The Value of a Business

This article is a reprint of Wise Bread's contribution to OPEN Forum from American Express -- where small business owners can get advice from experts and share tips with each other.

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Placing a value on your business is rarely a simple matter. If you've poured time and sweat into building up your company, your view of the value will reflect the effort you've put in. But an independent appraisal can offer a very different number than what you might come up with. It's important to have an objective idea of what a business' true value is, if only because you may consider selling it in the future.

The Real Earnings of a Business

Joseph Caffrey, a business broker with Worldwide Business Brokers, explains that the value of a business can't simply be based on what you've put into it yourself.

To a large degree, a business is valued based on what the benefits of owning that business are. Though such benefits can be intangible (being your own boss, for example), the benefits that concern us are monetary. We want to determine, as closely as possible, the value of the benefits enjoyed by the owner. This effort entails a process known as recasting the earnings — i.e., we analyze the business' profit and loss numbers to try to identify the true 'discretionary earnings' or 'owner's benefits' of owning that business.

Offering an example, Caffrey describes the following situation:

By way of example, let's imagine a business with revenue of $1 million. A glance at the P&L reveals net income of $75,000. If the business is a corporation, we examine Form 1120 of the business' tax return and see that taxable income is also $75,000. We then analyze both P&L and the tax return to identify which or to what degree certain expenses are really 'owner's benefits.' We look for what is called 'discretionary spending' — spending the owner has control over, unlike payroll, utility costs or rent. Our objective is to determine the business' true profit or Seller's Discretionary Earnings (SDE).

Owner's Benefits: The Determining Factor

For small business owners, there are many financial benefits that go along with owning your own business. There is a lot of discretionary spending that occurs in many businesses that owners directly benefit from, beyond the business necessities of certain expense.

Caffrey says:

Examples of such discretionary expenses include the owner's health insurance (and that of the owner's family), life insurance and disability insurance. In many cases, the business pays for the owner's vehicle, its insurance and its maintenance. We determine these costs, pull them out and put them in the SDE column on the spreadsheet we've built. Another modest benefit is that it is not uncommon for the business to pay for cell phones for the owner's family. More significant items include travel for tradeshows and association meetings, client dinners and, in the case of restaurants, the amount of food and drink enjoyed by the owners, etc. As an example, a business owner in Jacksonville, FL may get a mailer from his industry's association that the association's regional meeting will be held in Atlanta, GA and that the annual association meeting is in Honolulu, HI. The owner can attend the regional conference for $2000 or the national conference for $20,000. The $18,000 difference would be considered discretionary for our purposes and moved over to our SDE column. Another example is a real estate brokerage we've worked with that specializes in waterfront property. It is reasonable to assume that a boat, properly named, of course, is critical to the owner's business. The costs of owning/leasing and operating that boat are largely picked up by the business but are really benefits of owning the business.

Similarly, there's a question of the cost of the salary an owner draws against the business. If the salary is more than an owner would need to pay a manager to run the business — if the owner was absent from the day-to-day operations of the company — then the difference is also added to the SDE column.

Considering Similar Businesses

When putting a value on your business, it's also helpful to have an understanding of what similar businesses have sold for. Caffrey points out:

As in the real estate industry, databases exist recording business sales, by industry classification, by region, nationally and, to a lesser extent, internationally. We can determine what similar businesses have sold for…An analysis of such other sales will give the analyst a range of multiples that can be used to determine the 'comparable' value of the subject business. One example is a multiple of revenue in which the analyst will plot the sales price-to-revenue numbers on a chart, eliminate outliers, average the remaining sample and apply the result to the subject business.

There are other metrics used to determine the value of a business that take into account both the values of similar businesses and the SDE, according to Caffrey.

A database search shows that six similar businesses have sold in the past 12 months at .67, .59, .72, .94, .65 and .56 of revenue. The analyst eliminates the outlier (.94), averages the remaining sample (.64) and applies it to the subject business. Though this is a very simplistic explanation of this stage of the process, the value of the subject business, using the Multiple of Revenue approach, would be $640,000…A more important metric is the Multiple of Earnings approach which will provide a more meaningful valuation because it is based on actual earnings (SDE) and shows what the buyer can expect as a return on his or her investment. The process is similar to the Multiple of Revenue approach in that the analyst looks at the same six similar businesses, calculates the sales price as a multiple of SDE (2.4, 1.9, 2.2, 3.1, 2.1 and 1.8), eliminates the outlier (3.1), averages the remaining sample (2.08) and applies it to the subject business. Again, though this is a very simplistic explanation of this stage of the process, the value of the subject business, using the Multiple of Earnings approach, is $582,400.

Taking a look at the different valuations that can be placed on your business is a useful process because each metric can help you along to the clearest understanding of the true value of your business.