Small business owners usually have an idea about how much they want to sell their business for—but they have no idea what it’s actually worth.
Why? They’re too focused on the blood, sweat and tears they’ve poured into the business over the years and not enough on what the market will bear, says Greg Caruso, principal at Harvest Associates LLC, a transaction advisory firm in Baltimore. Coming to the realization that your business’ worth is not directly related to the amount of hard work you’ve put in is difficult. It’s also necessary to get the process moving.
And while the ultimate value, or sale price, given to you by professionals may be much lower than you were expecting (and it usually is, pros say), the experts have their methods. Here’s what goes into that final number:
The buyer. The sale price of your business is often determined by who’s buying. If a family member or top manager has agreed to buy your business over a 10-year period, for example, the deal could be structured where payment installments fluctuate based on the company’s performance. If a buyer strictly wants to buy your business for its assets, though, and does not wish to continue operating the business, the sale price will likely be determined by the value of these assets. “A buyer’s biggest question is, ‘How can I service my debt and get a reasonable return on investment?’” says Phil Corbin, a business broker with Henderson Business Group in West Des Moines, Iowa.
The approach. If you decide to get an official value from a valuation professional—usually a certified valuation analyst—expect to hear terms like “market-based approach” and “income approach.” These terms indicate which appraisal method the professional employed when valuing your company. The most common methods for a small business are:
- The income approach, which emphasizes your past, current and projected revenue and cash flow.
- The market approach, which derives value from historic sales of similar businesses
- The asset approach, which takes into account the fair market value of a business’ assets
The approach largely depends on the professional’s discretion and your company’s situation.
“Valuation is more of an art than a science,” says Scott Mashuda, managing director of Rivers Edge Alliance, a business brokerage firm in Pittsburgh. Typically, a small business valuation is based on a combination of the income and market approaches, he says.
Cash is king. Even so, most valuation professionals agree that cash flow is the top determinant when valuing a business for a third-party buyer. Why cash flow, and not revenue or assets? Because buyers are more concerned with how they’ll make money after the sale. “It’s pretty damn simple,” says Caruso. “Take the past 12 months of a small business’ cash flow—in my world, that’s every way the owner makes money—and the business will sell for two to three times that.” That’s why many business owners see valuations drop off precipitously during a recessionary period.
If you’re thinking about selling your business, get going as soon as possible. The biggest mistake you could make is to wait too long to get a value and put the company on the market, says Caruso. “Once a small business owner is checked out, they don’t stay motivated and the business diminishes very quickly,” he says. “So will its value.”
Original Article: NFIB