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
It is tragic when a business or anything else splits a family into pieces. Yet I see this all the time in family business succession matters.
This is particularly acute in the construction industry including specialty trades such as mechanical, HVAC, electrical and plumbing contractors because of the prevalence of family business. Exit planning between generations is difficult at best. Too often when the successor is chosen or when the stock is given or sold, the family fractures. This is not success. You can maintain peaceful Thanksgivings (maybe not all of them but most) and a successful business transition.
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Clear communication which includes listening to everyone is essential. Continuing to communicate (listening – not just telling) after splits in family / business opinion is crucial. It takes time (a long time, usually many years) and patience to accept that things may be different from what each family member hoped. It takes determination to build a business and it takes determination to keep communicating when you do not like giving or hearing the message. Communication in family businesses often requires creating a back channel with an outside person that really wants to see the whole thing work well for everyone. This provides a vent and an opportunity for someone with no emotional claim to provide another view.
A few more quick thoughts on transferring a family business:
Fairness is a big consideration. I don’t know what fair is but I often know if a situation is unworkable or just “way” unfair. Giving a business to 5 children evenly when 2 work in the business and the rest do not is a disaster waiting to happen. This is unfair to all. Often, life insurance is used to “even” out the opportunity being given to the children “getting” the business and the other children. Again, fair at the date this family/business decision is made and fair at the date of death 20 years later may or may not work out the way one hopes, but, it is much better than a guarantee failure.
Another matter is the children who are to lead the business must be trained and groomed for the post. Not all will be able to do it.
I equate running a business to riding a bike. You can ride in a child seat on the back for years. It feels like you are riding the bike. You have been looking over the shoulders of the rider and see everything she did. But it is not the same. Only getting on the saddle and grabbing the handlebars and peddling teaches you to ride a bike.
It is tragedy when the wrong child takes over and in a few years crashes a 35 year old family business. No one wants to burden their child with that. Telling a child that does not have the capacity is hard. Killing the golden goose is even harder. It just does not seem that way at the time you need to have the “you’re not the one” conversation.
How can the family test the child? Can they let him run a division? Perhaps start up a new company to tackle a growth area? Nothing prepares or tests an owner other than being an owner. Find a way to stress test the child if at all possible.
Another reason you are going to want to start the transfer early is generally the child is going to earn the money to pay for the business from the business. If the parent has done really well there will be gifting for estate purposes but in most cases the value of the business is going to fund the parent’s retirement plan. I would not advise any business owner to walk away from control and knowledge of what is really happening until the debt or payments to them are substantially made. This means you need to start the transition well before mom and dad intend to spend 11 months of the year in Florida.
In family business succession planning starting early and carrying through with clear communication including listening and consensus building is one key to creating an exceptional exit.
Gregory R. Caruso, JD, CPA, CVA
Harvest Business Advisors
Great stuff if I do say so myself. While geared for residential remodelers the talk applies to any cyclical business owner such as general contractors succession planning, subcontractors including electrical contractors succession planning, plumbing contractors succession planning, HVAC contractors succession planning, engineering firms succession planning and all sorts of distributors, manufactures, professional service firms and the like.
What I covered in the webinar was:
1. Why Succession Planning? Because with a succession plan you will build a better business that will be more manageable. You will resolve management and family conflicts (take it on if you really are willing to do what it takes). You will sell your business when you want to for more money in less time. Why would a business owner not want that?
2. What is a valuable business? Think of an ATM. Simple systems that can be mastered by ordinary people. The ordinary people (who are extraordinary at this point) use the systems over and over and in effect stay around. Works every time. Money or profits come out. While simplified that is what creates value in a business.
3. How do you actually capture and collect the value you created? How to minimize taxes, minimize risk, and maximize price through the preparation and sales process. Some of this is not what you think.
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Gregory R. Caruso, JD, CPA, CVA
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 email@example.com or 443.334.8000 to discuss selling your business, ordering a business valuation or buying a business.