Is Your Business Valuation Fact or Fiction?
Every business should have a current baseline business valuation. If you're a business owner and don't have a current valuation, you're not alone. Many business owners don't have an accurate market valuation of their company. If they do and it's not a current valuation, an owner may not realize how the value of their business has changed based on the years in business, the type of business, the industry in which the business operates, projected growth, and any number of other company metrics.
Even if you're not considering selling your business, knowing its value is extremely important. An updated business valuation is also a key component of your Exit Planning strategy. An annual business valuation helps you plan for and fix today those things in your business that bring the best outcomes in the future. For example, if you're a business owner who's been planning on the income from the sale of your business to fund retirement, you might be surprised or shocked to find you haven't created enough value in your business to achieve your retirement goals. If you're still years away from retirement, you have time to build the value. If you’re nearing your retirement date, you may not have enough time to build the value needed to sell and retire.
There are certain areas of your business that you should become familiar with to understand better how your business is valued and where to focus to increase the valuation. Here are some factors you will want to understand when reviewing your valuation:
Financial metrics: How much is your annual revenue growing or shrinking, and does that revenue turn a profit? What are your operating costs as a percentage of revenue, and are they going up or down over time? What are your overhead expenses, and are you able to trim them back to lower your breakeven profitability point? Many metrics make up your financials, so it's essential to understand them and track them to ensure your business uses its resources wisely and makes a profit.
Tangible Assets. Tangible assets are things like equipment, inventory, vehicles, and property. These tangible items are easy to calculate the value of, using current market pricing.
Intangible Assets. This is just like it sounds – your company's intangible items, like patents and trademarks, brand recognition, proprietary technology, and unique processes. These items can add huge value to the company and are frequently the differentiator between you and your competitors. It's good to have some idea of the value of your intangible assets.
Liabilities. We're all familiar with liabilities. These are any debts your business owes. And they impact valuation.
In addition to understanding these factors, you must also realize that there are many approaches to valuing a business. We've heard it said that you could ask ten different experts to value a business, and you'll get 11 different answers. Additionally, if you're planning to sell your business, you're going to value your business very differently than a buyer.
The difference in valuation between a buyer and seller during the sales process occurs for two reasons. One, the variables that affect the valuation – there are so many that both parties may not use the same variables. Two, there are multiple methods to value a company. Just Google Business Valuation, and you'll find hundreds of methods, online calculators, DIY books, and business valuation firms. In the case of a sale, both sides choose a way to value a company because it helps both parties consider what they would pay/accept for payment and highlights any valuation gaps. This is where the negotiations begin!
Let's talk about variables. Here's a list of common variables that can affect valuation.
History: How many years have you been in business? Are revenues growing or flat?
Industry: Is the market declining or growing?
Revenue: Is revenue contractual or transactional? Can you predict revenue?
Pricing: Is pricing commodity priced, or do you have value-added? Is it price-sensitive, or can it set market price?
Location: Can you grow where you are currently located? Are you landlocked? Is there a pool of employees available if you expand?
Technology: Is your technology scalable? Is it flexible so you can add services? Is it easy to tie in new financing systems, or would the buyer have to invest and revise your platform to fit theirs?
Planning: Do you have a strategic growth plan? What do you need to add to grow? Does that require a big or little investment?
Operations: What is the condition of your building? Are any renovations planned? What does your equipment list look like?
Sales and Marketing: Are the materials up to date? Can the sales team learn to sell additional products or services?
As we stated above about understanding and focusing on key business assets and metrics, it's just as important to have an idea of how these variables affect the value of a business. More importantly, how can you leverage these variables to increase your value. What variables are a shining star, and what variables need improvement in your business? Regardless of where you are in your company's life cycle, you can focus on variables to increase its value.
Top Three Valuation Methods
Let's look at the three most common valuation methods used by buyers in today's market.
Model One: Multiple of EBITDA
EBITDA is probably the most familiar to most business owners and a model that works well for a variety of companies because of the number of variables that can affect the valuation.
How It Works
1. Take your average net income1
2. Add back interest expenses paid
3. Add back tax expenses paid
4. Add back depreciation expenses
5. Add back amortization expenses2
Actual net income plus these add-backs equal your EBITDA. This EBITDA will be what you apply a multiple on to arrive at your baseline valuation. Keep in mind this option uses multiples that can typically range from three to eight times based on a company's history, tenure, and other factors. It is important that you use the same multiple—I recommend using three to remain conservative—year to year for your valuation. Possible add-backs—such as additional owner's compensation above what you would pay someone to do your job and extra perks such as cars, membership fees, fixed assets, or liabilities—can affect this valuation. EBITDA models can have all kinds of additions or subtractions and can really swing valuations between a seller and a buyer.
Model Two: Multiple of Gross Margin
The gross margin model works well for non manufacturing-based service companies with minimum assets or debt.
How It Works
1. Total your three- or five-year annual gross margin3
2. Divide that total by the years used above (three or five)
3. Take the above number and apply a multiple4
4. Look at the baseline valuation, which you can build from
Multiples can range from one to three or more. It is important to keep the multiple the same as you update your baseline valuation annually, so you can compare apples to apples and see the value created over time.
Model Three: Multiple of Revenue
The multiple of revenue model works well for software as a service (SaaS) companies and high-growth companies.
How It Works
1. Calculate your average annual revenue over a three- to five-year period
2. Apply a multiplier of one to two, with one being short-term growth and two being used if you've had longer-term growth
3. Arrive at your baseline revenue valuation
Your Valuation is Your Baseline
Whether you're creating your Exit Plan, gearing up for growth, or thinking of selling, get a proper valuation of your business done using a professional. Many business owners will have their accountant value their company, which is helpful for buy/sell agreements or insurance. However, since this approach rarely reflects what a buyer might pay and can give the business owner a false sense of what the business is worth, causing problems at the time of sale. Without accurate information, the owner could hold out for too much and not get a sale, or they could sell for too little and leave some of their hard-earned money on the table.
Regardless of where you are in your business, get a professional business valuation and update it annually. You never know when the unexpected might happen; a buyer approaches you out of the blue with a generous offer to buy your business, or something happens in your life that may cause you to sell before you planned. You want to be ready should the unexpected happen so you can make decisions from facts, not fiction, to make the best decisions you can on behalf of you, your family, and your business.
Working with a professional business advisor will provide an accurate business valuation that will help you in your exit planning or sale of your business. If you need help in preparing a valuation or updating an existing one before you’re ready to sell, contact Paradise Capital. Our team of experienced business professionals brings 50+ combined years of marketing, communications, finance, business planning and acquisition services working with a variety of brands.
Jack Nermyr, is a Valuation Analyst at Paradise Capital and graduate of the University of Minnesota, Carlson School of Management. Having worked with dozens of business owners, Jack has found that the truth lies in the numbers and uses his expertise to maximize our clients' business value.
1 Use a minimum of three-year average. Your advisor may use three or five years with two years looking backward or forward one, or a variety of ways to present your company in the best way based on the buyer. Your advisor will factor in whether you're growing and whether you were growing in the past. If you were not, the focus would be on the future. If you grew a lot in the past and are currently flat, your advisor may focus on the past.
2 Long-term clients show stability and give buyers a way to amortize the purchase over a longer period. This helps a buyer build post-acquisition models or a way to forecast future performance after acquisition costs, which makes the purchase look better for the buyer. This may yield a higher selling price for sellers who have long-term clients.
3 Varies based on history, growth, and forecast.
4 Multiples are based on company history, client's tenure, contracts, etc.