Determine Your Small Business’s Valuation
Here is what you need to remember
There is no one correct way to value a business as such use multiple methods to generate a range
Valuation accuracy is nearly impossible to determine because each buyer will have their range of willingness to pay; you will need to negotiate
The earlier you get a business valuation, the more likely you will be able to increase the valuation of your business and be ready for when the time comes to exit
Going to the grocery store or shopping on amazon you have a general level of confidence that the price of an item is generally what everyone is paying, these items are essentially commodities with a relatively standardized value. Throw that concept out the window for business valuations. You can and should use historic data and industry multiples to generate a business valuation, but more analysis is required to justify the value of a business. Location, industry, financial metrics, management team, historic operational decisions, amongst others are dynamic factors that can materially change the value of a business.
Case Study
Nikola Tesla owns and manages an RV dealership in Corpus Christi Texas. Nikola started the business in the early 80s and is considering retirement. He has grown the business from a small RV repair shop to what it is today, retailing new and used RVs and a comprehensive repair shop. Since 2010 his revenues have steadily increased and last year generated an EBITDA of $2 million. Nikola attributes his growth to retirees and historically stable oil business in and around the South, Texas.
Rosalinda Franklin also owns and manages an RV dealership, offering comparable services to Nikola’s, located outside of Seattle. Her business has grown because of the vibrant Seattle economy, population growth, and a large number of aviation manufacturing jobs in Puget Sounds. Rosalinda’s EBITDA is also $2 million.
Two comparable businesses but that “WHYS” behind the growth and historic performance are completely different. A comprehensive valuation will dig into and project how the justification for growth will change and affect business going forward. Take for example Rosalinda’s dealership, how and to what extent will Boeing laying off ~1,000 workers affect sales, or with Nikola’s dealership how will the increase in retiring people, 12,000 daily and nearly all “Baby Boomers” expect to retire by 2030, affect his business?
Why do you need to know the value
For most small business owners the majority, if not all, of their retirement is their business. Even if you do not plan on retiring or selling in the foreseeable future, it is smart business to know what is the value of your business and then work to increase its value over time. “That you can measure, you can manage.” Additionally, if a buyer were to make you an offer, you should know your valuation to better position yourself for negotiation.
Business valuations are not just completed for selling a business. They can be done for tax purposes, taking on an additional owner, working with lenders, estate planning, amongst other reasons. Moreover, a valuation helps businesses strategize for the future.
What factors go into the valuation
The factors that drive how much a business is worth generally depend on the type of valuation completed on the business. Different valuation methods will generally lead to different outcomes. The inputs of these methods range greatly. Moreover, within the methods, there are variations of inputs to triangulate how much a business is worth. For example, relative valuations can take an EBITDA multiple to derive one value and a user multiple for another value. Unfortunately, each valuation service provider will have their preferred methods to generate a valuation which they believe is an accurate representation of the business. Here are three methods to determine how much a business is worth:
An intrinsic valuation (Discounted Cash Flow) of a business, projects future cash flows forward then discounts the projected cash flows to the present value. This valuation takes into account sales projections, gross margins and operational expenses and how a business is turning assets into cash, the time it takes to turn over inventory, and the time it takes to pay obligations. This valuation method gives the company the power to create whatever future it deems possible. That being said, the validity of the valuation is only as reliable as the inputs. Sound justification of the inputs is required to support the projected future of the business.
Relative valuations are based on historic transactions. The market is the ultimate test and relevant transnational data are strong indicators as to what a business can be sold for. Relative valuations aggregate data from a peer group. The peer group should be comprised of comparable companies to the business being valued. Depending on the size and stage of the business, different multipliers are more suitable to apply to the business being valued. Common multiples are SDE, EV/EBITDA, EV/Sales, and EV/EBIT. The difficulty with relative valuations is (1) it is challenging to find data on applicable transactions, particularly with private companies, and (2) no two companies are the same. Applying a standardized multiple can be narrow-sighted and pigeonholes a business, making it out to be something it is not.
Case Study Continued
Nikola and Rosalinda’s dealerships are peers and have comparable financials. Nikola’s company appears to have taken on debt to grow/support the business and has invested in capital expenditures. He uses the business to pay for minimal personal expenses probably paying for a personal vehicle or two. His salary is modest but he lives in South Texas which does not have a high cost of living. Rosalinda appears to not like to use debt and has minimal depreciation, indicating she has not invested as significantly in capital expenditures as Nikola. Using Relative Valuation, applying a multiple to a certain metric of the business will lead to a value. Depending on the metric applied, the value of each business will either be the same or different. For example, a revenue multiple will lead to different values while an EBITDA multiple should lead to a similar value.
Liquidation is a valuation method that is typical for companies losing money and have a small chance of generating cash in the future. Value is derived by taking the book value of assets on the balance sheet, subtracting liabilities, and then adjusting the remaining value to market rates. Take for example a business with Accounts Receivable that has historically collected 80% of book value or a company vehicle that was fully depreciated via an expedited depreciation method, these types of adjustments are made to bring the value in line with the market. This business valuation method calculates a good baseline value for your business.
There are numerous other valuation methods than the aforementioned. Holistic evaluations take into account a variety of methods and inputs to generate a comprehensive value for the business. Knowing what the business is worth and what drives the value can help steer strategy in a manner that increases the value of the business in a more calculated approach. Running a business is challenging enough, leveraging information available can improve the probability of success.
What will buyers and investors consider in your valuation
Value is fluid and depends on the willingness of a buyer to pay. Buyers will look to negotiate on almost any value as such preparation is key. Depending on the buyer and the valuation methods used, different aspects of the business, and valuation will be negotiated. Negotiating is part of selling a business, valuations prepare business owners and buyers to address and value the strengths and weaknesses of a business. Once an agreement is reached it is almost certainly incumbent upon due diligence. When selling your business do not hide or withhold key data as the buyer will surely uncover it during the due diligence process and you’ll need to restart the negotiating process, with a more skeptical buyer.
Case Study
Mae Jemison owns and manages a Dentist & Orthodontist office in Decatur, Alabama. Mae recently had a valuation done of her business as she is considering buying a competitor and is looking to understand her valuation and determine how inorganic growth will affect it. Decatur, Alabama is a town of 55,000 people and has experienced stagnant growth over the latter half of the past two decades. The value of Dental and Orthodontic services has outpaced inflation and the general education level of the benefits of dental hygiene has increased significantly in the past five years. Revenue from Mae’s business has increased at 7% consistently through the last five years. Mae’s valuation projects revenue growth of 10% for the next three years then levels off at 4%.
Buyers and investors will look for patterns in the valuation to piece together the valuation’s logic. Considering the aforementioned example, if Mae foresees revenue growth, how will she achieve that and how will it affect the business? (1) will she need to decrease pricing to attract new customers (2) will she need to increase advertising to attract new customers (3) will she need to hire more employees to service the demand (4) will Mae need to invest in any capital expenditures to service the increased business (5) what if competition enters the market, how will stagnant growth affect the business. Investors and or buyers can ask what companies are in your peer group analysis and why they were selected. These are a few questions that buyers will consider when purchasing a business and entering into a negotiation. Sellers who have had regular business valuations will be able to provide meaningful answers effortlessly; they know the value of their business and where the value lies.
When to get a valuation done and how often are valuations needed
Coming to terms with selling your business is not an easy one. Many emotional factors play into this decision. Oftentimes, owners are forced into the decision to sell their business because of external reasons or the business has started trending downward. Waiting until you are ready to sell your business should not be the first time you have a valuation done of your business. It does not give you the time required to make changes to increase the value of your business. Investors and buyers will look at trends, combing through your historical financial statements.
A business valuation does not signal you’re selling in the next year, rather it depicts the price someone might be willing to pay for what is normally your greatest asset. A business valuation will point to how to increase the value of your business, addressing things like your cash conversion cycle, increasing profits, and generally should be the foundation of your business strategy. As you execute your strategy, the valuation will act as benchmarks to monitor your progress. Referencing your valuation as you make strategic decisions, such as: (1) how will buying the cross-town rival affect your business (2) should I add this product line (3) is building a new showroom worth the expense, is a more analytical approach to expanding your business’s operations.
Generally, getting a business valuation done every year to every other is a good idea and especially within five years of when you’re looking to sell your business. You will need time to implement change to increase the value of your business.
The finish line
A valuation is numerical data that supports the story of a business. Value is fluid and depends on the willingness to pay for each buyer and sell for each seller. Negotiating the value of a business is efficiently done when both parties have valued the business. There are numerous methods of valuing a business with each method more than likely leading to a different value. Business owners who know the value of their business are better able to measure the effectiveness of their strategy and increase the value of their business. Having a business valuation done every year to every other year is important and depicts how changes to operations are affecting the value.
