I have never met a business owner who believed his business to be worth less than $5,000,000, even if they were generating $100,000 in annual turnover.  It is an odd truism that I suspect reflects the eternal optimism and frontier spirit that embodies the American entrepreneur.  “I started this company.  I built it from the ground up.  It is worth $5 million; at least.”

There is an entire niche industry comprised most prominently of certified independent valuation practitioners and non-certified business brokers who hold varying claims of legitimacy in determining the value of a privately held business (Of course, the value of a publicly held business is worth the stock price multiplied by the number of outstanding shares or “market capitalization”).

Ultimately and most importantly, the value of a business is what someone is willing to pay you for it at the time you want/need to leave.

Repeat after me, business owners, “My business is worth what someone will pay me for it at the time I’m ready or need to leave.”

The question therefore, is how does one walk into the conversation with a potential buyer knowing at least generally what the buyer would be willing to pay?

The answer is more challenging, but not impossible to determine.  The most frequently used methods for valuing a business are as follows:

1)      Book Value.  This is what I call a “liquidation value”.  If you closed the doors of the business and liquidated everything, what would be the net between the dollars coming in, in exchange for your assets, and the dollars going out, to pay for your liabilities?  This is usually a not-so pretty number in most small businesses.

2)      Multiple of Revenue.  This is what I call the “optimistic hindsight value”.  There are a number of databases, industry studies, magazines, and other secondary sources of information that provide a generalized, “multiple of revenue” valuation for a business.  Usually, this is around a 1 to 1.5 times revenue figure, but depends completely on the industry being considered.  I have one client with a 98% customer concentration issue running on a series of 1 year contracts.  It is unlikely they would earn a 1.5 times revenue offer in this situation.

3)      Multiple of Earnings.  This is what I call the “well run business hindsight value”.  Regardless of earnings, it is gross margin and then operating margin that determine whether a business truly has value.  Can the business generate cash?  Typical multiples of earnings are between 3 and 5 times EBITDA (earnings before interest, taxes, depreciation, and amortization).  This range is most easily comprehended by looking from a buyer’s perspective.  I want to earn a 25% cash return on my investment, which is far higher than investing in a public company (earning 6-8%) so I am adequately being compensated for risk.  Therefore, I will invest 4x earnings.  If I am comfortable with a 20% return, I will invest 5x earnings, etc.

4)      Discounted Cash Flow.  This is the “optimistic future earnings value”.  This value is determined by projecting revenue and expenses over a period of time (usually 3-5 years), and then discounting to present value what those future earnings would be worth today.  This is a very powerful tool because it takes into account the fact that business buyers are really not buying what you did last year; instead, they are buying what they think they can do with your business in the future.

So, why are there so many ways to value a business?  Because each method tells a different story.  If I want to buy a business out of bankruptcy, I won’t pay more than book value.  There is good logic as to why Warren Buffet uses book value as a means of seeking undervalued stocks.  If I am buying a business operating in a slow growth and mature market, I tend to look at multiples of earnings.  However, when I’m buying a business with a niche product, or one that operates in a high growth market, it is the future that matters most and therefore, I tend to use a discounted cash flow model.

It does make a difference.  I provided an internal valuation benchmark for one client who was earning $800k on $3.2 million in sales.  The book valuation was indeed grim at $275k because he was highly leveraged and had little cash in the company.  Multiples of revenue were between $2.8 and 4.1 million, while multiples of EBITDA were between $1.6 and $3.7 million.  The discounted cash flow, however, due to the introduction of a hot selling new product line, generated a valuation of between $4.9 and 6.8 million.  Ultimately, the client received an offer from a strategic buyer (someone in the same marketplace looking for synergies) of $4.4 million because of the future opportunity.

My recommendation is to use all of these methods to generate a value, and then settle on some form of weighted average – so you have a number floating around in the back of your mind.  Hopefully, this number will meet or exceed the number you also have floating around regarding what you need to satisfy your goals and ambitions for selling the business. And remember the golden rule of valuation…. a business is worth what someone is willing to pay for it at the time you are willing to sell.

This entry was posted on Monday, March 15th, 2010 at 9:52 am and is filed under Sell Your Business, Strategic Advisors, Selling a Small Business, Professional Advice, Exit Stories, Emotional Selling, Exit and Answers, Buy a Business. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.