The Ultimate Guide on How to Value a Business? cover image

The Ultimate Guide on How to Value a Business?

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Figuring out the value of a business is a bit like trying to solve a puzzle—it's a blend of creativity and logic. It's not quite as straightforward as, say, appraising a house. There are so many more variables and considerations.

But hey, don't worry! I want to share my method with you, a quick way to estimate a business's worth, especially when it's generating revenue in the sweet spot between $500K and $5M.

First things first, you'll need to do a bit of homework. Here are the initial pieces of information you need to collect:

  • Last full 3 years of Profit and Loss Statements
  • Current Balance Sheet
  • Details on Lease or the Real Estate if owned
  • What does owner pay themselves and what do they do?
  • Any other family members employed?
  • List of Discretionary Expenses (expenses that are optional, or beneficial to current owner)
  • Major Equipment List with Market Values
  • Unusual Events Last 3 years? Any lawsuits? Gov handouts? Insurance Claims? Major Equipment bought/sold?

 

Before you dig in, ask yourself 4 common sense questions:

  1. Do I understand how this business works?
  2. Does this business work without the owner?
  3. Is there ONE customer or supplier that this business is completely at the mercy of
  4. What exactly is a buyer buying here?

It's time to do an SDE-based, Income Approach to Value, which is really just 3 big parts.

  • Determining SDE the last 3 Years
  • Deciding how to Weight the last 3 Years' SDE
  • Choosing an Appropriate Multiple to Multiply SDE to Reach our Value

 

What is SDE exactly? It stands for Sellers Discretionary Expenses and it's the theoretical "Earnings Power" of the business or the total "Owner Benefit".

It's the "Earnings Firehose" you theoretically should have available to service acquisition debt, pay yourself or a GM to run it, reinvest for growth, or take home in profit.

If you owned this company, debt free, and worked in it full time (paying yourself $0) paying only necessary expenses, the SDE is what you'd make in profit. It's the maximum earnings possible on a normal year in the company's current condition. Now let's find it.

Addbacks:

  • Owner's Family Member's Salary and Payroll Taxes
  • Owners Benefits & Perks (healthcare plan for owner and family, cell phone bill, life insurance, owner's vehicle, anything that is paid out to owner and their family that will go away with the sale)
  • Rent if Owner-Occupied Real Estate (will subtract a fair market rent later)
  • One-Time Expenses that don't apply to a Buyer (cost of an expansion or remodel, a one-time consultant, a big one time abnormal bad debt, a lawsuit settlement, etc)

 

Don't forget the EBITDA addbacks too:

  • Interest Expense (Buyer will buy debt free)
  • Taxes (INCOME TAXES ONLY, Buyer responsible for their own tax bill and strategy)
  • Depreciation & Amortization (phantom expenses Seller isn't writing actual checks for)

 

Now let's do some Negative Adjustments, the opposite of addbacks:

 

  • Market wages to replace Seller's family members (family members working for company are usually overpaid or underpaid)
  • Any "other income" that's not the core business stuff, like interest income, selling assets, gov handouts eg Covid JobKeeper payments
  • Fair Market Rent if Owner-Occupied - The coming Rent increase if leased and you know LL will raise
  • One-time anomalies, windfalls of revenue not applicable to a Buyer - Deferred Maintenance (any stuff that should have already been fixed that the owner neglected)
  • Capex if it's an Equipment Heavy Business w/trucks or machines that need periodic replacement (specifically Maintenance Capex, or a budget to replace major equip necessary for current sales level. Subtracts some of Depreciation addback.)

 

Alright, you've crunched the numbers and found your Seller's Discretionary Earnings (SDE)! It's time to repeat the process for the past two years' Profit & Loss (P&L) statements.

 

Lay them out together, and let's find a story in those numbers. After all, trends can really talk.

 

Chances are, you've ended up with three different SDE figures for each of the last three P&Ls. But to get the real value, you need just ONE SDE number, so let's try weighting.

 

Take a look at your SDE trends. If it's been growing consistently and you think that'll continue, then go ahead and pick your most recent and highest SDE figure. It's a winner!

 

On the other hand, if your SDE is more like a roller coaster, you'll need to get creative. Here's where your intuition steps in.

 

You might average the last three years, or maybe discount one year that's an outlier and average the other two. Trust your gut!

 

Now, if the trend is going downhill, that's a different ball game. You might have to lower your SDE substantially. Keep in mind, lenders and appraisers aren't going to expect your SDE to grow.

 

But if it's declining, they will definitely penalise you. In such a scenario, ask yourself: would anyone want to buy a business that's not growing, and why?

 

Once you've figured out your weighted SDE, it's time to multiply it by a certain figure. Here are some standard multiples to keep in mind:

 

Less than 100K SDE? Most likely 2x or less, or might not even sell.

100K-500K SDE? Expect 2x - 3.5x.

500K-1M SDE? You're looking at 3x - 4.5x.

Over 1M SDE? You're in a whole new league!

 

But how do you choose a multiple within these wide ranges? Time to dig into industry-specific information and look at the unique qualities of your business.

 

Business reference guides and databases can offer industry-specific rules of thumb to find a median multiple. While some may simply choose the median multiple, you can do better than that. 

 

Suppose your range is 2.2x -3.7x with a median of 2.9X. Look at your business in relation to the industry. Do you have higher margins? More stable income? Superior systems, technology, reputation? Then, boost your position on the scale. If it's underperforming compared to industry standards, slide it down.

 

Once you've made your pick, your business value = Weighted SDE x Your Chosen Multiple.

 

But hang on, we're not done yet. You've got to view it from a potential buyer's perspective too. Think about the most likely buyer for your business. Can they afford to buy it, make a decent living, service any debt, and still have a 25% cushion?

 

If not, your valuation might be a little off. Always ensure your valuation still makes sense for your potential buyers. Happy valuing!