Fit Small Business | March 2016 | By Priyanka Prakash
In this article, we’ll show you how to value a business, starting with the framework and then walking you through an example. When you are finished reading, you should have all the tools you need to conduct a basic small business valuation.
3 Step Framework for How to Value Business
Step 1: Calculate Seller’s Discretionary Earnings (SDE)
Most experts agree that the starting point for valuing a small business is to normalize or recast the business’ earnings to get a number called Seller’s Discretionary Earnings (SDE). SDE gives you a good idea of a business’ true revenue potential, that you can then use to estimate the value of the business.
Small businesses report expenses on their tax returns with an eye towards reducing their tax burden. For this reason, using revenue numbers from a business’ tax return can underestimate how much revenue the business actually produces.
SDE gives you a better idea of the business’ true revenue potential by adding back in expenses listed on the tax return that are not necessary to run the business. It also adds back in the owner’s salary and one-time expenses that are not expected to recur in the future. This increases the net income of the business and gives you a good idea of its true profit potential.
According to Wayne Quilitz, President of business brokerage firm Murphy Valuation Services, here are some examples of things that would be added back into the net income reported on the business’ tax return to calculate SDE:
- Owner’s salary and perks
- Family members on payroll
- Non-cash expenses such as depreciation and amortization
- Leisure activities, such as business golf outings
- Charitable donations
- Any personal expenses, such as the purchase of a personal vehicle, that were noted as expenses on the business tax return
- Business travel that’s not essential to running the business.
- One-time expenses that are unlikely to recur after the sale of the business, such as the settlement of a lawsuit
In general, one-time expenses and anything that’s not essential to running the business should be added back to the business’ income to calculate SDE.
Step 2: Find Out the SDE Multiplier
Generally, businesses sell for somewhere between 1 and 3 times SDE. This is called the SDE multiple or multiplier. Finding the right SDE multiple is really more of an art than a science because it varies based on industry and geographic trends (market risk), company size, the business’ tangible and intangible assets, independence from the owner (owner risk), and many other variables.
The biggest factor influencing the SDE multiple is usually owner risk. If the business is highly dependent on the owner, it cannot be easily transferred to new ownership, and the business’ valuation will suffer. Market risk is also important. If you’re buying or selling a business in an industry and/or area that is expected to grow in the near future, the SDE multiple will be higher.
You can find out the approximate SDE multiple to use by looking at BizBuySell’s media insights quarterly report. BizBuySell provides multiples for different industries based on reported business sales data. For a more personalized estimate of the multiple, you can also consult a business broker or appraiser.
Step 3: Add Other Business Assets and Subtract Business Liabilities
The final step of how to value a business is to take business assets and liabilities into account. Intangible assets of a business (e.g. goodwill, reputation, trademarks, etc.) are typically included in the SDE multiple. Similarly, inventory and fixtures, furnishings, and equipment (FFE) are usually accounted for in the SDE multiple.
However, according to Wayne Quilitz, “SDE multiples from different databases may include different assets in valuing a business.” For example, a popular database called BizComps does not include inventory in its SDE multiples, so inventory must be added into the valuation separately.
Other assets like real estate (if the business owns any property), accounts/receivables, and cash on hand are generally not included in the SDE multiple. These assets should be added into the
valuation separately (as shown below).
The final step to calculating the value of a business is to subtract any liabilities such as debt and interest payments (as shown below).
Final Business Valuation Formula
SDE * Industry Multiple
+ Real estate
+ Cash on hand
+ Any other assets not included in the SDE multiple
– Business liabilities
= Business’ Estimated Value
Below, we’ll walk you through an example of how this works, but first, there are a couple of things to keep in mind.
Take emotion out of the valuation process
Most experts we talked to said that sellers set the asking price for their business too high. Michael Karu, a CPA at Levine, Jacobs & Company, explains that this is because “sellers often think they are the only ones who can properly run their businesses.” They place too much value on the amount of time and effort that they have put into the business even if the financials don’t support such a high valuation. Sellers should come to the table with a fair understanding of the business’ past successes and failures and reasonable expectations about the price.
On the flip side, most buyers have unrealistic views of how they will be able to run the business. To their detriment, says Karu, most buyers believe that they can successfully turn around any losing venture. It can be easy to place blame on current management for a failing business, but buyers should keep in mind that certain things about the business, such as location and competitors, cannot be changed even when they take over. These things need to be accounted for when pricing the business.
Having a number like SDE to drive the valuation helps take emotion out of the valuation process and results in a more accurate estimate of the business’ worth.
Decide if you need professional assistance
Before setting out to value a business, you have to decide how you’re going to conduct the valuation. Buyers and sellers can either value the business on their own (with the assistance of their accountants and attorneys), or they can hire a professional appraiser.
Value a small business on your own
The main benefit of valuing a business on your own is that saves you money. The experts we spoke to quoted different price ranges for appraisals, but a good ballpark is $8,000 for appraising a small business that’s worth under $500K.
Valuing a business on your own is also faster. A professional appraisal takes 2-4 weeks, while you can get a valuation within a few hours on your own.
If you do decide to value a business on your own, we strongly recommend using online software such as BizEquity for guidance. BizEquity will walk you through the business valuation by asking you questions about the business. It’s easy to use and costs $500 for a comprehensive business valuation report.
Hiring an appraiser
Although hiring an appraiser can be expensive, these are certain advantages to doing so. The main advantage, says Naman Shah, a Market Lead for BizEquity, is that a professional appraiser will audit the business’ financials to make sure they are correct. When using software like BizEquity, the final valuation will only be accurate as the numbers you enter.
Another advantage of using an appraiser is that it can result in a more personalized valuation. A tool like BizEquity takes into account intangible factors (often called “goodwill”) when valuing a business, such as reputation of the business and how important the owner is to its continued success. However, an appraiser will be better able to manipulate intangible factors to come up with a valuation that’s agreeable to the seller and buyer.
If you decide you’d like to hire an appraiser, we recommend starting with BizEquity. They offer certified appraisals for $2,000-$3,000, which is a great deal compared to what some appraisers charge. You can also find an appraiser on the American Society of Appraisers website.
How to Value a Business Example: Family Restaurant vs. Franchise Restaurant
If the explanation above was enough to get you started, you can stop here, but if you’d like an in-depth example of how to value a business, read on. Instead of boring you with a detailed academic explanation of business valuation, we’ll walk through an example of how to value a family restaurant versus a franchise. We chose to compare a franchise and an independent restaurant because while on the surface they are similar as they both are in the food industry, they have different valuations. In short, an independent business has many more risks and therefore a lower valuation, on average, than a franchise business.
Business 1: Joe’s Family Restaurant and Cafe located in Missouri
- $528,747 – Annual Revenue (Total cash generated by sales)
- $80,799 – Annual Seller’s Discretionary Earnings (SDE) (The number you get after recasting the business’ earnings with add-backs)
- $234,000 – Real Estate (Estimated worth of property and buildings owned by business)
- $31,950 – Furniture, Fixtures, and Equipment (FFE) (Refrigerators, fryers, booths, counters, etc)
- $3,500 – Inventory/Stock (Food, napkins, ketchup, etc)
- $40,000 – Liabilities (debt, interest, etc.)
Business 2: Subway Franchise located in New Jersey
- $373,200 – Annual Revenue
- $76,272 – Annual SDE
- $150,000 – FFE
- $4,500 – Inventory/Stock
- $30,000 – Liabilities
Calculating an Average Value to Get Started
Once you have the SDE for a small business, you can use it to calculate a ballpark value for the business. You will further refine this ballpark later, but to get an average, you multiply SDE by a business sale price multiplier. Using statistics from restaurants sold in 2014, bizbuysell.com determined that the average multiplier for the restaurant industry is 1.96.
Using this figure, we can calculate an average value based on industry norms for Joe’s Family Restaurant and Cafe and for the Subway franchise.
$158,366 – Family Restaurant and Cafe ($80,799 x 1.96)
$149,493 – Subway Franchise ($76,272 x 1.96)
If you stopped here, you would think that Joe’s is worth more than Subway. There’s more work to be done, however. The multiplier that you use, and hence the final valuation, will depend on multiple factors.
Factors That Influence the Multiplier/Base Value
Calculating the average value of a business using the SDE multiplier method can be a good first step. In the restaurant industry, the average SDE multiplier is 1.96, as mentioned above. Using this multiplier, Joe’s Restaurant has a slightly higher value than Subway.
However, there are lots of different factors that affect whether a specific business’ multiplier is above or below the industry standard. Think of the industry standard multiplier and the specific business multiplier as two separate numbers, one giving you a general value based on industry averages and another giving you a more specific value based on variable factors of each individual business. In most cases, small businesses are given a business specific multiplier of 1 – 3.
Here are the main factors that influence a specific business’ multiplier/business value:
Assets add value to a business. The more assets a business has, the more it will be worth on the market and the higher the multiplier that will be used for the valuation. There are two main kinds of assets: Physical and non physical. Normally, non-physical assets are a bigger component of business value than physical assets.
Physical assets refer to all of a business’ material, tangible assets. This includes but is not limited to the following: furniture, fixtures, equipment, real-estate, inventory (sometimes included in asking price sometimes priced separately), company vehicles, etc. You must take account of depreciation when assessing the value of these physical assets.
Physical assets typically don’t have a major effect on a business’ multiplier. However, owners sometimes want a higher multiplier if they have recently purchased new equipment. Let’s say a restaurant has just purchased a whole new set of friers and stoves. That means that equipment will not have to be updated in the near future, cutting down on future costs, which can raise present value.
Joe’s Restaurant vs. Subway
Let’s get back to our example. Subway has around $119,000 more in physical assets than Joe’s restaurant. The odds are that Subway’s multiplier will be higher than the industry standard of 1.96 due to its high level of physical assets. Joe’s restaurant, on the contrary, has nothing special in physical assets, so the industry standard is still a pretty good benchmark for its valuation at this point.
Non-physical assets are all of the positive aspects of the business that are not material in nature. These include but are not limited to a business’, brand, reputation, independence from the current owner, recipes, trademarks, copyrights, and other factors, also known as “intangible assets” or “goodwill.”
Why Do Non-Physical Assets Matter?
Non-physical assets are the biggest influencer of a business’ individual SDE multiplier. A wealth of non-physical assets means a much higher multiple. A lack of non-physical assets means a much lower multiple. Why? Because the wealth or lack of non-physical assets often determines whether or not a business transitions successfully to a new owner.
Joe’s Restaurant vs. Subway
In most cases, buying a franchise is considered a much safer bet than buying an independent restaurant, because of the wealth of non-physical assets that inherently come with a franchise.
Getting back to our example:
Subway Franchise Non-Physical Assets
- Nationally Known Brand
- History of Financial Success
- Informed Marketing Strategy
- Standardized Operating Procedures
The non-physical assets above benefit every Subway franchisee, regardless of location, demographic, or owner charisma.
Joe’s Non-Physical Assets
- 35 years of success
- Loyal local customer base
- Good reputation in community
The fact that Joe’s restaurant has been relatively successful as a business for 35 years is great. However, there is no guarantee that the restaurant will be successful once Joe leaves. Here are some big risks.
- Customers may start going to another location – Many times, local customers choose one establishment over another because they have a personal relationship with the owner. If Joe leaves, customers may as well.
- Older employees may retire – If there are employees who were hired by Joe and are loyal to him, they may decide to leave when he goes. Or, if they agree to stay, it may only be for another 6 months or a year. If these employees hold crucial positions in the business, such as manager or head cook, you could lose some of the most valuable team members that made Joe’s Restaurant such a success.
- Supplier relationships may end or deals may change – If Joe had relationships with his suppliers, they may have been giving him an extra good deal, like lenient credit terms. When Joe leaves, those deals may dry up, or the suppliers may see it as an opportunity to back out altogether, which means of lots of extra work, effort, and time to find new suppliers.
In other words, the non-physical assets associated with Joe’s restaurant are much more closely connected to the owner of the business, making it less likely to transfer successfully to a new owner. This is often referred to as “owner risk.”
Owner risk is one of the biggest, if not THE BIGGEST, single factors influencing business value. If a business has so much owner risk it cannot survive the transition to new ownership, than all other aspects of a business’ value are pointless.
What are the business’ future prospects?
Industry and geographic trends also influence how to value a business. This is often referred to as “market risk.” If an industry is booming and trending towards your particular business, the higher your multiplier will be. In the same way, the more the population growth and popularity of a business area is growing, the higher your business’ specific multiplier will be.
The truth is, people are never going to stop eating fast food. Fast food is trending towards healthier food, but this is a major part of Subway’s brand recognition. So, as far as industry trends are concerned, Subway has good prospects. Geographically, New Jersey is staying pretty steady economically (Of course, specific geographic regions within a state can often have very different trends than the state as a whole, so it is also important to research local area trends). Given this information, Subway’s multiplier is probably above the industry average of 1.96.
Although Joe’s restaurant has had success in the past, David Coffman of Business Valuations & Strategies PC explained that restaurant success is trending away from independently owned businesses and toward franchises. So, the industry outlook is shaky, at best. Geographically, Missouri is actually doing pretty well, with dropping unemployment rates and a rise in entertainment and leisure jobs. So, Joe’s business specific multiplier might be a bit above the industry average of 1.96 due to the state’s positive economic trends.
The availability of seller financing also has an impact on the sales price multiplier. In nearly 80% of cases, a business has some kind of seller financing option available to the seller, typically around 30-60 % of the business value. If a business does not offer seller financing, it will take longer to sell and its value is decreased. In our example, both Joe’s and Subway offer seller financing, so the value is not affected.
Real Estate and Lease Terms
The last main factor that can influence how to value a business is the property and land that the business occupies and/or owns. If a business leases a building, the amount of time remaining on the lease is an important factor. If the lease still has 3-5 years on its term, that will work in the seller’s favor. If your lease ends in less than 3 years, that can at times lower the multiple of a business because the new owner will have to renegotiate the lease.
If a business actually owns its own property and building, then the value of that real estate is estimated separately and added onto the SDE value of the business.
In this case, Joe’s restaurant owns its own property and buildings estimated at $234,000 in value. That number is added onto the value of the final SDE x multiplier value.
Subway’s lease term still has 4 years left on it, so the value is not significantly affected.
Other Factors That Affect the Multiplier
The factors we’ve covered above are not an exhaustive list of what can affect the SDE multiplier. Any number of things, from the business being in a desirable or undesirable location to the business having a diverse or narrow customer base to the business having many or few liabilities, can affect the multiple. The specific details of every transaction are different.
Final Values/Multipliers In Our Example
Joe’s Restaurant – 2.0 Multiplier Estimated Business Value = $161,598
Estimated Real Estate Value = $234,000
Liabilities = $40,000
Total Estimated Value = $355,598
David Coffman helped me put together these values. Although Joe’s restaurant has had reasonable success in the past, the industry is trending away from independently owned restaurants. Also, the likelihood of new owner success is questionable because Joe’s is a family owned business with a long reputation in the local community. Nevertheless, due to Missouri’s positive economic climate, Joe’s business specific multiplier is a little higher than industry standard, at around 2.0. Although it does not have a very high multiplier, the real estate value actually makes the investment a pretty good one.
Subway Franchise – 2.8 Multiplier Estimated Business Value = $213,561
Liabilities = $30,000
Total Estimated Value = $183,561
Subway’s business specific multiplier well exceeds the industry average multiplier of 1.96. There are several reasons for this. First, the industry is trending toward franchises, meaning market risk associated with the business low. Second, since Subway is a franchise, the transition to a new owner is less risky. Considering all of these positive factors, Subway’s business specific multiplier is almost a whole point above the average industry multiplier of 1.96. Ultimately, the estimated business value of Subway is significantly higher than that of Joe’s Family Restaurant and Cafe.
Several of the valuation professionals I talked to stated that “business valuation is more of an art than a science.” Many of these professionals said that it could be good to compare several methods of valuation. That being said, using the SDE method of valuation as explained above should give you a pretty good estimate of a business’ worth.