Planning Your Exit Strategy: Small Business Valuation

by Jeffrey Moses

Eventually most small business owners will need to calculate the worth of their business - for the purpose of sale, loan application, estate planning, net worth calculation, etc. Also, valuation is critical when deciding to purchase a business.

There are numerous valuation techniques, ranging from simple "rule of thumb" methods to more complex ratios that include asset valuation and industry average valuations.

1. Rule of Thumb Valuation. This method usually involves a multiplier to determine the worth of a business, projected upon the cash flow and profitability. Often, the base for the multiplier is termed "Earnings Before Interest and Taxes," or EBIT. "Earnings," in this sense, translates to "profit," not "gross income." The EBIT is multiplied by 3, 4 or 5 to determine the valuation of the business.

Why 3 to 5 as the multiplier? Because it can be expected that a business would earn back an investment in 3 to 5 years. The 3-times multiplier represents a return of 33 percent per year, while the 5-times multiplier represents a return of 20 percent per year.

The valuation of a business with few tangible assets would be calculated by 3, whereas a business with substantial assets and other attractive features would be calculated by 5. In some instances, multipliers of less than 3 or more than 5 could be used.

Another way to determine the projected cash flow and profitability of a business is what is termed "Owner Benefit." This is the discretionary cash flow that would be expected from the business for one year.

Discretionary cash flow takes into account the fact that most small businesses calculate income in such a way that income taxes are minimized. Many companies operate at low net incomes (or even negative net incomes), while they may actually be highly profitable. Discretionary cash flow is the amount of money that would actually be available for paying for the business and generating profit.

Note: the valuation of a small business has many variables and is never an exact science. Some tangible assets clearly increase the valuation (buildings, land, equipment, inventory), but the value of even these are often open to debate, based on appraised value, length of remaining life expectancy, importance to the operation of the business, etc. Other assets are highly subjective in value, including goodwill, customer base, location, length of time the company has been in business, barriers to entry (for new competitors), etc.

It's rare that the buyer and seller of a business come up with matching valuations. Compromise and negotiation begin with a comparison of valuations.

2. When businesses are asset-driven, such as retail stores, online or direct mail stores, manufacturing companies, wholesalers, etc., much of the valuation depends on accurately determining the value of these assets. Included in asset valuation are: Fair Market Value of Fixed Assets and Equipment, which is roughly how much it would cost to purchase comparable assets and equipment at current prices; and Inventory, usually at wholesale value. Asset valuation is normally added to Owner Benefit to determine the value of a business that is asset-driven.

3. Industry Average Valuation. This method uses valuations of comparable types and sizes of businesses that have sold within the last six to 12 months. At best, an industry average valuation produces a ballpark figure that can be a starting point for estimates of value. Variations that would affect industry average valuation include comparisons to the norm of: location, quality of assets, customer base, length of time in business, barriers to entry, goodwill, etc.

The approaches to valuation discussed in this article are introductory at best. When placing a value on your business, or on a business that you are considering purchasing, work closely with your accountant, business adviser, and business brokers to assure accuracy and practicality.