Most small business owners are rightly proud of what they’ve built. When it comes time to sell, it can be extremely challenging to put a value on years of blood, sweat, and tears. But practically speaking, if you’re considering selling your business, having a deep understanding of how others will value what you’ve built will help you get the fairest price and make the process of working with potential buyers far more seamless.
At Baton, we offer free business valuations based on widely accepted valuation methods and by comparing your business to similar actual sales in your industry. We wanted to share with you what that process looks like so you can start thinking about how to do your own valuation or how to better understand your free valuation from Baton.
What is a Business Valuation?
A business valuation or "business appraisal" is a process whereby a business’s assets and financials are evaluated to get to an understanding of what the business is worth to an external buyer. There are many ways to discern what a business is worth.
The key to selling a business successfully is trying to align your valuation expectations with those of what a buyer is willing to pay. Sophisticated business buyers will often have their own valuation process, but if you’re starting to consider selling your business, having an understanding of how others will value it is a great starting point.
Additionally, having an understanding of what your business is worth and how others calculate that value is a great way to increase the value of your business. By focusing on the right metrics before you want to sell, you may be able to dramatically increase what your business is worth when you’re ready to do something else.
There are a few key components that generally go into a business valuation:
- How much profit your business generates - depending on the type of business you’re in and the way you do your accounting, there are different ways to interpret profit, like Net Income, which is just your revenues minus your expenses, your Seller Discretionary Income, which is what a business owner generally takes home after after tax, EBITDA or Earnings Before Interest Taxes Depreciation and Amortization, or free cash flows which is a measure of how much actual cash your business generates.
- The value of your assets - generally a business buyer is going to consider the “stuff” you need to run your business, and how much it would cost them to buy those same items vs. buying them in the sale of your business.
- The intangibles - these are things like reputation, brand, customer lists, etc. Many of these you’ve built over years and they can often have tremendous value that is hard to capture in a financial statement.
- What the market will support - like anything humans buy and sell, we put more value on some things than others. Some industries and businesses are more attractive to business buyers than others, and the more competition to buy certain types of businesses, generally the higher their purchase prices.
What Are the Different Methods of Determining Valuation?
There are a number of different formal valuation methods you can use when determining what your business is worth. Below are the three main valuation methods financial professionals, business buyers, and investors generally use when valuing businesses.
Income Value Approaches
Income value approaches derive a company’s present value from what it is expected to earn in the future. These are generally the most common methods for valuing companies that are bought or sold, and there are various ways to calculate a business’s income value. Generally, a buyer or a valuation expert will look at a company's total revenues and expenses to determine how much income it generates today, they’ll make a projection into the future as to what that business will continue to generate, and then come up with a valuation based on what they think they can afford to pay for the business while still seeing a return on that investment in the future.
Income Value approaches are very common for small business transactions, and if you decide to work with a broker or get a business valuation from Baton, both will generally start by looking at your income and giving it a multiple.
For valuation purposes, usually income is calculated as Seller Discretionary Income (SDE) and/or EBITDA (Earnings Before Interest Taxes Depreciation and Amortization. That income is then assigned a multiple, and that’s the value of the company.
Market Value Approaches
Market value approaches estimate the value of your business by comparing it to similar businesses which have recently been sold. When using this approach, it is important to have a very large sample size of comparable businesses. Real estate is most commonly sold due to market valuations, but sophisticated business buyers will generally also understand the market value of your business.
At Baton, we believe a good valuation takes into account multiple valuation methods to determine the fair market value of a business. We are here to help you determine which valuation method is right for you – completely free of charge!
What Are Some of the Factors I Should Be Aware of When Placing Value on My Business?
To gain a better understanding of the true value of your business, it’s best to put yourself in the minds of potential buyers. Business buyers are thinking about the purchase of your business as an investment. As an investor, buyers will consider whether what they pay for a business will make them more money than what they invest and over what period of time that will happen.
Whether a first-time business owner or a private equity firm that’s purchasing hundreds of companies, any buyer will consider what it would cost them in terms of time and dollars to build something similar to what you’ve created.
If you have customers and you’re generating revenue, you’ve done work that someone else may want to buy instead of starting a similar business from scratch. One of the things to consider is how far you are from “scratch”...as that can help put you in the minds of a potential acquirer. If you’re wondering if you should or can sell, check out this article.
As you’re probably aware, starting a business usually means months if not years of negative cash flow – one of the big pros to buying vs. building a business is walking into a business that is already generating cash.
Buyers will also consider the level of sophistication you’ve developed in running your business. Can they easily recreate what you do, or has it taken you years to come up with the processes, personnel, and customers that drive your business day-to-day? Do you have multiple locations that have taken years to develop? Does your business run without you? Or are you a “keyman”, meaning you’re necessary to run the business, and the buyer will either have to personally replace you, pay you to keep working, or hire someone with a similar skill set (this is called “keyman risk”). The harder your business is to replicate, and the more seamlessly it runs, generally the more buyers and the more they’ll be willing to pay.
At Baton, we believe valuing your business is not as simple as looking at revenue or cash flows. With our free valuation, we take into consideration many of the things a potential acquirer will look at, and we factor that into the valuation range we provide. These concepts, like “keyman risk”, sophistication, customer risk, etc. are often considered “intangible assets”. A buyer will base the price of your business on both your tangible assets, like equipment and intangible assets.
Tangible Assets vs. Intangible Assets
Tangible assets can be thought of as assets that your company has that you can physically touch. Cash, buildings, and inventory all fall under the umbrella of tangible assets. Generally, a business buyer will want to know what it would cost to build what you have physically created for your business, but that alone isn’t what they’re buying. They’re also buying all your intangible assets.
While Intangible assets are not physical things, they may be more valuable than your tangible assets. Intellectual property, trademarks, customer lists, and domain names are some examples of intangible assets. Being aware of intangible assets and assigning a fair monetary value to them is likely an important part of a proper valuation.
Business Value Based on Profits + Owner's Salary
Many small businesses are valued based on a multiple of the seller's discretionary income (SDE), or basically the net profit the business would generate if someone else was running it without you being involved.
When we run valuations at Baton, we look at your profit and loss statement and add back in any unnecessary expenses for the new owner, “normalizing” it. This includes taxes, deprecation, amortization, interest expense, and some other expenses. If you’re paying yourself an annual salary and you could argue that you’re not necessary to run the business or you could hire a professional manager for less than you pay yourself, you can add back some or all of that salary. Many business owners expense vehicles and other costs through their business that may not be necessary to actually run the business day-to-day, and those are also added back in. Once the P&L is normalized, you’re left with SDE.
Sometimes people will value a business based on EBITDA (earnings before interest, taxes, deprecation, and amortization). EBITDA and SDE are similar. Usually, larger businesses are valued on EBITDA as it does not add back in the owner's salary, as larger companies generally require a management team to run it.
After calculating SDE, a buyer will apply an industry multiplier to come up with their valuation. An industry multiplier is the number that SDE or EBITDA is multiplied by to determine business value. This number varies by industry, and it can change from year to year depending on market conditions and the demand for certain types of businesses.
Generally, the larger and more sophisticated a business, the higher the multiple, as these businesses present less potential risk to a buyer from an investment perspective. A buyer will look at a coffee shop with a few employees and a 5yr lease and see that it’s maybe only worth 2X SDE. That same business with 10 coffee shops, 100 employees, a roastery, proprietary procurement processes for specialty beans in South America, and a strong local brand could fetch 5X+ SDE.
Industry trends affect the value of your business. There are certain industries, like vet clinics for example, that captivate the private equity and investment communities. Often, a groundswell of interest arises in these types of companies, and as a result, they begin selling for higher and higher multiples. If you find yourself in one of these industries, you likely know it, as you’ve probably been contacted by potential acquirers that are actively looking to buy businesses like yours.
Similarly, sometimes the investment community expresses less interest in certain types of business as the result of some prevailing change in trends. The internet, for example, rendered some services businesses, like travel agencies, almost obsolete. Those businesses now fetch far lower valuations than say a vet clinic.
Last 12 Months Sales and Beyond
Business buyers will generally want to see your financials as far back as you can provide them, going back at least three years, but they will focus most of their valuation efforts on the last twelve months (or trailing twelve months) of SDE or EBITA.
Despite being a relatively short period of time, looking at a company’s last twelve months provides good insight into the current state of a business. If your business’s financials have taken a turn for the worse in the last twelve months– especially without a strong explanation– it could harm your valuation. Alternatively, a good valuation will look at the growth of the business over the previous few years. If your profits have grown or remained stable, that represents both opportunity and consistency that are attractive to potential acquirers.
How Do Investors Evaluate My Business?
If you’re that coffee shop owner, you may not have thought about starting your business as an investment. Perhaps you just loved coffee and hated working as a manager at Starbucks. You took your savings and purchased the equipment to get started. You were the first and only employee until the business grew to the point where you could afford to hire others. Now you own 10 coffee shops! And your time and money are paying off…
As mentioned earlier, most business buyers will be viewing the acquisition of your coffee shop through a slightly different lens than you may have had when you started it. Instead of grinding to get something going, they’re looking to invest a sizable amount of money into an asset (your business) that is generating cash flows, with the idea that they will make back their initial investment and more.
Some buyers/investors may be “owners/operators”, looking to move from a job or another business into something they can dedicate their time to. Others may be more passive investors, looking to put money into a business that can run itself and pay back their investment over time. Then you have private equity firms that buy businesses primarily as an investment vehicle to either maximize the cash flows of that business or grow and then sell the business for more money, generating a return on another sale.
The simplest way to think like an investor is to consider how long it will take them to make back the investment they make to buy your company, what they can pay themselves along the way, and what they might be able to sell your company for in the future depending on what they think they can do with it.
An owner/operator may invest $200,000 of his own money and take out an SBA loan for $800,000 to buy your business for $1M. If your business currently generates $250K in SDE, they’ll be able to pay themselves a nice salary to run it, work to improve that revenue number, and pay off the loan.
A passive investor will think similarly, but assume he might be able to hire someone to replace you and pocket the difference without having to be that involved in the business.
A private equity buyer will be thinking differently. She will assume that she can either dramatically increase your SDE in a short period of time, or she’ll have bought many similar companies to yours, and “rolled them into one”, generating a much higher valuation for the overall entity than any single business would sell for on its own. You can read more about this strategy here.
How Can I Value My Business at Different Stages of Its Growth?
Business valuations are impacted heavily by where they are in their stages of growth. If you’re interested in exploring the various growth stages of a small business, check out this exhaustive review from the Harvard Business Review.
For simplicity's sake, small business buyers generally look at how far past the startup stage your business is. If you are still heavily involved, reliant on a few customers, and there are few processes and procedures in place that drive the business forward, it will generally have a lower valuation.
If you’re actively involved in the business, but you could be replaced by a competent manager because it’s reached a level of self-sufficiency that isn’t entirely reliant on your time and talents, you’ve reached a phase of growth that is more attractive to buyers.
If your primary role is working “on the business”, thinking about ways to grow rapidly and improve processes, and you’re not needed in the business much or at all, your business will likely fetch a much higher valuation.
How to Calculate Your Business’s Value?
Baton believes every business owner deserves to know what their business is worth — so we made it free. We evaluate hundreds of comparable businesses, taking location, industry and other factors into consideration, and compare the results of a variety of valuation methods (eg. discounted cash flow, cash flow multiples, revenue multiples, EBIDTA multiples, and more). Our proprietary algorithm weights these values to produce an estimated valuation range that gives owners a realistic view of what the business may be worth if sold today. Along with your valuation range, we’ll provide actionable advice on how to prepare your business for a sale and maximize your chances of selling on the higher end of the range, along with personalized connections to our vetted partners.
If you’re considering alternatives to Baton, check this article out on how much valuations cost.
When to Consider Using a Business Valuation Expert
An outside, professional business valuation will help you accomplish two things: it will remove your personal bias toward valuing your own company, and it will provide you with a lens through which to evaluate serious buyers. Just because you think your business is worth $1,000,000,000 doesn’t mean anyone is willing to pay you that much for it. Similarly, if someone offers you $100k for something that’s actually worth far more, you should know that to save yourself the time of dealing with unscrupulous or realistic buyers.
Tips for Sellers: How to Prepare for the Sale
We’re building Baton to help small business owners understand and realize the value of their businesses. Whether you run a solo coffee shop or a multi-unit doughnut business, we can help you understand the value of your business and connect you with potential buyers and partners. But understanding your business's value is just one stop on the journey of selling your business. Check out this guide where we break down the three-step process every company goes through when selling to help you better understand what it takes to sell a business.
Trying to understand what your business is worth can feel like a daunting task. You’ll need to get your finances in order, work with a valuation expert to dive into some aspects of your business you may not normally share with strangers, and you’ll need to keep running your business. But if you’re considering a sale, understanding what others think it’s worth is the best place to start. You can start planning what comes after based on how your personal finances would be impacted by a sale, and you’ll be able to begin a discussion with potential buyers from a place of knowledge rather than ignorance.
At Baton, we offer free valuations based on reliable data. We collect real financial data from countless buyers and sellers to make sure we’re providing you with an accurate and realistic range for your specific company. When it’s time to sell we’ll connect you with brokers you can trust. Regardless of what stage your business is currently at, your journey starts with Baton.