If you were to sell your small business right now, how much would a buyer be willing to pay for it?
The answer involves more than just the current worth of your assets and revenue. It also takes the viability of your business — its potential to generate profits in the future — into consideration.
For many small business owners, that’s an unknown that they have a hard time figuring out. But it’s something a prospective buyer needs to know before they make an offer.
Even if you’re not selling your business anytime soon, it’s important to know its value in the open marketplace. If you’re doing any retirement or estate planning at all, you need to know how much you can expect to live off the sale of your business in the future.
Knowing your business’s value also helps you understand the factors that contribute to it. You can identify aspects and items that drive value and address issues that detract from it. You can fine-tune strategies and discover opportunities for future growth.
It’s a little surprising how many business owners don’t know the true value of their business. At the same time, it’s understandable. There are myriad factors and complexities in estimating financial worth. It’s a daunting task to assume on top of day-to-day operations.
But the process for estimating your business’s value is, at least, relatively easy to explain.
The first step in determining your business’s value is to calculate the worth of what the business owns.
This evaluation includes equipment, fixtures, vehicles, supplies — anything your business needs to run. These are tangible assets, things that anyone can buy on the open market. Their value is fairly easy to determine.
You may also have some intangible assets that contribute to your business’s intrinsic value. These include trademarks, copyrights, patents, brand recognition, contracts, trade secrets, intellectual property, and other items generally referred to as “goodwill.” These factors can be difficult to express in numerical terms, but they’re important. Talk to a business lawyer to find out how to value them.
Next, calculate all your outstanding debts, liabilities, salaries, and business expenses. Subtract the total from the total worth of your assets. The result is your business’s net worth.
Potential buyers of your small business aren’t just interested in obtaining your assets — they also want to know how much income it will generate.
However, in determining your business’s value, you need more than historical results. One single year of income reports doesn’t tell the entire story buyers need to hear. They also need to know, if they buy your business, how long they can expect the business to stay open — and how much they’ll earn in revenue.
To arrive at this information, you need two components: your business’s SDE and a multiple.
Seller’s discretionary earnings (SDE) is the small business equivalent of a large corporation’s EBITDA: Earnings Before Interest, Taxes, Depreciation, and Amortization. When a big company computes its EBITDA, they take their net profit as reported to the IRS and add back in all those items. The result is their pure net profit, a good estimation of the company’s true value.
SDE works the same way, with a couple of significant differences. In addition to a small business’s net profit, plus taxes, interest, depreciation, and amortization, SDE also includes the business owner’s salary and personal benefits.
Salary is included in the SDE because it reflects how much money the prospective owner can expect to earn. Personal benefits are included because most small businesses report things like travel, entertainment, company outings, remodeling, charitable contributions, and other one-time expenses in their tax filings. They don’t strictly relate to business operations, but they add value to the owner in some way.
Compute your earnings before tax and interest. Then, add back in your personal salary and discretionary purchases. That’s your net income. Then subtract future debts and liabilities, and you have your SDE. Potential buyers may well want to know this information, so it’s a good idea to have it handy.
The SDE by itself doesn’t equal the total value of your business — just the number that’s on the books. There’s an additional component that accounts for factors like growth, time in the business, customer base, location, and industry standards. It’s called the SDE multiple.
The SDE multiple is an indicator of a small business’s attributes and market presence. There are no set guidelines for the SDE multiple; they vary from industry to industry.
Generally speaking, businesses with higher multiples have consistent growth, longevity, broad customer bases, long-term employees, desirable locations, favorable lease agreements — intangible attributes that add to their worth.
A business may have a lower multiple because it hasn’t been around long, has fewer customers and employees, has incomplete or questionable accounting, has tough competition, or other factors.
For the vast majority of small businesses, an SDE multiple between 1.5 and 3.5 is usually justifiable. But, as mentioned, it can be an elusive figure to determine. The best approach is to retain the services of a business consultant or appraiser with expertise in the industry and local market.
Multiply your SDE by the corresponding multiple, subtract any debts and liabilities you haven’t already accounted for, and you have a good representation of your business’s market value. The eventual buyer will be the final decider, of course, but you have a solid number to start with.
When you begin the process of evaluating your business’s value, have these pieces of information on hand:
Include any relevant information you might have beyond this list, too. The more data you have, the more precise your final valuation will be.