At Advanced Business Brokers, we often get asked what a business is worth, and invariably most people want it to be a simple math formula. Sometimes referred to as a multiple. Unfortunately, there are many pitfalls to this oversimplification and in reality, multiples are figured out in one direction, by taking a price someone sold a business for and dividing it by some metric (often earnings) to arrive at a multiple.
M (multiple) = P(price) / E (earnings)
From what we learned back in grade school then, by simple math, the following should be true
P = M x E. And yes, that would be correct math, but it is flawed when it comes to valuation. Otherwise, the stock market would be much more predictable and have a lot lower volatility. The truth is that multiples are usually an average of many transactions with some lower and some higher.
“Cash flow is the net amount of cash and cash equivalents being transferred in and out of a company”
The value of a company is driven by two things: cash flow, its ability to make money along with evaluating inherent risks in the industry along with that business. There are factors that can be adjustments to these and therefore there is no simple math formula. No buyer is going to walk in with a blank check and take two numbers and multiply them, fill in that amount and be done. Unfortunately, it’s just not that simple.
Think about it, every business is unique; with different management, employees, business strategies, clients, products, and services. There are other things to consider too like has the business been growing or declining; is the staff seasoned, new, or close to retirement? These factors and many more could add to the value or be a major detractor from it. So where do you start?
The first reality that most business owners need to understand is that smaller businesses (those that make less than $1 million in earnings after expenses) will sell for somewhere between 2 and 4 times their cash flow. We did state that a simple equation like this doesn’t work, however, the fact is that there are lots of risks in these smaller businesses that tend to keep prices in this tight range. However, understanding where in that range is realistic can be the difference of tens of thousands, if not hundreds of thousands of dollars. It also can mean the difference between selling or not getting any offers. There is a reason that currently about 80% of the businesses that go to market DON’T sell.
Buyers will be focused on cash flow and the risks in the business. It is helpful to understand that offers and deal structures reflect the need to pay expenses, make a reasonable wage, and protect against risks. When evaluating cash flow don’t forget that rent and your wage need to be comparable to the current market. This is often a once-a-lifetime event for you, it is highly recommended to build a trusted advisory team: Business Broker, Banker, CPA, Attorney, and others to help you navigate the process.
Having a quality team of advisors (business broker, lawyer, accountant, etc.) to evaluate opportunities will work well for you. It is helpful to understand that the selling of a business is a very emotionally driven time. Business owners have often spent more hours building a business than with their own families and it is their “baby”.
Trust the process and stick to the fundamentals; you may have to walk away from an opportunity if a seller is stuck in emotional logic. Often a simple question to ask is, “does the business cash flow support paying for the loan, business expenses, rent at market rates, an owner’s salary for work in the business (with some left to cover unexpected expenses), or provide a reasonable return on investment? These questions are something your business broker should present to you.
In our world, we help educate sellers to strive to sell their businesses at a fair price and buyers to expect to pay a fair market price. This is often crucial for a smooth and successful transition in ownership because both parties will be working together during that time. If one side feels resentment in the deal, it can make for a very rocky transition, or worse yet, it can lead to a deal not closing at the last minute.
How do you calculate the value of your business? Advanced Business Brokers will assist you! Contact us today!