How Much Is Your Small Business Worth? Why the Purpose of the Valuation Matters
“How much is my business worth?”
It sounds like a straightforward question. Many business owners expect there should be a formula: enter the earnings, apply the correct multiple, and get the answer.
Unfortunately, small-business valuation doesn't work that way.
A business can legitimately receive very different valuations depending on why it is being valued, who is doing the valuation, what assumptions are being made, and what the resulting number is supposed to represent.
That's particularly important for an owner planning an exit. A technically sophisticated valuation isn't necessarily the same thing as a realistic estimate of what an outside buyer might actually pay for the business.
What Is the Valuation Actually For?
Before hiring someone to value a business, determine the purpose.
A valuation might be required for:
- A business sale
- A business acquisition
- Tax planning or transferring shares
- A shareholder dispute
- Divorce or other legal proceedings
- Investment purposes
- Retirement and exit planning
Different purposes can require different methodologies.
For example, valuing a minority shareholding for tax or legal purposes can involve questions about control and discounts. A court-related valuation may require a credentialed professional capable of defending the methodology.
But an owner asking, “What could I realistically sell my business for?” is asking a different question.
For that purpose, we use what we call a Most Probable Selling Price (MPSP) evaluation.
The objective isn't to produce the largest theoretical number. It's to estimate what an outside buyer might reasonably pay in an actual transaction.
Buyers Really Want Answers to Two Questions
When someone evaluates a small business for acquisition, there are two fundamental questions:
“What is the cash flow?”
And then:
“Will the cash flow continue after I become an owner?”
The first question helps determine what a buyer might be willing and able to pay.
The second can determine whether they're willing to buy the business at all.
That's why valuation cannot be reduced to multiplying earnings by a number.
A buyer also needs to understand customer concentration, systems and processes, owner dependency, employee relationships, competitive position, and where the goodwill of the business actually resides.
If most of the goodwill resides personally with the owner, for example, the historical cash flow may become less valuable to a buyer who isn't certain it will survive the transition.
Why You Can't Just Average Comparable Business Sales
Actual transaction data can be extremely useful.
If you're valuing a restaurant, for example, you can look at sales of other restaurants and examine what buyers have historically paid.
But you have to interpret the data.
Imagine finding a small café that sold for five or six times Seller's Discretionary Earnings (SDE). At first glance, you might conclude that comparable cafés deserve a five- or six-times multiple.
Then you discover the café generated only $13,000 of SDE.
What probably drove the transaction?
The espresso machine, refrigerators, counters, furniture, fixtures, and other assets may have been worth enough that the resulting sale price merely happened to equal five or six times SDE.
Simply averaging transaction multiples can therefore produce misleading conclusions.
As I often remind people, business valuation is not a cookie-cutter exercise.
Can a Valuation Be Mathematically Correct but Still Wrong for Your Purpose?
Absolutely.
A spreadsheet can contain perfectly correct mathematics and still produce a number that isn't useful for the question you're trying to answer.
I encountered this with a restaurant owner whose accountant had completed extensive valuation work and concluded that the business was worth approximately $1.6 million to $1.65 million.
When we normalized the financial statements for an MPSP evaluation, we calculated approximately $230,000 in SDE.
Our estimate of the most probable selling price was approximately $571,000.
That's an enormous difference.
It doesn't necessarily mean somebody couldn't create a methodology that mathematically supported the higher number. The problem was whether an outside buyer in the small-business marketplace would actually pay it.
That distinction becomes critical when the owner is building a retirement plan around the expected proceeds from selling the business. Pasted text
Be Careful About Valuations Based on Future Growth
Another situation involved a buyer examining a company that sold and installed materials used in housing.
We calculated approximately $113,000 in SDE based on the company's current performance. Even if the business returned to previous performance levels, we estimated SDE would be approximately $242,000.
The seller had received a discounted cash flow valuation estimating enterprise value at approximately $1.5 million.
The mathematics wasn't necessarily the problem.
The assumptions were.
The valuation assumed substantial future revenue growth while cost of goods sold and overhead remained relatively constant.
For a small owner-operated business, there's another problem with paying for projected growth.
“If you think you can grow the business, why would you make that growth part of what you pay the seller?”
If the buyer will be doing the work required to generate future growth, the buyer will generally want the purchase price to reflect what the seller has already built—not all the improvements the buyer hopes to create afterward.
That's why forward-looking analysis in an MPSP evaluation is generally limited. When appropriate, current year-to-date performance might support a forecast of the current year, but that is very different from pricing years of assumed future growth into today's valuation.
Why an Unrealistic Valuation Can Damage Your Exit Plan
An inflated valuation doesn't just create disappointment when you eventually list the business.
It can distort years of financial planning.
If you've been told your company is worth $1.6 million, you may start planning your retirement as though $1.6 million will eventually become available.
But if the actual market of qualified buyers is closer to $600,000, your retirement plan has a major hole in it.
That's why owners should investigate probable selling price years before they intend to sell.
Discovering a valuation problem early gives you time to do something about it.
How Can You Increase the Value of Your Business Before Selling?
An early MPSP evaluation can identify areas that may make the business more attractive to buyers.
One tool we use is a Locus of Goodwill analysis, which looks at whether goodwill resides primarily with the owner, the company's brand, or its location.
Benchmarking can also identify operating improvements.
Suppose your gross margin is two percentage points below comparable businesses in your industry.
If you can improve purchasing, bidding, or pricing and permanently increase gross margin by two percentage points, that additional profit can flow to the bottom line.
Now apply an appropriate valuation multiple to the improved cash flow.
You've potentially increased the value of the company while also enjoying greater profitability during the remaining years you own it.
The Best Time to Learn What Your Business May Sell For Is Before You Need to Sell
Most small-business owners are experts at operating their businesses.
They're not necessarily experts at selling them.
That distinction matters.
If you're planning an exit, don't begin with the question, “Who can give me the highest valuation?”
Begin with:
“What type of valuation answers the question I actually need answered?”
If the goal is to sell the business to an outside buyer, you need to understand the cash flow a buyer will recognize, whether that cash flow is transferable, what comparable transactions indicate, and what deal would realistically make economic sense for someone on the other side of the table.
Knowing that several years before your exit gives you something even more valuable than a number.
It gives you time to improve it.
Find Out What Your Business Could Realistically Sell For
If you're considering selling your business now or planning an exit several years from now, David and the ALP team offer Most Probable Selling Price evaluations as part of their seller and exit-planning services.
The process can help you understand normalized cash flow, probable selling price, where the goodwill resides in your business, and areas you may be able to improve before going to market.
Learn more about preparing and pricing your business for sale:
https://howtosellmyownbusiness.com
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