Determining the selling price of a business is a consequential financial decision for an owner. The process is a detailed evaluation of the company’s past performance, its assets, and its potential for future earnings. A proper valuation sets the stage for a successful transaction, attracting serious buyers and ensuring the owner receives fair compensation.
Understanding Key Valuation Terms
At the heart of business valuations are financial metrics representing profitability. For many small, owner-operated businesses, the most common is Seller’s Discretionary Earnings (SDE). SDE starts with the company’s net profit and adds back the owner’s salary, benefits, and other non-essential business expenses, showing the total financial benefit a new owner could expect.
For larger businesses, a different metric called Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) is often used. EBITDA measures operational profitability without the influence of accounting and financial deductions. It is calculated before deducting an owner’s salary, making it suitable for companies where the owner is not the primary manager.
Central to calculating SDE and EBITDA are “add-backs.” These are expenses on the books but not necessary for future operation. Common examples include the current owner’s salary and bonuses, personal health insurance paid by the company, and one-time purchases that won’t be repeated.
How Business Valuation Is Calculated
The most prevalent method for valuing a small business applies a “multiple” to its calculated earnings, whether SDE or EBITDA. This multiple is a multiplier reflecting the perceived risk and potential return of the investment. For instance, if a business has an SDE of $200,000 and the multiple is 2.5x, the valuation would be $500,000.
The multiple is determined by factors including the industry, market conditions, and the business’s specific characteristics. For most small businesses, multiples of SDE range from 1.5 to 3.5. A stable business in a growing industry will command a higher multiple, while one with inconsistent earnings will receive a lower one.
While the earnings multiple method is dominant, other approaches can provide a more complete picture. An asset-based valuation calculates the net value of all company assets. A market-based approach looks at recent sale prices of comparable businesses to establish a benchmark.
Factors That Adjust the Final Price
Several attributes can significantly increase the valuation multiple. A business with a high percentage of recurring revenue, such as from subscriptions or long-term service contracts, is highly attractive because it promises stable future income. A diverse customer base with no single client accounting for a large portion of revenue reduces risk, and a strong management team that can remain after the sale also adds value.
Conversely, certain characteristics can lower the multiple. One of the most significant risks is high owner dependence, where the business’s success is tied to the personal relationships or skills of the current owner. Other negative factors include:
- Poorly maintained or incomplete financial records.
- Operating in a declining industry.
- Facing intense competition.
- Experiencing high rates of customer churn.
The Importance of Professional Guidance
Navigating the complexities of selling a business is a challenging endeavor, and attempting to do so without expert help can lead to costly mistakes. Professionals such as business brokers and M&A advisors bring specialized knowledge to the process. Their primary role is to provide an objective and defensible valuation, which becomes the foundation for the entire sales strategy.
These professionals also manage the tasks of marketing the business confidentially and vetting potential buyers. They create marketing materials that highlight the company’s strengths while maintaining discretion to avoid alarming employees, customers, or competitors. By screening interested parties, they ensure that only financially qualified and serious buyers are brought to the negotiating table.
Beyond valuation and marketing, advisors guide the owner through the intricate phases of negotiation and due diligence. They act as an intermediary, handling offers and counteroffers to secure the best possible terms. During due diligence, when the buyer scrutinizes the company’s financials and operations, an advisor helps prepare the necessary documentation. Engaging professional guidance can maximize the final sale price and facilitate a smoother transaction.