Jack has been working for himself since the day he graduated from high school. His summer gig of mowing lawns for his neighbors grew into a landscaping company.
Fast forward forty years. Jack’s Lawn Service started getting so many customers that he had to hire on a team. Now, he leaves the administrative side of things to his office manager, and a dozen of Jack’s trucks drive around town.
Jack has loved the journey of growing his business, but he’s getting older now and he is ready to think about retirement. Jack has given his blood, sweat, and tears for his business, and he has sacrificed more time with his family than he would like to admit. Finally, Jack believes he can cash in on all his hard work. He lists his business for $1 million. After weeks go by without as much as a single call, Jack finally gets some interest…
…from a buyer who wants to buy his business for $300,000. Less than a third of what he listed his business for. The investor says his offer is fair because it is a 2X multiple on the $150,000 of annual profit Jack makes.
Jack hangs up the phone because he’s disgusted by the low offer. So many business owners find themselves in this unfortunate situation. After growing their business, business owners (who become sellers) don’t truly know how to value their business.
Can you see parts of yourself in Jack’s story?
Understanding business valuations prevent these situations from happening and protects the interests of both the buyer and seller.
What is a business valuation?
Valuation is the process of assigning value. It is a measure of worth that is arrived upon using standard formulas. Business value comes from assets, processes, financials, profitability, and systems. Prices for business are determined using simple math formulas.
Sellers often view their business in terms of the future, but buyers are concerned with more than that. Buyers examine historical data, current data, and projections for the future. Valuation finds a balance using a combination of this financial data and industry data.
How do you determine a business valuation?
Business valuation = (Profit/EBITDA/SDE) X an industry multiple.
There are two ways to determine revenue. One way is EBITDA. EBITDA is an acronym for Earnings Before Interest, Taxes, Depreciation, and Amortization. In other words, it measures exactly how much money a business made without considering expenses.
Some businesses do not have depreciation and amortization because they do not have physical assets. In that case, use another revenue metric called SDE. SDE is an acronym for Sellers Discretionary Earnings. This is a metric of what the seller has left over after expenses, and it is the most common valuation for small businesses.
EBITDA and SDE are both net profit. Elecor, Inc. uses one to three years of financial data to determine both of these numbers. The length of financial data depends on the investor’s preferences. Elecor believes that recent data is the most relevant. Three years of financial data are considered to identify trends, but an offer is typically made on the last twelve months of data.
Next, multiply the profit metric (EBITDA or SDE) by an industry multiple. There are public charts that determine multiples for every type of business in the industry.
Here is an example: https://www.eval.tech/valuation-multiples-by-industry
Each year or financial quarter, new charts get published. The charts are specific to each region of the world. Each chart consists of an alphabetical list of industries with numbers (multiples) beside them.
When choosing a multiple, be sure to use an up-to-date chart for the right region of the world. Some multiples are very high. Others are very low. Regardless of how big or small the number is, accurate multiples produce fair valuations.
Here’s how it works:
Let’s say the EBITDA of a large plumbing company is $5 million. For the right region and the right time, the multiple for the plumbing industry is 3.
Business valuation = EBITDA or SDE x Multiple.
In this example, $5 million (EBITDA) x 3 (multiple) = $15 million. The business is worth $15 million, and that would be a reasonable asking price.
Why Valuation Matters
Valuation determines what a business is doing. Buyers are not concerned with how the business has done or what it can do. Buyers have to make levelheaded decisions based on what the business is doing.
For example, in the year 2020 thousands of businesses expected to have a banner year. Businesses that were thriving in January 2020 had already closed their doors by the fall of that year because they could not weather the economic impact of COVID-19. Valuation prevents buyers from overpaying for potential earnings that may never happen.
Elecor still uses the past twelve months of financial data to measure business valuation. External factors, such as COVID, elections, or even natural disasters, can be very telling about the health of a business. How does a business operate in crisis? Those are key trends to watch.
Understanding Valuation
Real estate is a common example of valuation that people use in everyday life. Comps (the selling price of other homes nearby) determine property value.
If all comparable houses on Daisy Lane have sold for $300,000 in the past year, that number is a good estimate for price per square foot. This is a fair valuation because the data is recent.
One homeowner on Daisy Lane has spent a fortune upgrading the kitchen and backyard. With these add-ons, a $600,000 asking price for a house on Daisy Lane is still unreasonable because internal upgrades in a home don’t matter, what matters most are the comparables (comps) paid for other houses nearby.
Many businesses have acquired hundreds of awesome reviews or thousands of active followers on social media, but business valuation does not necessarily consider every aspect of a business that makes it unique.
Business valuation considers profits, assets, and industry multiples. Value is always determined by the buyer because an asset is only worth what someone is willing to pay.
Where is the range of fairness?
Fair valuations are easy to explain. An investor can show a seller the exact industry multiple they used. A seller can back up an EBITDA value with financials.
Elecor encourages sellers to list their business for a range, rather than a single asking price. This facilitates negotiations that will be reasonable to both parties.
The lowest end of the range should be the price that the seller must walk away with, and the higher end of the range can be a little higher to allow for wiggle room in negotiations.
Disadvantages of Poor Valuation
An improper valuation is not fair to both parties. If the selling price is too low, the seller is not properly compensated for their hard work. If the selling price is too high, the investor cannot make a return on the investment. Elecor avoids these negative outcomes by creating win-win situations that address the needs of both parties.
Often, valuations that are too high or too low prevent a deal from happening before they even start. If a valuation is way too high, many investors will not even give the business a second look.
If the valuation is too low, this can also make investors wary. Just as in the housing market, an extremely low valuation is a red flag that makes buyers believe there is something wrong with the asset.
Low valuations can happen when a seller is very motivated. They could also signify a serious problem with the business. While a low valuation may not be the demise of a deal, it can cause the investor to ask serious questions.
Valuation assigns a fair value to a business using current data on profit and industry standards. Proper valuation is provable and fair to everyone.
Valuations that use common standards and proper multiples is a simple math equation. Either party can explain how they arrived at a certain valuation in a matter of minutes, and they can provide sources to support their view.
Valuation Quotes
“Managers and investors alike must understand that accounting numbers are the beginning, not the end, of business valuation.” – Warren Buffett
“Nothing turns off an investor more than when an entrepreneur comes in with a ridiculous valuation.” – Kevin Harrington
“Selling, in particular, can be a challenge; many investors are tempted to become more optimistic when a security is performing well. This temptation must be resisted; tax considerations aside, when a security reaches full valuation, there is no longer a reason to own it.” – Seth Klarman
More Resources
https://www.entrepreneur.com/article/66442
https://www.thehartford.com/business-insurance/strategy/selling-a-business/determining-market-value