Valuations of small businesses are complicated by several key factors and they are not scientific; it’s much more of an art. First, most are owner-operated businesses. The seller has typically put in years of sweat and hard work. They are emotionally tied to the business and so when the time comes to sell, logic usually goes out the window. Typically, what an owner thinks their business is worth, rarely has anything to do with its value.
Next , the buyer on the other hand initially approaches the valuation entirely from a black and white perspective. For them it is a matter of determining an acceptable return on investment versus other opportunities and secondly, making sure that the business type itself is one that they are capable of running. Regarding an ROI, on one end of the scale a buyer can put their money into an ultra-conservative investment and generate an insignificant, yet safe return. The other end of the scale is going to Las Vegas and plunking it all down on 17 black and praying for the best. For that risk, a 35 to 1 return makes sense. Buying a business has to fit somewhere in between and should return 15 to 33 percent for a buyer’s cash investment. Insofar as determining whether the business is right for the buyer, their valuation can be swayed if they begin to falling love with the idea of owning a particular business.
Then buyers and sellers have to look at the opportunity! Does the business for sale have a very large upside - can it grow substantially with some new capital, effort and attention? Most buyers are looking for this and will pay outside the regular formula of x times EBITA. Too many buyers just look at a multiple of EBITA and not the opportunity and too many sellers just look at the opportunity and not the reality if their EBITA.
Unlike real estate where sales of similar property types determine the market prices, no two businesses are the same and therefore comparable sales or “Rules of Thumb” valuations are not very effective. That aside, comparing like business sales can eliminate some of the marketplace confusion.
Finally, when you add in all of the intangibles of a typical small business - a lack of any substantial hard assets, the unusually high percentage of Goodwill in a typical sale, and the common issue in owner operated businesses where the seller is often “the business”, it can be a major challenge when buying a business to nail down a proper valuation and avoid overpaying. Despite the fact that no two businesses can be exactly the same, examining the range of multiples paid from business across sectors can give a buyer some insight into prices paid. \
While there are a number of valuation methods that can be applied, the most common and effective methodology is the income multiplier method, or, to put it simply: it’s a formula by which a multiple is attached to the company’s profit so that a buyer pays x times that profit. With that in mind, the two critical factors to arrive at a prospective purchase price are (a) what number should be multiplied and (b) what multiple should be used.
Getting to the actual number to be multiplied can be a challenge in a small business. Since the financials of most small businesses are structured to lessen the tax burden, one must really dig into the numbers to determine how much profit the business is actually making. It requires a detailed analysis and adjustments, which are commonly referred to as “add-backs” all of which fall under the umbrella of “Owner Benefits”. The terminology can vary (i.e. Seller’s Earnings”, “Adjusted Income”, etc.) but the components are the same.
Overall, there are many factors that go into the pricing of a business for sale but the cornerstone of common sense still must stand true. Real financials showing an accurate profit, solid business with strong steady past, a business NOT relying on the owner & perhaps most of all, a business that is on stable footing with exceptional opportunities to grow. Hopefully the owner has put thought into how to grow the business, however, the buyer or broker may have ideas on how the business can scale IE. franchising, multiple locations, etc. Remember, the goal is to buy a business you can sell, not buy a job!