If you own a small business and require a share freeze, partnership dissolution, or are starting to exit plan for the sale of your business, the first question owners often ask themselves is, “What is my company worth?” Most accounting firms provide business valuation services to answer this question. However, our experience is that they tend to misvalue small and medium-sized businesses.
The problem is that these firms are applying big company valuation methodology to small operations. They are too focused on the numbers and not enough on the company itself. Sometimes, they make the reverse error by focusing on the tax-reported numbers.
In this post, we’ll explore the details surrounding business valuations, including the proper method for your company and our process at Sunbelt Canada.
Table of Contents
- Most often, a business owner will get a business valuation if they are retiring or looking to sell.
- Different companies are valued based on their size and various methods. What might work for a Fortune 500 company likely won’t work for a small business.
- Buyers may look at a business’s worth as different from the valuation.
What is a Business Valuation?
A business valuation gives a company an absolute economic value. This final number can be reached in many ways, often with specific methods and formulas to determine an exact amount. It is often used to determine the list price of a business if the owner is looking to sell.
When Should I Get a Business Valuation?
At Sunbelt Canada, we perform an average of 1,000 small business valuations annually. Typically these companies have fewer than 100 employees, have revenue of $50,000,000 or less, and are privately owned. Most valuations we do are for exit planning or the sale of a business. In either case, we recommend that you begin well in advance.
The valuation will provide valuable information about the value drivers for your business. It will assist you in focusing on the activities that will have the greatest ability to increase value. Some of these may relate to restructuring to increase salability or reduce taxes. Depending on the specific factor, they might take years to complete and be effective. However, others can be implemented quickly and are effective almost immediately.
Types of Business Valuations
There are many valuation methodologies that work for various types of businesses. We use 14 different procedures at Sunbelt Canada. These include the following:
- Market Capitalization
- Times Revenue Method
- Earnings Multiplier
- Book Value
- Liquidation Value
There are also several different methods to consider that might incorporate various formulas but look at similar data sets. These might be based on the following:
- Discounted Cash Flow (DCF) method
- Earnings-based method
- Asset-based method
- Multiples analysis method
- Net book value method
- Scorecard valuation method
- Venture capital method
- Berkus method
- Risk factor summation method
The valuation that we have found to be most appropriate for small businesses is the market-driven one. This methodology works similarly to how realtors appraise a house. It requires access to a reasonable sample of done deal transactions, but it is often the most reliable and accurate valuation for these companies.
If you consider the real estate scenario where the list price hinges on what houses sell for in this or a similar area, your realtor then adjusts for differences. They could look at the cost to build or value per square foot. For the most part, nothing will be more accurate than looking at sales of similar houses in the neighbourhood.
Which Valuation Method Should I Use?
Generally, this depends heavily on the kind of broker you are working with. They might have methods that continue to work for them in certain industries or regarding unique companies. While we prefer the market-based approach, you may be interested in exploring an assets-based approach if your business is more niche and focuses on different services. Ultimately, you’ll need to consider why you are doing the valuation in the first place and what you hope to achieve once you know the final number.
Business Valuation Considerations
It is worth noting that different methods will provide different valuations. In addition, these are simply guidelines to view the overall economic value of your business, a snapshot rather than the complete picture.
For example, most small business owners and their accountants do their financial reporting and tax returns to minimize the tax payable. As a result, they may run discretionary expenses throughout the business. Discretionary could mean expenses that are not necessary to support the business’s revenue. These might include travel and entertainment, health and life insurance, automobile expenses, payments to the owner or their family members, and much more.
How Sunbelt Does Business Valuations
The first step in our valuation process is to recast financials to determine what the business actually makes the owner. This process includes removing depreciation, amortization, taxes, and interest and then revaluing current assets. We start by working with the business’s accountant to understand what is included in each line of the financials. From there, it will shift to focus on the owner to determine accurate discretionary expenses.
Our team typically requires three to five years of a company’s financial records to review. This gives an accurate perspective during the recasting process and is critical to understand the real benefits of ownership.
Once we have completed the recasting, we review four databases. Each has more than 40,000 transactions recorded over the past 40 years. Our team contributes to these directories and subscribes to their use.
We start by looking at industry and size, and from here, we can determine what an average business in your sector of similar magnitude sells for. This is based upon a multiple of revenue, a multiple of EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), and a multiple of Seller’s Discretionary Earnings (SDE).
We then analyze your company concerning many factors which affect value. These include, but are not limited to, the following:
- Owner dependency
- Client loyalty
- Marketing systems
- Operating systems
- Recruiting and training programs
- Competition, location
- Condition of facilities and equipment
- Pending changes that will affect your business
- Supplier relationships
- Revenue collection systems
- Revenue forecast for the next five years
Our database research and the above details allow us to put together a benchmark that adjusts based on our original calculations. These final changes can be considerable – they may double or reduce a value by half.
Although we have concluded a typical company valuation, we are not finished. Using the determined value and the revenue forecasts for the next five years, our team now develops pro forma financials for the coming five years. This helps to structure a deal based on our determined market value.
Potential buyers can clearly see a down payment amount, lender financing and costs, and seller financing and costs. If this draws in buyers, the valuation is successful. If it has not, we go back to the drawing board to see where we went wrong.
A Business Valuation Example
Previously, our brokerage worked with someone interested in purchasing a dry cleaning company. So, we did a valuation of two dry cleaners. Company A had revenue of $1,200,000 and an EBITDA of $600,000. Company B had a revenue of $1,200,000 and an EBITDA of $325,000. We valued B higher than A. Here is our reasoning:
- Company A had senior staff and obsolete equipment. The operation looked at significant capital expenditures and derived much of its business from hotels, but this depended heavily on tourism.
- Company B had new environmentally sound systems, equipment and technology and employed young, well-trained staff. It was the most significant player in its small market, having many good commercial clients and good outlets.
The buyer who was considering both doubted our valuation based on numbers alone. The individual ended up buying Company A, but the following year saw a major decline in tourism and thus business for the dry cleaner he purchased. Earnings fell to just $100,000. Meanwhile, Company B’s profits increased by $25,000 annually for the next five years.
If you are interested in knowing what your business is worth, reach out to your local Sunbelt broker’s office. All our business analysts are well-trained and excellent at what they do. We have invested in the tools, resources, and skills necessary to do an excellent job for you. Personally, I am a life-long member of the Institute of Business Appraisers, hold numerous designations, and even teach business appraisal for several organizations. Our focus and our experience are in small, privately held businesses.
We have 30 locations across the country and are proud to say that we sell more businesses than anyone in Canada. This means we have the experience to get your company bought or sold with ease. Contact us today to get started and see what your business is worth.