You’re either ready to sell your business or considering it for the first time. Understandably, one of the biggest questions you have is one of the most common: how much is my business worth?

The total value you receive for your business may vary depending on economic factors, the premise and standard of value selected, and the valuation method applied. But the true value of any business is its ability to generate future cash flows.

If you want to value a company’s ability to generate future cash flows you need to understand a variety of factors. You can’t simply rely on multiples, you need to understand the business — the products and/or services it offers, its position within the industry, types of customers it has, its competitive advantages and more.

Benefits of a Professional Business Valuation

If you want to understand the value of your business in the current market environment, we highly recommend hiring a business valuation expert. No two businesses are exactly the same, and a valuation expert is an outside party who understands the entire valuation process and has the necessary experience to examine all areas of your business to determine its true value in today’s market.

There are a number of credentials that can help you identify a certified valuation professional. I choose to hold the CVA (Certified Valuation Analyst) designation, but other valuation designations include:

  • CBA (Certified Business Appraiser)
  • ABV (Accreditation in Business Valuation)
  • ASA (Accredited Senior Appraisal)

In addition to discussions with management to understand qualitative factors, a valuation expert will also perform research to fully understand competitive advantages the firm may have, current industry dynamics and the current economic environment in order to more accurately assess the current market value.

Besides helping determine how to price your business for sale, a thorough valuation can also help identify key value drivers and areas that could be enhanced in order to increase business valuation. A good valuation can also serve as an operating dashboard to ensure you are meeting goals and enhancing business value in the future.

Multiple Approaches to Valuing a Business

There are 3 different approaches to valuing a business, and multiple methods within each approach. We don’t need to cover all of the methods in detail here, but it’s important to provide a high-level overview of each approach so you know what to expect when selling your business.

Asset Based Approach to Valuing a Business           

This approach calculates value by adding up all the assets of the firm and subtracting all of the liabilities.

This approach is good for estimating the value of a non-operating business — like a holding company, or a business that continues to generate losses. A “non-operating” business does not manage any assets or directly conduct any business whatsoever. As an example, the business may simply collect money and distribute it to the appropriate parties.

Many use the asset approach to set a floor value when determining business valuation. Because if the price offered for a business is lower than the value of its assets minus liabilities ($1,000,000 in this example), then anyone could just buy the business, liquidate all the assets, payoff the debts and be left with more than they paid.

So, for businesses that are able to operate profitably into the future, you will want to value the business as a going concern and the asset approach should not be relied upon.

 Market Approach to Valuing a Business    

The idea behind the market approach is that the value of a business can be determined by reference to reasonably comparable guideline companies (“comps”) for which transaction values are known.

This is where people use multiples when selling a business. Multiples are simply the result of dividing an actual selling price by a financial metric common to many firms. Although we can calculate them on a variety of numbers, the most commonly used multiples when selling a business are revenue multiples and cash flow multiples.

One of the problems with using this approach for small to mid-sized private companies is that not all transactions report their data, which leaves us with an insufficient amount of information on which to make an assessment. Insufficient data often leads to inaccurate multiples.

In addition, no two businesses are exactly the same, so relying on a multiple for one business does not imply that multiple is the right one to use for another business – even if those businesses are the same size, in the same industry or both. Even if you think your multiples are accurate, you need to understand if those apply to last year’s numbers, training 12-month numbers, annualized run rate numbers or other before you can accurately use them to determine price when selling your business.

Here are a couple simplified examples to show how two businesses, even though they are the same size and operate in the same industry, may have different multiples.

Let’s start with revenue multiples:

 If we simply relied on a revenue multiple to value these companies, we may see that each company has the exact same revenue and operates in the same industry, therefore concluding that we could use the industry revenue multiple of 1.2x to determine valuation for each company.

But what if one of the companies had some form of competitive advantage (lower cost to manufacture, more efficient workforce, higher brand image, etc.) that allowed them to obtain 30% profit margins. Meanwhile, the other company had a less trained workforce, older machines, and hadn’t yet developed a brand image, which resulted in them having only 15% profit margins.

Clearly these two businesses should not be valued the same, which is why we can’t rely solely on revenue multiples.

 Now let’s look at cash flow multiples:

 Note: Many people use EBITDA (Earnings Before Interest, Taxes, Depreciation & Amortization) as a consistent measure of cash flow between different industries. So, in our examples we use EBITDA multiples.

For this example, we assume the two companies have the exact same revenue and profit margins (unlikely in reality). If we relied solely on the 5x industry EBITDA multiple for companies of this size, we would value both companies at $25,000,000.

But what if one of the companies had only been growing at 1% per year for the past few years (or worse) and was expecting similar growth (or worse) in the future. Meanwhile the other company had been experiencing annual growth of 7.5% (or higher) and expected similar growth (or even better) in the future.

In this example, we just laid out one factor —  growth — when there could be many others. But you can see that a prudent buyer would not pay the same amount for each of these businesses, nor should he.

If you feel your business is exactly like all of the other businesses in your industry, then multiples may be fine, but most businesses are unique in one or multiple ways. So, while multiples may be a great starting point for initial discussions, and may be used as a point of reference when comparing to other firms in the industry after you determine actual value, you should not rely solely on elementary math from a limited data set when you’re determining how to price your business for sale.

Note: Recently there has been a lot of focus on recurring revenue businesses, including some software businesses. Many of these businesses have very similar business models and are highly scalable (adding additional customers and revenue results in almost zero additional costs).

 Due to these facts, buyers have been simply relying more on multiples of recurring revenue to determine how to price their business for sale. Although still not 100% accurate, it has become more acceptable due to the business models and scalability of these companies. In our opinion, we will see this evolve in the near future to reflect differences in business models, operating costs and competitive advantages.

Income Approach to Valuing a Business    

The income approach, and in particular the Discounted Cash Flow Method (“DCF”), is the methodology we place the most weight on when determining how to value a business for sale. This is because the DCF measures the value of a firm’s ability to generate future cash flows. It does this by understanding the uniqueness of each company and capturing the economic dynamics of the business.

Here’s an example of what a discounted cash flow valuation may look like:

Here’s a brief overview of the steps involved in the DCF process and how it determines value:

(There is a lot of detail within each of these steps, but that is beyond the scope of this guide)

  1. Determine estimated future cash flows for the business
  2. Determine a terminal value by assuming a terminal growth rate
  3. Determine a discount rate to reflect the perceived level of risk to future cash flows
  4. Discount the projected future cash flows, and terminal value, back to today then sum those values.

Step 1 includes a lot of work to understand why historical numbers were as shown, determine accurate adjustments to “normalize” the numbers and prudently estimate future projections as accurately as possible. There are a number of factors that impact this assessment and utilizing a professional with experience valuing a number of firms over various time frames can make a major difference.

Steps 2 and 3 use a variety of economic data as well as industry and company specific data to determine both the terminal growth rate and the discount rate. Step 4 simply applies calculations to arrive at a valuation.

A valuation expert will take the time to gain a thorough understanding of the business, through conversations with the owner and reviewing years of detailed financial information. They also use that info to understand key drivers, research industry dynamics and evaluate the current economic conditions in order to develop educated assumptions for the future

One common criticism of the DCF valuation is that it relies on a lot of assumptions, and therefore the valuation is only as good as the underlying assumptions that were made. In addition, it is nearly impossible to predict what the actual numbers will be in the future. While these criticisms are correct in theory, there is a lot of expertise that goes into the process of making assumptions and projecting financials. This is why it is so important to use a valuation expert to perform a professional valuation of what your business is worth in the current market.

So, while the income approach doesn’t come without potential limitations, many agree that it is the best way to assess the unique factors of each company and it’s why we at Your Legacy Partners give this method the highest weighting when performing our valuations.

Factors That Impact Business Value

While there are many factors that can impact the value of a business for sale, too many to discuss in detail here, below you will find an overview of a few of the more common categories for you to consider as you determine how to price our business for sale.

Revenue Types, quality, growth, recurring nature, predictability
Profits Amount, margin, growth, consistency
Customers Quantity, type, concentration, contract, churn
Products & Services Quality, consistency, price, mix
Employees Number, efficiency, tenure, turnover, compensation, management
Competitive Advantages Economies of scale, operational processes, branding, technology, location
Growth Historical, opportunities, projections, resources needed to execute
Competition Number & size of competitors, barriers to entry, positioning, market share
Technology Systems used, quality, innovation, patents
Capital Expenditures Historical, projected, requirements to grow

Having sat on the buying side of the table for numerous years, we have deep insight into what buyers look for and use that to help our clients who are selling a business get the highest price possible.

We also have an article on “What Buyers Are Paying More For In Today’s Market” which can be found by clicking this link.

The importance of understanding an accurate value of your business in today’s market will help you when evaluating offers later in the process to sell your business. Like many owners, this is possibly your most valuable asset.

One that you’ve dedicated countless hours and multiple years of your life to. There are a variety of things you’ve done to make your business unique and you should settle for nothing less than a thorough and professional assessment of your company, in the current market, in order to determine how to price your business for sale.

Selling a business can be difficult, time-consuming, and frustrating. Before you take the plunge, prepare yourself by reading our 70+ page ebook, The Ultimate Guide on Selling Your Business. Still have questions about selling your business? You can contact us here.