When you put your business up for sale, there are many complicated issues to consider, the biggest of which is determining the selling price. Learn about the different business valuation methods you can use here.
Selling a business can be a challenging undertaking. Most people haven’t been through the business sales process before and are surprised to learn how different it is when compared to a typical real estate transaction.
The entire process of selling a business is usually much more involved and can be much more complicated. For instance, finding an appropriate business buyer, qualifying leads, maintaining business confidentiality, tax issues, asset sale versus share sale, due diligence, vendor financing, transitions, employee issues, liabilities, working capital, and so on.
Besides all of these issues, though, probably the most confusing issue for many owners when selling a business is determining an appropriate selling price. For most people, determining a selling price (or business valuation) is a mystery. It’s one of the most important decisions a business seller can make, though.
Setting the selling price too high will discourage potential buyers from inquiring about the listing. If the price is set too high and it stays on the market too long, it may lead to red flags (buyers may think there’s a problem with the business if it’s listed for too long). Conversely, setting a selling price that’s too low isn’t good in that a business owner is not realizing the fullest value for their business.
There are some common useful methodologies that can be used to assist in determining the listing price of a company when selling a business and help arrive at a fair number.
Discretionary Earnings Multiple Method
This method is a common way that small businesses are valued. It is a (relatively) easy method to determine a business’s listing price and is quite intuitive. Essentially, the concept is to determine a business’s “discretionary earnings” that it delivers to the owner and then applying it to a multiple to determine the value of the business. A simple example — if the discretionary earnings of a business are $150,000 and it’s determined that the earnings multiple is 2.2 times, then a valuation of approximately $330,000 would be appropriate ($150,000 x 2.2).
It’s important to properly calculate “discretionary earnings.” A qualified business broker or business appraiser can assist you with the calculations, but the concept is to calculate the earnings available to an owner as a result of running the business. It usually involves taking pre-tax income and adding back some discretionary items like owner’s salary, personal items, and so on.
Making calculations like this is easier if you’re keeping good books. The ZenBusiness Money app can help you track and manage your money from an easy-to-use dashboard.
The next step is to determine the right multiple. Multiples vary by industry, geography, and time, so it’s important to get a supportable multiple that’s in line with the market reality. Again, a qualified business broker or business appraiser can help you. If you’re selling a business, please work with a professional to help you determine a selling price.
Discounted Cash Flow Method
A much more sophisticated method to determine the selling price of a business is the discounted cash flow methodology. Essentially, the concept is to forecast the cash flow that the business will generate into the future and then discount the stream of future cash flow that has been estimated back to the present by applying a cost of capital. Confused yet?
The principle is that a business is worth the “present value” of the future earnings it will generate, adjusted for time (a dollar earned in the future is worth less than having a dollar now). So, when a business buyer buys a business, they are really buying a stream of future cash flow. The earnings that the business will generate in the distant future are worth less than the earnings it will generate in the near future, so time-based adjustments need to be calculated.
Please bear in mind that this methodology is generally not used for small businesses. If you’re selling a business that’s mid-sized or more complicated, you may encounter this methodology.
Asset-Based Business Valuation
Please use extreme caution if you want to value your business based on the value of the physical or tangible assets. Often, business sellers believe that the only way to value their business is by adding up the market worth of their physical goods. This could lead to a costly underestimation of the business’s value. This approach doesn’t factor in the intangible value that is inherent in the business (example: goodwill).
For instance, suppose an owner of a very profitable service-based company with very few “hard assets” was selling, and they decided to value the company based on the market value of these hard assets. The owner would be grossly underestimating the business’s true value by neglecting to consider the company’s goodwill and any other intangible assets.
If you’re selling a business and want to base its value based on the tangible assets, please use caution and consult with a reputable business broker or business appraiser.
Sometimes emotions can work against you
Many times business owners get emotionally attached to their companies, especially those that have built their businesses from scratch and have personally invested years of hard work. Selling a business is more than just a business transaction. Emotions must be acknowledged — and managed.
Often, these owners may think their business is worth far more than it really is (which is understandable and natural). Emotions can, however, get in the way of prudent business decisions, so please take care to not make selling decisions (or pricing decisions) based on an unsupportable value.
Please bear in mind, there are many other detailed issues surrounding a business valuation that must be considered. These can impact the methodology used when selling a business (for instance, an asset sale versus a share sale). This article is a general overview of the process and a brief summary of a couple of methods used. If you decide to sell your business, please consult with a professional about determining a fair market price for your company.
Disclaimer: The content on this page is for informational purposes only, and does not constitute legal, tax, or accounting advice. If you have specific questions about any of these topics, seek the counsel of a licensed professional.
Steve Skrlac is a professional focused in the field of business brokerage. Steve serves the market from Toronto (GTA) to Hamilton, Ontario, including most of the “Golden Horseshoe.”