earning Based Valuation

Cash flow is the fuel that drives business value, especially in the sale and purchase context. Why? Because when a business is purchased, the business must pay for itself. In other words, the net cash flow is used by the buyer to purchase the business.

At first glance, this method seems like it should be quite simple. All we need to do is look at the income statement or tax return, right? Well, no, not exactly.

Those sources only show taxable income. But because owners of closely held businesses usually want to minimize their tax burdens, taxable income doesn’t equal the true earning potential of the business.

The tax laws allow businesses to take deductions for ordinary and necessary business expenses. Some of these expenses, however, are discretionary. Though they’re true business expenses, they’re optional because they don’t have to be incurred to maintain the business revenues.

For example, a business owner might take a trip to the annual industry convention in Hawaii, and then add on a couple of days to the end of the trip to adjust for “jet lag.” Or, an owner might have the business pay for his new Mercedes or fully-loaded F-150 that is used in the business.

The trip and vehicles are deductible as business expenses. Yet, if she didn’t make the trip one year, the business wouldn’t suffer, and an ordinary car or truck would have worked just as well.

Recognizing this is the case, we want to get back to the real earning capability of the business. This is the “income” that is used when determining the business’ value. Adjustments are made to the P&L Income to arrive at the Discretionary Income of the business.

The opposite situation applies to under-paid expenses. For example, if the owner’s spouse works in the business but is not paid a salary, or the owner doesn’t pay rent on a business facility he owns, the market values of those under-paid expenses are deducted from the net income of the business. Remember, the buyer will incur those costs at a market rate when they take over the business.

Of course, normal expenses—those that are necessary for the operation of the business—are not used to adjust P&L Income. These include salaries, taxes, and insurance for the staff, as well as rent, office supplies, marketing and advertising, and other similar expenses.

Categories of discretionary expenses that are added to P&L Income include:

  • Travel and entertainment for the owner,
  • Automobile expense for the owner,
  • Cell phone for the owner,
  • Salary for the owner and family (for no-show or overpaid positions),
  • FICA, Medicare, health and life insurance, and pension contributions for the owner,
  • Rent for real property owned by the owner that is above a market rental rate, and
  • Charitable contributions.

Categories of underpaid expenses that are deducted from P&L Income include:

  • Rent for real property owned by the seller where the rent is below market rate, and
  • Family services provided to the business at no cost—with the actual cost for the buyer to secure the services being deducted from P&L Income.

The goal of both add-backs and deductions is to arrive at the true earning capability of the business. The process of determining the true earning capacity is called “recasting” the financial statements, and the end result is the “Seller’s Discretionary Earnings” (SDE) or “Adjusted Net.”

Recasting is done for several years of business operations, and the results are sometimes averaged using a weighted average. The most recent year’s earnings are heavily weighted, while the earnings of earlier years are discounted. For example, the present year’s earnings may be weighted at 1.5 or 2 times, while the first year’s earnings may be weighted at .20.

The weighting value depends on the stage of life of the company and the company’s growth over the time period. For a mature company with low growth, the weighting will be consistent. For a start-up venture, the earlier years will be discounted substantially.

This valuation method uses the following formula to determine business value:

income based business valuation formula

Weighting the earnings may be somewhat difficult, but the real trick with the earnings based valuation is setting the capitalization rate. The capitalization rate is the return on investment sought by the buyer. In other words, it is a statement of the risk involved in the business as compared with the other investments available to the buyer.

For example, if “no-risk” investments (e.g. T-Bills) are generating annual returns of 4%, stock market blue chips 12%, and small capitalization stocks 18%, the small business capitalization rate will be in excess of all those rates. This reflects the fact that there is substantially more risk involved in running a closely held business than in investing in a company through publicly traded stocks.

If the business is heavily dependent on owner goodwill, the industry is changing, or the earnings fluctuate rapidly, the capitalization rate could be as high as 50%. For most closely held businesses, however, the correct capitalization rate is between 20% and 33%. Thus, as a rule of thumb, most closely held businesses are worth between 3 and 5 times the weighted average of the normalized earnings before taxes.

Market Based Valuation

The marked based valuation is not entirely independent from the earnings based method. If we recall our used car analogy from above, we compared the relative condition of the car to the base market value to get the sale price. In other words, not all 1996 Dodge Neons are alike.

After recasting the financial results is complete and the true earning capability of the business is known, the business is compared with other businesses that have sold in the past and have similar results (i.e. that are in the same condition).

Unfortunately, though, specific information about prior business sales isn’t freely available on the internet; it is only available from subscription databases. (Don’t worry: Your broker will have access to these databases).

These databases show the SDE, the gross revenues, and the closing sale price for tens or hundreds (and sometimes thousands) of previously sold businesses.

linear regression for business sales

Unfortunately, though, these data aren’t uniform. The sales vary based on a lot of unique factors. So, a mathematical projection is calculated—technically called the “linear regression”—to come up with an estimate of fair market value.

Each dot in the figure above represents a sale, and the line predicts the ratio of the sale price to the SDE, also known as the multiplier. The multiplier for the figure is 2.36, meaning that each $1.00 of SDE equal $2.36 in sale price. The multiplier is then multiplied by the SDE to arrive at a probable selling price.

Multipliers vary widely depending on the industry and the size of the business. Businesses where the goodwill is dependent on the owner (e.g. professional practices) have a very low multiple, sometimes as low as 1 or 1.5. This is also the case when the current market is flooded with a certain type of business, the business doesn’t have a good track record, or the gross revenues have been flat for a few years.

On the other hand, businesses with a higher salability will have a higher multiple. Businesses in hot industries, that have been growing steadily for a long time, or have a good employee team can have multiples that exceed 3. It is rare, though, for a business type to have a multiple in excess of 4.

What Do You Do Now?

Now that you have arrived at an honest and well-founded value estimate for your business, there are proactive steps that you can take to maximize the value of your business.

This involves early planning of your exit strategy and focusing on improving your business’ salability. If you understand what types of buyers you will have and which of those buyers will pay a premium for your business, you can then tailor your business to each of those types to maximize the value of your business.

How Can We Help You?

Here at Alexander Abramson, we focus exclusively on business-related legal matters. We have advised closely held businesses and business owners for years on business succession strategies and business sale transactions.

Ed Alexander is also a Florida licensed business broker and a shareholder of FitzGibbon Alexander, Inc., a Central Florida consulting, business valuation, and business brokerage firm.

We would love to speak with you directly about how we can help you sell your business. Call us 407-649-7777 or email a team member to set up an initial consultation.

Business Law Newsletter!

Sign up for the Alexander Abramson newsletter for guidance and advice on Florida business law. Make smarter business decisions and outpace your competitors.
Scroll to Top