What Is A Business Worth?
How much is Apple worth? At a cursory glance, the company is worth $2.08 trillion. But how was that value calculated?
In Apple’s case, determining how much the business is “worth” can be a pretty straightforward process: simply take the number of outstanding shares of Apple stock, and multiply that number by the value of a single share of Apple. This process of valuation is known as market capitalization.
For small and medium-sized businesses - Main Street businesses, as we often call them in the mergers and acquisitions world - this process is not nearly as useful. As such, we need a different valuation method.
Seller’s Discretionary Earnings (SDE)
The first step in determining the value of this type of business is calculating the seller’s discretionary earnings (SDE). To do this, we must first determine the business earnings before interest, taxes, depreciation, and amortization (EBITDA). The formula for this is simple: Net Income + Taxes + Interest Expense + Depreciation & Amortization
From there, we add the wages and benefits of the shareholders and/or owners to the EBITDA. This gives us the SDE.
Why do we add wages and benefits into the EBITDA? The simple answer is that in businesses of this size, there can be dramatic differences between how different owners pay themselves out. Some owners might be taking a huge chunk of business earnings, while others might pay themselves a pittance.
The new owners will be able to pay themselves however they see fit, so it’s reasonable to include owner/shareholder payout into the valuation of the business.
Note that if the owners or shareholders are working in an operations role, there will also be an adjustment for the Fair Market Salary of their operational role in the company.
The valuation multiple
Buyers are rarely looking to purchase a business for what it’s worth now - they want to purchase a business they believe will grow and thrive. As such, the present value of the business as shown by the SDE does not represent the potential value the business can obtain through growth.
This is corrected through the use of a multiple. This multiple can be as low as 1x SDE, or as high as even 5x SDE.
The factors that can affect your valuation multiple
The higher the multiple, the more your business is worth - that’s the simple math. What’s more challenging for those new to selling businesses is determining which multiple should be used.
Revenue and the multiple
Growing revenue every year is the single biggest factor that affects the multiple. Remember, buyers are looking to purchase a business they believe will continue to grow. When the seller can demonstrate their revenue is growing year over year, it’s a very positive sign that the business will continue to grow.
Another factor related to revenue is how much of your revenue is profit - a business with a 20% profit margin will likely have a higher multiple than one with a 10% profit margin.
Operational factors and the multiple
Then there are factors related to operations. The value of a business has a lot to do with the personnel that business has on staff. A business whose managerial staff have been there for 15 years and who have no intention of leaving will likely sell for a higher multiple than a business whose management goes through a revolving door.
Customers are another major operational factor - a diversity of customers means a diversity of revenue streams, which is appealing to buyers. When a business gets most of its revenue from a single customer, it will tend to sell with a lower multiple - and if that customer gets wind that the business is going to be sold, things can get even worse.
Industry factors and the multiple
Finally, the industry a business is in, and how that industry is forecasted to grow (or decline) over the years can be an important factor in determining the multiple. So too can the economic climate - more specifically, how willing banks will be to lend to sellers who want to buy businesses in your industry. Your business model will also play an important role in determining how much banks are willing to lend.
These are only a few of the many factors that can influence the multiple. Our team takes steps to ensure we find the right multiple for your business. One example of this is pre-financing every listing to know exactly how much banks are willing to lend when in a given environment.
As a business broker in Vancouver, we understand the ins and outs of valuation. Call us today for a free consultation - we’ll go over more than a dozen factors that could influence how much your business is worth.