Small business owners often have a very difficult time trying to determine the value of their business. Perhaps the owner has never taken the time to consider the value. Perhaps the owner believes there really is no value to the business in the event that he or she ceased to operate the business. More often, the owner simply doesn’t know how best to value the business. But, it is important that a business owner understand and have at least a vague notion of how to value the business and to use that knowledge to keep a running estimate of the ongoing value. The information is vital for estate planning, for retirement planning, and also for determining whether to keep or sell the business. The longer the owner puts off understanding the business’s value, the fewer the potential planning options will be available.
Big caveat: I am not a valuation expert. There are much more qualified individuals that can apply comprehensive valuation methodologies. This article is simply a “back of the paper napkin” way of determining the value of your business. For a legitimate valuation to meet specific needs or requirements, you will need to hire a business valuation expert (e.g. an individual with the ABV accreditation) for a minimum of a few thousand dollars.
The first common metric is to look at the business’s EBITDA – Earnings Before Income Taxes, Depreciation, and Amortization. It is a rough proxy for operating cash flow of a company and is, simply put, the profits after all expenses have been paid (including salaries) but before financing (interest expense), taxes (corporate taxes), and capital investment considerations (depreciation). Then, to determine the value of the business, the owner would multiply the EBITDA by a factor (a multiple) – typically a fair market value factor of three to five for a small business but might be as low as one or two. As an example, if the EBITDA for 2019 is $100,000, then the business might roughly be worth $400,000 (a four-factor example).
Unadjusted EBITDA is not a great method for all types of businesses. For example, an entity taxed as a C-corporation is incentivized to inflate the salaries of the working owners to avoid the double tax structure of the C-corporation. Alternatively, an entity taxed as an S-corporation is incentivized to deflate the salaries of the working owners to avoid part of the FICA tax on compensation. The conclusion then is that artificially adjusted compensation for owners should be adjusted to fair (realistic) wages to calculate the adjusted EBITDA. For example, the business owner that takes a wage can determine what it would take to pay another person to do the same job and use that compensation for the calculation. Again, as an example, if the business is a convenience store S-corporation where the owner works full time and is paid a wage of $30,000 a year (and an additional $100k in S-corporation distributions), but a replacement for the owner would likely command a wage of $60,000 a year, then the $60,000 figure should likely be used as fair compensation to determine the value of the business.
Sometimes, current EBITDA simply doesn’t produce the most relevant information. This might be the case where the business is pushing its income towards growth (buying more inventory, paying more for marketing, or improving company assets). Alternatively, a company’s value may simply be a function of the value of its assets less liabilities. As is evident, the value determined here gives no consideration to the “going concern” or “goodwill” of the business including its reputation or ability to generate revenue or income. Instead, it is another simple metric that might be helpful in a business with high levels of inventory or equipment. It is more helpful especially when the same business can’t show sufficient EBITDA because it continues to invest in more equipment or inventory. Similarly, to EBITDA, this value is not a conclusive metric, but simply a helpful metric in gauging the value of a business.
Of course, the best metric of value is this: what would a willing buyer pay for your business? This kind of metric is not easy to come by without actually engaging in the process of selling the business and soliciting offers. But, it is still possible that the business owner has received unsolicited offers or off-the-cuff offers. While not providing any certainty, such offers might help to narrow the owner’s understanding of value in conjunction with other metrics.
There are probably dozens of other metrics that are important to know. But, I am not the guy to provide that kind of analysis. Call a valuation expert to help you sort through and determine relevant methodology and the application of the methodology in guiding your financial decisions.
* Licensed, not practicing.
Content in this material is for general information only and is not intended to provide specific advise or recommendations for any individual. Beau Ruff, Cornerstone Wealth Strategies, and LPL Financial do not provide business valuation services. Please consult a qualified professional for your business valuation needs.
Securities offered through LPL Financial, Member FINRA/SIPC. Investment Advice offered through Cornerstone Wealth Strategies, Inc., a registered investment advisor and separate entity from LPL Financial.