When selling a business, one of the first questions that comes up is: “What is my business worth?” There are two ways to answer this question- the short way and the long way.
The short, simple, straightforward answer is: a business is worth what the market is willing to pay.
How often have you heard someone say, “nobody is worth that much money!” You hear it when people are referring to professional athletes, hedge fund managers, actors, and other individuals who make annual salaries that are incomprehensible to most of us. While this is a natural reaction, I would suggest that they are easily worth that much, and in some cases, more. In many professional sports leagues for example, there is a cap which limits how much teams can spend on salaries (without incurring a crippling tax). While a cap is conducive to maintaining the integrity of the game and putting a premium on strategy, it is not a free market. If it were, the team owner willing to spend the most money wouldn’t have any tax restraints and would therefore be able to pay an unlimited amount of money for any given player. Simply put, when someone says “nobody is worth that much money!”, I would argue that they are wrong. Some teams, some investors, some fans, etc. are more than willing to pay the going price- and that, by definition, is the market value. The same goes for the world of business acquisitions in that a business is worth exactly what someone is willing to pay for it.
Although the above is true, most people do not find this answer to be necessarily helpful or fulfilling in terms of determining a baseline price estimate. For that reason there is a longer, more involved, answer to the question “What is my business worth?”:
At the outset, it’s crucial to determine a range within which potential buyers (i.e. the market) will be interested; one that satisfies all parties involved. A common misconception when it comes to determining a business valuation is that the value needs to be a firm number. This is simply incorrect- for a couple reasons. First, if you underprice your business, it will be attractive to a lot of buyers (all else being equal) and it may sell quickly. By doing this you might miss out on selling it for a higher price had it been properly priced. Second, if you overprice your business, you may deter serious inquiries and your business may remain on the market, untouched. For these reasons, it is important to determine a fair market value range, select a starting price within that range, and be willing to adjust your price to buyer demand.
Sounds simple, but how do you determine a range? Well there are a number of different methods you can use to establish a range- no one being better than the other. The goal in this exercise is to begin with a simple range and then refine it by applying more variables.
A common way to determine a price range is through the EBITDA valuation method, which relies on a multiple of EBITDA to determine a company's value.
To start, you’ll need to determine the company’s EBITDA- or in layman’s terms, gross profit. EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It is calculated by subtracting expenses from revenue (excluding interest and taxes) without depreciation and amortization (what you pay for tangible and intangible assets).
The reason this number is so important is because earnings, at their purest form, is what makes a company valuable. The other items mentioned above (interest, taxes, etc.), can cloud a business’s true earnings and ultimately affect its valuation. For example, imagine a business saddled with debt. Most debts, especially high interest debts, could make that business appear very unattractive on the surface. However, if the business is able to remove the debt, perhaps by way of new owners paying with cash or borrowing at a low interest rate, the business could actually turn out to be rather lucrative. The point is, when doing a valuation, we want to strip away any unnecessary items in order to get to the central value created by the business.
Once the EBITDA has been determined, the next step is to look at an item called a ‘selling multiple’ to determine its valuation. Updated lists of these specific multiples, sorted by industry, are easily accessible online. For the basic calculation, you want to take your predetermined, recent EBITDA figure and multiply it by your industry’s ‘selling multiple’. As a rule of thumb, most established businesses are priced between two and five times EBITDA (often shown as 2-5X). Again, by way of example, a business with an EBITDA of $100,000 could potentially sell anywhere from $200,000 to $500,000 (i.e 2-5X EBITDA).
Note that these multiples are simply guidelines and there are various factors that can increase or decrease a given multiple and therefore the valuation. Distressed businesses typically go for less, and firms that appear to have potential for high growth generally sell for more. Some examples of variables that can affect selling multiples include but are not limited to location, whether or not the business is growing, how secure the customer base is, overall size, and how long the business has been profitable. As a result, each of the these variables can push the selling multiple in a positive or negative direction. It goes without saying that an increase in positive factors will correlate to higher multiples.
One quick thing to note is that very small businesses (stable revenue under $100K), are likely to trade closer to one times EBITDA. The reason being is that, typically, these businesses are primarily owner operated. In such cases, it is important that the existing owner’s salary (if applicable) is included in the price as the new owner may not want to work at the business and will need to hire someone to take over the previous owner’s position.
Since there are many inputs and the price range can vary quite a bit, a good way to double-check that a business’s valuation is in the right ballpark is to use a comparable. Similar to the way real estate appraisals are done, looking into comparable businesses for sale within a similar industry can be informative. These comparables can act as yet another benchmark in determining a fair and competitive sale price for your business.
One crucial thing I want to address is this: accurate or not, many business people have a number in mind prior to beginning the pricing process. They know exactly what the business generates and they know how much work is involved in making the wheels turn. Be careful not to confuse the ‘potential’ of the business or how many hours you have put into it, with the selling price. As humans, we are all susceptible to psychological biases in that we greatly value the items we own, particularly when emotionally invested. For this reason alone, it’s a good idea to get a second opinion. Selling a business can be a huge undertaking. For many people, it can be the largest transaction they will ever make. There are professionals out there who can assist you in determining an appropriate pricing strategy. Just as you would obtain an appraisal on your home prior to selling it, you can get a valuation of your business by a certified professional to ensure you are on the right track. Such valuations generally cost less than $2,000 for small businesses. The cost can be higher for larger, more complex businesses.
That being said, the above mentioned tips can definitely help you determine your sale price range. As mentioned in the beginning, it really comes down to what the market is willing to pay. As a responsible seller, you should determine a fair market range (rather than a set price) and be prepared to sell within that range. Hopefully these guidelines will help make your business transaction proceed smoothly and ease any potential seller’s remorse by knowing you have done your homework and are getting a fair price for your business.