Small business valuation for selling your business, or business merger and acquisition purposes is tricky and depends on many factors. In this article I summarize how a valuation multiplier for a small business could be calculated. The calculated value should also be checked against the business sales comps available from one or more databases such as Pratt’s Stats, www.bvmarketdata.com and BizComps, www.bizcomps.com. You can also look in The Business Reference Guide by Tom West, available at www.bbpinc.com . Also, get a check from a reputable experienced business broker or valuation professional in all cases before entering into contracts or even negotiations.
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This methodology is most effective for businesses with a value between $150,000 and $1,500,000. Below $150,000 in value in my experience it is hard to reasonably calculate value although in many cases it does exist. If the value is low enough you must also look at what the liquidation value of the assets may bring. Sometimes this is the highest value. Once a company grows larger than $1,500,000 there are other methods that may be more accurate which should be used to estimate value. We will post another article or articles on valuing larger businesses in the near future.
This methodology works for estimating the business value or business sales value of most types of companies including subcontractors, electrical companies, HVAC, plumbing, engineering firms, service firms such as CPA’s and consultants, manufacturers, government contractors, retailers, restaurants, etc.
Generally, the multiplier is calculated by looking at risk and how the business will continue to generate cash flow for the new owner and the perceived desirability and growth prospects of the firm. This is similar to the concept behind bonds or bank accounts. Junk bonds pay more interest than government insured savings accounts in order to attract your investment dollar. Of course, you will never lose principal on the government insured savings account. Small businesses are very risky and carry a large discount usually in the 20% to 50% range. The safer the business the higher the multiplier. The higher the multiplier the higher the value and price when it comes time to sell.
Typical factors in the calculation:
- Ease of entry into business
- Location of business
- Competition in Market Area
- Historical profit trend
- Industry trend
- Size of business
- Management systems in place
- No one customer providing more than 10% or 20% of sales revenues
- No major suppliers that would be hard to replace
- Availability of financing
- Condition of Books and Records
One way to do the analysis is to rate each factor above from 1 to 4, with four being the most favorable, then divide by the number of applicable factors. In all likelihood your business multiple will be between 2 and 3. The average is between 2.3 and 2.7 depending on who is collecting the data. Businesses that tend to be owner intensive such as auto shops and small independent restaurants tend to sell around 2 or less. Highly efficient larger service firms with contracts may sell for 3 to 3.5. Again, only proven rapid growth companies or unusually hot businesses (think BMW auto dealerships) reach above 4.
Example of Calculating a Multiplier:
Sam’s Auto Repair factors
Ease of entry into business 1 easy to enter
Location of business 3 Sam’s is in an urban area where auto related land usage is discouraged
Competition in Market Area 3 Same as above – few competitors, hard to get a nearby location
Historical profit trend 3 Sam is profitable
Industry trend 2 Too many new cars
Size of business 2 Sam’s is still small
Management systems in place 2 Has great receptionist / scheduler
No one customer exceeding 10% or 20% 4 Few large commercial acc.
No major suppliers that would be hard to replace 4 Many parts stores and suppliers
Availability of financing 2 Hard to finance Auto related
Condition of books and records 3 Easy to follow, accurate books and records and tax returns
That totals 11 factors with a sum of 29 creating a multiplier of 2.6 which is high for an auto repair but the assumptions make this look like a pretty good small business. Give him poor financial books, low profitability, and a neighborhood with car repair on every corner and you quickly have a 2 multiplier.
Now you just multiply your discretionary cash flow by your multiplier and you get an estimate of value. ($150,000 discretionary cash flow times 2.6 equals $390,000 estimated value). If done accurately (experience helps!) this can produce a very good indication of value. It is also useful for internal purposes just as a check to see how you are doing as good businesses are valuable businesses.
DISCLAIMER: Please note that this is a useful formula for preliminary planning or tracking your progress but is not a substitute for a proper valuation when selling your business. NEVER go to market or enter into important negotiations or legal proceedings based on a rule of thumb formula such as this. Get proper valuation assistance. Call us.
Gregory R. Caruso, JD, CPA, CVA
Harvest Business Advisors