Business valuation for M&A or other purposes such as divorce, partner disputes, IRS and estate planning purposes are complex formal processes. What is provided here is a basic rule of thumb business valuation approach useful for preliminary planning for companies with revenues between $50,000 and $5,000,000 and/or owner profit plus owner salary of $75,000 to $500,000 range.
Do not use the provided business valuation formula for formal final uses such as going to market in a sale situation or legal proceedings etc. without review and approval of a valuation professional. Many businesses such as contractors, engineering firms, sub-contractors, specialty contractors such as electrical contractors, plumbing contractors, HVAC contractors, landscape contractors, suppliers, retailers, business services, manufacturers and the like can use this business valuation formula.
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A small, owner-operated businesses with an active working owner who performs day-to-day tasks such as sales, production, direct management etc., can be valued using the following formula:
Owner’s salary plus profits plus expenses benefiting the owner (such as underemployed family member on the payroll; exotic travel to conventions; auto; heath insurance; pension to owner etc.) plus one-time charges (perhaps a large legal bill in one year only) plus interest plus depreciation and amortization equals the Seller’s discretionary earnings or SDE.
If you are an absentee owner in a business that is usually owner run, then you can add your manager’s salary back to the cash flow. If you have cost advantages your Buyer will not have, subtract these. Those often involve rent where you own the building the business occupies. Most Sellers adjust the rent to market cost at the time of the sale so that should be factored into the formula.
Some people call this “normalizing” the cash flow. The idea is to show a Buyer what her normal discretionary earnings will be. They are called discretionary earnings because the owner decides what to reinvest and how to pay herself. You can pull many of these figures directly from the company income tax return. The total is then multiplied by a value called a multiplier. In most cases the multiplier is 1.5 to 6 with between 2.3 to 2.7 being about average for small businesses.
Example of Calculating Value:
Consider this example of Bob Smith who owns Smith Electric. Bob has a steady base of service work with some new construction mixed in. Bob has four service crews and still often performs remodeling jobs himself. Bob makes about $100,000 in salary. His wife makes $35,000 working one day a week as the bookkeeper. Bob drives a company truck all the time. He has health insurance through the company. He spent $12,000 last year on interest and had $35,000 in depreciation. Bob runs the business from an office warehouse which he owns. The business does not pay rent to Bob for Smith Electric’s 2500 square feet of space.
The valuation math would work like this:
Salary $100,000 plus excess salary to wife estimated at $20,000. Plus personal use of truck estimated at $5,000 plus health insurance at $11,000 plus interest at $12,000 plus depreciation at $35,000 minus $24,000 estimated rent. This totals $159,000. Assuming Bob has a high percentage of service work which tends to be predictable then his multiplier might be around three. That would put the value of his business at about $477,000. If Bob mainly performed new construction work obtained from competitive bids, his multiplier would be around two because of the risk involved in obtaining future work.
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