How Much is a Business Worth
The short and quick answer to the question “How Much is a Business Worth?” is that it is worth the greater of the value of its earnings (further explained below) or the fair market value of its assets.
Whether you are a prospective seller, a prospective buyer, or an investor, it is important to understand how business worth is determined. Rest assured, it is best for each of the aforementioned parties if the business valuation determined using the multiple of earnings method exceeds the fair market value of the business’ assets. That means the business is profitable and the assets are being used efficiently to create more cash flow than the assets themselves are worth.
Determining Business Worth
Profitable companies are valued using a multiple of earnings. For smaller businesses (with earnings between $50,000 and $1,000,000), a multiple of 1 to 4 is applied to seller’s discretionary earnings. For larger businesses (with earnings between $1,000,000 and $10,000,000), a multiple of between 4 to 8 is applied to EBITDA.
Seller’s discretionary earnings and EBITDA are indeed related to each other, though there is a slight difference. EBITDA is defined as Earnings Before Interest Taxes Depreciation and Amortization. Seller’s discretionary earnings is equal to EBITDA plus owner’s compensation and owner’s perks. There can be the need for further adjustments to either EBITDA (known as Adjusted EBITDA) or seller’s discretionary earnings to “normalize” a company’s operating results. There are many factors that go into this calculation, so it is important to learn more by reading about Add Backs for Business Valuation, Earnings Multiples for Small Business, and EBITDA Multiples by Industry.
Implications of not Understanding Business Worth
For prospective sellers, it’s critical to determine the fair value of your business. If you underprice the business vs. its fair market value, you’d obviously be leaving money on the table.
However, there are downsides to overpricing a business, which may be contrary to immediate thought. As a business owner, you may think: “I’ll start with a high price to provide negotiating room.” But that approach can be counter-productive because serious buyers tend to simply pass on businesses that are overpriced due to fear the seller has unreasonable expectations. For more information, read Issue #11 - The Importance of Setting a Realistic Offering Price.
Ultimately, the best course of action is to price a business realistically and facilitate the transaction process. Sellers should consider reaching out to business brokers, many of which offer no charge, no obligation evaluations to determine how much a business is worth. To identify qualified business brokers, read Issue #13 - Choosing a Business Broker/Intermediary.
For buyers and investors, undervaluing a business runs the risk of insulting the business owner, which may preclude the possibility of acquiring a good business. Obviously, buyers and investors must know how much business is worth to avoid overpaying and adversely affecting the return on their investment in the company.
ATTENTION: Business Owners & Prospective Sellers!
For a more in-depth explanation of how to value a business, check out these 6 articles featured in the How to Sell a Business Newsletter Series. There may be nothing more important to a successful sale than your full comprehension as to what your business is worth and how your company value will be determined. Following is a brief description of the 6 articles:
Newsletter Issue #6 - How Small Businesses Are Valued Based on Seller's Discretionary Earnings - Explains SDE and contains a chart of SDE multiples by business size.
Newsletter Issue #7 - SDE vs. EBITDA vs. Adjusted EBITDA Leads to Multiples Confusion - Explains the importance of specificity in describing “earnings” to avoid confusion when choosing a valuation multiple.
Newsletter Issue #8 - An Example of SDE vs. EBITDA vs. Adjusted EBITDA - Explains by example how one company with the same valuation has 3 different multiples. Hint: the multiple depends on the measure of earnings.
Newsletter Issue #9 - A Seller's Discretionary Earnings (SDE) Worksheet - Contains an example of an SDE worksheet with 29 add backs.
Newsletter Issue #10 - SDE and Business Valuation Variations amongst Sellers, Buyers and Lenders - Explains how a seller, a buyer and a lender arrive at different business valuation conclusions based on their acceptance or rejection of the 29 add backs in Newsletter Issue #9.
Newsletter Issue #11 - The Importance of Setting a Realistic Offering Price - Explains why it is counter-productive to overprice a business for sale.