How to Value a Business for Sale
When it comes time to buy or sell a business, it’s important to set your personal feelings aside to do a systematic business valuation and establish a realistic and competitive selling price. You’ll need to objectively analyze the business, study the current market, and consider employing professional business appraiser or business broker.
Understand the Three Valuation Methods
There are three common, acceptable business valuation methods. One may be more suitable than another, depending on the type of business being valued, including its industry, size, and circumstances of sale.
Income Based Business Valuation Approach
An income based valuation approach is based on projected future earnings. It is recommended for businesses that have significant potential for growth. There are two variants of this approach, capitalization of earnings and discounted cash flow (DCF).
With the capitalization of earnings method, the historical cash flow of a company is divided by its capitalization rate. A capitalization rate is expressed as a percentage and represents the rate of return on the capital including equity components and debt. This method helps to identify risks and quantify the potential return on investment. This calculation is especially useful for valuing service-oriented businesses.
The discounted cash flow method takes the company’s projected cash flow and then discounts that amount for risk using the weighted average cost of capital. This projection is usually calculated for one year and then assumes perpetual and constant growth. Because of that assumption, this method of valuation is best used when an analyst is confident about the assumptions being made.
Asset Based Business Valuation
An asset-based business valuation focuses on the book value of a business and deducts liabilities. It is often used in conjunction with other methods of valuation and may be required as part of the due diligence process for private companies. Struggling businesses with little to no profit may often sell at this value in an asset sale.
Market Based Business Valuation
A market-based business valuation is one of the simpler business valuation methods, and arguably the most relevant. By comparing a business to other, similar companies that have sold recently, you can determine the market value of the business at issue. You will want to find companies with similar financials within your sector and then calculate the pricing multiples. The multiples frequently used in this approach are revenue, and cashflow (SDE or EBITDA).
Now that you have a sense of the different ways in which you can value your business, the following tips will help you calculate the best price before putting your business up for sale.
1. Prepare the financial statements and determine the SDE.
The first step in any business valuation is preparing the company’s financial statements. Gather financial records for the past three years including: income statements, cash flow statements, and balance sheets. If the business hasn't been operating for three years, consider using a projection model.
Next, work with your accountant to transform the income statement into a seller’s discretionary earnings (SDE) statement, which considers non-recurring purchases and discretionary expenses to more accurately reflect the value of your business. SDE helps to show the full financial benefit a business produces for its owner, because it includes expenses that aren’t required to run the business. These expenses include your salary and personal expenses, travel that’s not essential to the business, charitable donations, leisure activities, and one-time expenses like settling a lawsuit.
(For more detail, see Seller's Discretionary Earnings (SDE): An Overview.)
2. Use price multiples to estimate the value of the business.
Most business buyers will initially base the value of the business on an industry multiple of its earnings. Price multiples provide buyers with a tool to estimate their return on investment. They are a quick way to arrive at a general estimate of the business’s sale price.
For example, nationally the average business sells for around 0.6 times its annual revenue and 2.4 times its annual SDE. Once you’ve determined the annual revenue and SDE, find the appropriate multiples, plug in the numbers, and do the math. The trick is to find the right multiple for the business since they vary materially by industry and market.
You can find industry and sector specific SDE multiples based on sales on BizBuySell on our small business valuation multiples page.
3. Adjust the multiple accordingly
Once you’ve found a starting point or range, you will want to consider how certain factors of your specific business operation will call for a higher or lower multiple.
For example, if an industry is experiencing a boom and popularity is growing, that would increase your multiplier. However, if the business does not offer seller financing, the multiplier may decrease.
One of the key factors a buyer will want to understand is how involved the owner is in daily operations. Most business buyers want to buy an income stream, not a job. A business managed largely by employees is much more valuable than one who’s owner needs to work 60 hours a week. The more “passive” the income stream, the higher the multiple.
Also, a change in ownership can mean changes in supplier relationships. Customers who were once loyal to an owner may start going elsewhere. These types of issues are called “owner risk.” If an existing business has a great deal of owner risk, it may not survive a transition to a new owner. Those risks can negatively impact the overall value of a business.
4. Use comparable (or comps) of ‘For Sale’ and sold businesses.
Recent sales of comparable businesses (or ‘comps’) are a popular valuation rule of thumb that will offer you a realistic picture of what similar businesses are selling for. By identifying examples of similar businesses that have sold in the same area, you can get a better sense of a realistic selling price.
Comp data can be accessed through several online sources, as well as through a business broker, who can help to provide you with the right multiplier for your market.
BizBuySell maintains an inventory of hundreds of thousands of successfully sold businesses used in our valuation center options. It also helps to monitor current businesses for sale. You can narrow your search by industry and geographic location, and then narrow it further by gross income and cash flow.
5. Take steps to improve the value.
Owners are often disappointed with the outcome of the various business valuation methods. The good news is that there are many ways to improve it. Remember that buyers are interested in businesses that offer the greatest potential for future profit. Documentation of several years of profit growth will add value to the company.
Buyers are looking for an easy transition into their new business, so evidence that the business is well-organized and running smoothly will also add to the company’s value. The business seller should have an organized package of detailed financial records, compliance with health and safety regulations, renewable leases, employee policies, staff with transferable contracts, supplier lists and an established client base will go a long way. Potential buyers will be impressed and more likely to feel the business is a good investment for them.
Seller financing is another way that owners can potentially improve the value of a business. By partially financing the sale, the owner can benefit from a higher selling price, interest income, and a wider field of potential buyers.
6. Consult with a professional and get a formal valuation.
Hiring a professional business appraiser or business broker not only allows you to benefit from his or her expertise, but it also provides the objectivity that you may lack when it comes to making a fair assessment of the business. Many brokers are experienced at conducting a formal valuation or have connections with qualified appraisers. A qualified professional should have the designation of Accredited in Business Valuation (ABV). Accountants who have earned this certification are required to pass an exam administered by the American Institute of Certified Public Accountants (AICPA). In addition to the exam, these specialists must meet business experience and education requirements to be certified.
Valuing a business correctly is essential in a competitive market, and enlisting the help of a third-party professional will not only eliminate seller sentiment from the sales process, it will also shorten it by aligning the business value with up-to-date market conditions.
(To find a great, local broker, see BizBuySell's Business Broker Directory.)
Conclusion
Valuing a business requires a multilayered approach, so owners will combine more than one business valuation method to gain a very accurate appraisal. Most small businesses start with an SDE and add more analysis based on sales, cash flow, and liability. All these factors combined will give you an accurate business valuation.
It’s important to strive for accuracy when coming up with that target number to list your business for sale. When priced incorrectly, you run the risk of selling your business for less than it is worth. Or, on the flip side, you might scare off investors by pricing the business too high. It is always best to get advice from experts if you have the time and resources to do so.
To get started, try using BizBuySell’s BizWorth Calculator, which will apply an industry multiple from our large database of comps to your business’s financials.