For me, it was the excitement that comes with forging my own destiny and being my own boss, pursuing my passion, and ultimately, to profit from my hard work.
Fortunately, my efforts paid off, and for many years, I managed to invest my profits outside my business to mitigate the risk associated with having all my eggs in one basket. Then, I was able to execute a successful transaction to private equity in 2017.
For many small business owners, the sale of their business could very well be the largest transaction of their lifetime.
I have many friends who risked everything to start their business, including mortgaging their homes. I know of a few situations where these business owners leveraged their profits in order to more rapidly expand their business, and in some of these situations, these owners walked away with tens of millions of dollars on the successful sale of their company.
The challenge is knowing when to walk away and next, in maximizing the value of the business.
The purpose of this blog post isn’t to address the when, but rather, the how much. If you want to read the former you can visit this article: How Do You Know When to Sell Your Business? It’s Not All About the Money
How Much is Your Business Worth? A Look at Business Valuation
The easy and obvious answer to business valuation is … your business is worth what someone is willing to pay for it.
Now the more complicated business valuation formula takes many variables into consideration.
For example, a seasoned veteran like Warren Buffet values a business based on a discounted cash flow basis, meaning that he will consider how much cash a business generates each year projected into the future, and then discount future year’s cash flows using a long-term T-bill rate.
For the typical small business owner, the above calculation might be too complex, although looking at the discounted cash flow model clearly makes sense. Alternatively, a much simpler approach is to look at your prior year’s normalized profits, typically EBITDA (earnings before interest, taxes, depreciation, and amortization), and then multiply that by a variable like 4, 5, 6, or more, depending on many circumstances like economic, the competitiveness of the industry, competitive moat of the business itself, the current economic cycle, guaranteed residual income flow, and many other factors.
How Do Normalizations Impact Business Value?
Before I detail the formula of what your business is worth, I want to explain that it’s important to look at “normalized” profits. For example, if you put personal expenses like your boat, non-business-related meals, or gym memberships through your business, then that would have to be backed out.
In addition, if there were other one-time expenses like hiring a consultant for an expensive project, or one-time software-related fees, they could also be backed out.
On the other hand, because the list of normalizations can sometimes be long, and because they’re somewhat arbitrary, the buyer might not agree to all your normalizations.
The simple formula would look like this:
Simple Business Valuation Formula = (EBITDA + Normalizations) x Business Valuation Multiplier (BVM)
Adding numbers to the above, assuming your business did $1,000,000 in profits last year with $100,000 in normalizations = $1,000,000 + $100,000 = $1,100,000 x 5 (BVM) = $5,500,000 business value.
Here’s where things get interesting.
For every dollar increase in revenues without an associated increase in expenses, you increase the value of your business by the business valuation multiplier. For this reason, there’s a large incentive to maximize profits, and/or reduce expenses the year prior to your sale. If you manage to increase profits by $100,000, for example, then you’ve just increased the value of your business by $500,000.
Similarly, for every $1 you decrease expenses while keeping revenues flat, you also increase your business’s value by the BVM.
While understanding that your business’s profitability is quite straightforward, as are the normalization calculations, what becomes somewhat arbitrary and open to interpretation is the BVM (business valuation multiplier).
Also, don’t forget, when you’re doing your calculations, you need to subtract any long-term debt you have in your business. If you’ve determined that your business’s value is $5 million, for example, and you have $1 million in bank debt, then the assumption is that you’re going to clear this debt on sale, so your business’s value will now be $4 million.
A Review of Ten Variables that Impact Company Valuation
Any buyer is going to want to see some of the following in your business, and each one will impact the valuation, either positively (in your favor), or negatively, depending on the circumstance:
- Management beyond you as the owner who can run the business if you’re no longer there
- A clean set of financials –accrued income statement, balance sheet, with high net profit margins
- A recurring stream of revenues. For example, if your business produces a recurring steady stream of revenues, perhaps through maintenance contracts or subscriptions, then this is much more favorable than a business where every dollar in revenue is one-time.
- The competitive nature of the industry
- Barriers to entry
- The competitive moat you’ve created in your business. For example, even businesses in a competitive industry can create a competitive advantage and moat through branding, service, innovativeness, and so on.
- The assets sitting inside your business and on your balance sheet. Things like inventory, cash-on-hand, equipment, and machinery will all impact valuations, keeping in mind that having $1,000,000 in cash inside your business doesn’t mean that your business’s value increases by that amount, as the cash-on-hand and inventory is often removed on closing calculations.
- The sustainability of the revenues and potential other exogenous factors that could impact your business in the future
- The business’s trajectory with revenues and profits. For example, are revenues higher or lower this year over last year’s? Increasing is favorable, and decreasing could be indicative of a larger problem that could reduce value considerably.
- The current economic cycle. For example, considering we’re in the midst of a recession, and many businesses are closed as a result of the pandemic, it will likely impact valuations. An astute buyer will recognize the value beyond the cycle and look at the future potential of the business, but, either way, economics will impact your business’s value.
When valuing your company, the potential buyer will have a large impact on the valuation. For example, a strategic buyer might be willing to pay a much higher multiple than a private equity firm, or a stand-alone private buyer.
Let’s say you’re planning on selling your HVAC business. If the buyer is from the same industry and is operating a competitive business, then combining their business with yours will provide immediate savings after the merger.
Suppose when merged the new business will now have two offices, warehouses, controllers, sales directors, photocopiers, and so on. If the new buyer can immediately reduce the expenses of the combined business, then those savings go immediately towards their bottom line and improve profitability. Doing that will increase the new business’s valuation by a multiple of the savings, and in turn, the strategic buyer might be willing to pay more than a private equity shop.
I go into much greater detail on how to make an acquisition and the math behind combining two entities, and the term merger arbitrage, in this article: How to Expand Your Business Through Acquisition and Make a Killing
Revenue Multiple Valuation – Enter the SaaS Shop
One type of business whose valuations seem to defy common logic is the SaaS (software as a service) type firm that typically sells for revenue multiple valuation.
I’ve spoken with entrepreneurs running a SaaS business with literally zero or even negative profitability who have been able to sell their businesses for six, seven, and even greater times revenue. NOT profits, but, revenue. The company valuation is based on revenue.
A buyer of this type of business is hoping for a completely 100% recurring SaaS revenue stream, rapidly increasing revenues, high gross margins, and low client churn. The challenge here for the seller is that there’s a constant pressure to keep the high-growth rates continuing– otherwise, it compromises valuation since these companies are trading (selling) as a multiple of future earnings and growth.
Shopify, although publicly traded, is a perfect example of a company that was viewed as being overvalued back in 2016 when the stock was trading at 8X revenue. It’s also a perfect example of a company that’s trading as a multiple of revenue, not earnings. The markets at the time, in 2016, were looking at Shopify’s future growth potential, and the stock subsequently tripled. Fast forward to 2017, and the markets were once again screaming that Shopify was overvalued, only to have the stock triple again, and it’s been on a tear ever since.
Some of the entrepreneurs whom I have spoken with over the last couple of months, and through the March pandemic time-frame, were on target to sell their business in the near-term, but are now having to rethink their plans as they battle a more challenging business environment.
It wasn’t that long ago that their company valuation was a multiple of a large revenue stream, and now, not only has their revenue declined but so have the multiples.
So if you’re looking at how much your business is worth and valuing your business for sale, there are many variables at play. A rule-of-thumb is normalized EBITDA x 5. If you start with that, unless you’re running a rapidly growing SaaS business, you’re probably in the ballpark, and knowing the above will hopefully help you as you gauge how to position your business for sale.
P.S. I am just getting started with my new podcast. You can listen to the first episode here:Why did you start your business?
Now, in case you’re wondering how much it costs to sell your business, you can read this: How Much Does it Cost to Sell Your Business?
Now, if you’re in a position to sell your business, or considering doing so, you might be interested in reading this article: Life After Selling Your Business. The Good, The Bad, and The OMG, What Did I Just Do?
You should consider subscribing to my blog. I publish one article a week on small business and wealth creation. You can subscribe here.
Also, I published a book during the summer of 2018, “The Kickass Entrepreneur’s Guide to Investing, Three Simple Steps to Create Massive Wealth with Your Business’s Profits.” It was number 1 on Amazon in both the business and non-fiction sections. You can get a free copy here.