Business Valuation for Business Sale Price Estimates – More Detail on Calculating a Valuation Multiplier

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.comYou 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.

Want to know more?  Please click here for the downloadable e-book. “7 Things You Must Know Before You Order a Business Valuation” 

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
609-664-7955

gcaruso@harvestbusiness.com
www.harvestbusiness.com

 

Revisit, Rethink, Recharge, Restart

Teamwork … it is the fuel that allows common people to attain uncommon results” 

                                                                                                         —  Andrew Carnegie

Good news – no more daily updates about the “fiscal cliff”.  It’s over, done, finished. What drama!

Back to the business of sales and acquisitions.  A study* was published last year that rated the challenges buyers and their advisors face when working on an acquisition. The findings were based on input from 70 participants who were experienced, motivated and wanted to do deals. Conclusion: there is no “silver bullet” in getting deals done, but the study emphasized several good learning points.

We’ve summarized the results below in the following format:

Challenge topic
Rated: two ratings – buyer followed by advisor
Comments

          Note: the ratings range from 1-5 (1=very easy, 5=very difficult).

We hope this helps you, buyers and sellers as you revisit, rethink, recharge and restart your own exit planning goals.

Considering Selling Your Business? Please click here for a downloadable e-book, “ 10 Ways to Increase the Value of Your Business“.

Study Results:

Acquisition Strategy
Rated: 3.7 and 3.8
Comments: key driver of alignment between buyers and advisors; if unrealistic, the plan is too general and not enough emphasis on action-related tasks.  Post-closing success begins with good strategy and planning.

Deal Flow 
Rated: 3.6 and 3.7
Comments: access to deal flow is a conscious effort combining communication and networking skills, strategy articulation and identification of real opportunities.  Prospecting and follow-up are very time consuming.

Team Formation
Rated: 3.3and 3.7
Comments: teams must rise to times that demand intensity, coordination, trust and candor. Find external advisors you can trust, not those just trying to get any deal done.

Engaging Sellers
Rated 3.3 and 3.6
Comments: key to the deal, knowing the sellers and their advisors motivations: i.e. the key sellers’ “drivers”; “Staying in constant contact until the moment is right”.  Sellers tend to over-value their business and are not prepared for requests during due diligence.

Business Valuation
Rated: 3.8 and 3.5
Comments: sellers place less reliance on market comparables then do lenders and advisors. The challenge is how the comparable being used relates to today’s market. Understand the 2 or 3 key value drivers and test them during due diligence.

Financing
Rated: 3.8 and 3.7
Comments: banks focus on projections, track record, relationships, a clear understanding of the opportunity given the level of risk, management team and experience, the strategy behind the deal and the integration plan.  No company should start the acquisition process until they have financing to affect the acquisition strategy.

Negotiation
Rated: 3.7 and 3.6
Comments: it;s one thing to agree on a price (“hand shake”); the potential for the deal to derail is real during this process. The absence of experienced advisors is a common source of deals that fail.  Most targets retain less experienced advisors,making the negotiation and documentation process very painful at times.

Due Diligence
Rated: 3.6 and 3.6
Comments: due diligence needs to focus on valuation of the target and how uncertainties can best be handled in the final purchase contract.  The challenge is not with the information; it’s the lack of information the target does not have.

Post Sale Integration
Rated: 4.2 and 4.0
Comments: this item received the highest rating by a significant margin. Integration plans should begin at the very beginning of the acquisition process. Misplaced optimism, overconfidence in the deal and confusion with senior management surface.  Acquisitions often involve competitors who add to he mistrust and anxiety. 82% of participants rated this as “challenging” to “very challenging”.

Final thoughts and comments from the participants

“Acquisitions are difficult – finding the right acquisition targets, managing egos and continuing to run a business during the acquisition process…”

 “Plan on more details and value the experience of your team and advisors. Successful acquirers are those who have made multiple acquisitions.”

 “The use of politeness, graciousness (towards the other side) and humor are greatly undervalued in acquisition settings.  Relax and be polite.”

 “It would be valuable for a soup-to-nuts service from strategy through integration.”

 *Study: Joseph Feldman, Feldman Associates 2012

Clients choose Harvest Business Advisors for our accurate business valuations and our consistent ability to deliver the highest price in the smoothest sale transaction possible. Harvest provides business brokerage, business valuation, and business succession planning services. We have extensive experience in the information technology and professional services, manufacturing, distribution, and contracting fields. We maintain offices in Maryland, New Jersey and Virginia. Connect with us at info@harvestbusiness.com or 443.334.8000 to discuss selling your business, ordering a business valuation or buying a business.

 by Ed Davis, Partner

 

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