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How do I know what my company is worth?

When thinking about selling a company, usually the first question a businessperson asks is “How much is it worth?” Unfortunately there is no cut-and-dried answer to the question. Entire books have been written about valuation, and there are so many variables involved (and many of them are very subjective) that different experts looking at the same company could end up with different selling prices. There are some commonly accepted techniques and rules of thumb used, which are presented here.

Basically, there are two major ways to figure the price of a small business. One is the company’s ability to generate sales, cash flow and/or profits. The second method is to value the company based on its assets. Which method is used depends on the condition of the business and the industry it is in. Typically, an independent valuation firm or business valuation professionals can offer an array of valuation and consulting services for businesses of all sizes. Lexington does not offer Valuation Services.

Valuing a business based on sales

In some industries, the norm is to determine value by using a multiplier times the firm’s annual sales. Consulting firms, radio stations, temp agencies, PR or ad agencies, professional practices, retailers and insurance brokers are often valued using a multiplier of annual sales. The multiplier depends on the exact type of business, the predictability of sales from year to year and many other factors. Generally, the industry multiplier is the starting point and is then adjusted based on specifics of the company. For example, the industry’s multiplier may be two times sales, but the firm has experienced strong, consistent growth in the past three years – that may boost the multiplier to 2.5 or higher. Or perhaps the firm has one client that makes up one-half of its billings – the higher perceived risk may drive the multiplier down to 1.5 or lower. If your business has low fixed costs, few assets and little retained earnings, the sales multiplier technique may be appropriate.

Valuing a company using cash flow or profits

We won’t split hairs here, even though there are some differences between cash flow and earnings the philosophy is the same. The price is based on the company’s ability to generate a stream of profit (which can be defined in different ways) or cash flow (sales less expenses). The seller then projects this stream of cash over five or more years to calculate the worth of the business. Often, discounted future earnings are used which takes into account the time value of money – cash received in year five is discounted based on projected interest rates.

In this method, disagreements can occur regarding calculation of cash flow and estimated sales projections. Many cash flow and EBITA (earnings before interest, taxes and amortization) projections use “recast” numbers to reflect the effect on profits of perks that a business owner takes from the business. This recasting is extremely important, and is discussed in a separate article directly below this one.

What factors affect the multiplier?

As you read this, you’re probably commenting to yourself that the multiplier is a subjective number that the buyer or seller pulls out of the air. There is plenty of room for judgment, but by and large, a profitable, reasonably healthy, small business will sell in the 2.0 to 6.0 times EBIT range, with most of those in the 2.5 to 4.5 range. So, if annual cash flow is $200,000, the selling price will likely be between $500,000 and $900,000. But there are many factors that affect the multiplier.

Examples of Positive factors (that raise multipliers) include:

  • Proprietary products, with strong brand and/or patent or trademark
  • Diversified customer base – no one customer more than 10% of sales
  • Strong management team with few key personnel
  • Weak competitors and a healthy market share for your company
  • Products that are early in the Product Life Cycle
  • Diversified products – no one product more than 15-20% of sales
  • Ability of the company to meet some growth with current plant and equipment
  • No pending legal or government action
  • Financial ratios that are near or above industry averages

Examples of Negative factors (that lower multipliers) include:

  • “Me-too” products that are just like competitors
  • One or a few customers make up more than 25-30% of sales
  • Strong competitors and a weak or declining market share for your company
  • Products that are near the end of the Product Life Cycle
  • One product makes up more than 20% of sales
  • Major investment needed soon in plant and equipment
  • Pending legal or government action
  • Financial ratios that are below industry averages

Here is a very important point about the factors just listed: If your company has one, or even a few, of the negative factors, you are typical! There is no perfect business, but buyers will use these factors to negotiate the price down. You should make a mental note to work up a plan to convince buyers that the negatives can be overcome.

Valuing a company based on assets

Many businesses are sold under less-than-ideal conditions. What if there are no profits or cash flow? What if the owner passed away suddenly, and there is high financial risk for a new owner taking over? In these cases assets may be used to value the business. The value of the tangible assets usually sets a rock-bottom selling price for the business. Intangible assets may be worth money too – goodwill, customer lists, trademarks, patents, leases, permits and contracts are all intangible assets that can be factored into the price. Many buyers balk at paying a lot for intangibles, but for the seller it pays to evaluate each one for its worth. Hiring an appraiser is often a good idea when the price of a business will be based largely on assets rather than cash flow.