Do You Know How to Determine the Value of a Business?
Expert Advice
Business brokers help arrange the sale and purchase of businesses every day. These experts know how to determine the value of a business based on numerous methods and formulas. Through careful analysis of financial records, debts and liabilities, asset appraisals, and consideration of numerous intangible factors like age of the business, intellectual properties, business reputation, brokers reach a final valuation for a particular business.
Brokers and professional business appraisers use complex formulas and methods for determining the value of a business to set a reasonable sale price. Methods such as asset based, the market approach, and the income approach provide calculated analysis of a business’ worth. While these methods provide in-depth analysis, they are still merely an estimate. What a buyer is willing to pay for a business and what a lender is willing to loan on a business ultimately determine the final sale price. For small business owners, there are easier ways to figure out how to determine the value of a business.
Case in Point
Tom Jeffreys Sign and Banner is a 20 year old sign shop in Huntsville, AL, a bustling high tech metropolis. The store boasts clientele like Lockheed Martin and Northrup Grumman. For 18 years, the business profited while others in the industry failed. In preparation for retirement, the owner, Tom Jeffreys, sold the store in 2010.
Before the sale, Tom sought the advice of several business brokers. He needed to know how to determine the value of a business in order to set a reasonable sale price. The business consisted of numerous commercial printers, computers, raw materials and supplies, as well as an 18 year track record of healthy profits and little debt. In addition to tangible assets and financial health, other factors such as reputation, unique selling propositions, and existing or repeat clientele all needed consideration. Naturally, Tom turned to the experts for help.
You Don’t Need an Expert
Tom took his first steps towards setting his sale price years before the actual sale. The consummate business planner, Tom reached out to numerous business brokers and professional appraisers. Each broker offered the same advice. Even with annual sales over a quarter of a million dollars, the expense of professional analysis simply would not be worthwhile. Brokers offered him an easier option. Figure it out yourself.
The Formula
According to the broker’s advice to Tom, a five year return on investment for the buyer was the simplest income based method for determining the value of the business. The average business buyer, one can assume, typically wants their money back within the first five years of purchasing the business. In short, this income based formula considers profits and salary potential over a five year period.
As a business owner, you probably pay yourself a salary. A healthy business earns a profit over and above your salary. A percentage of these profits, for a healthy well-planned business, normally would be re-invested in the business for equipment upgrades, training, or any number of business improvements. The last five years’ worth of your salary plus profits should provide the five year return on investment figure for your buyer, thus determining your business’ indicated value and reasonable sale price.
The Formula:
(annual salary + annual profits) x 5 years = business value
Example:
$60,000 annual owner’s salary + $32,000 annual profits = $92,000 discretionary income
$92,000 annual discretionary income x 5 years = $460,000 estimated business value/sale price
Verifiable Results
Naturally, the buyer’s willingness to meet your price and the lender’s willingness to finance that amount affect the sale. Any estimate of a business’ value is subject to verification. Before a lender will approve the sale price of a business, they typically want proof of the business’ value and integrity, as well as the financial stability of the buyer. No matter what formula or method you use to determine the value of a business, historical data and financial documentation to back up your valuation is required. Typically, a buyer and their lender will want three years of financial statements, tax returns, and other pertinent documentation to bolster your valuation.
References and Resources
S.C.O.R.E, How to Value Your Business https://www.score.org/article_business_valuation.html
The Huntsville Times, SBA Loans https://blog.al.com/huntsville-times-business/2010/10/post_20.html
Tom Jeffreys. (February, 2011.) Telephone interview.
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