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How To Value A Small Business

What do an ice cream shop, a coaster manufacturer, and a consulting practice have in common? Each business is easy enough to value (and therefor buy or sell) if you know how to assess it.


Business Value


Broadly defined, business value is the price a company’s tangible and intangible assets should bring in a competitive and open market under all conditions requisite to a fair sale.


I consider these the 5 key components of business value:

  1. Market value of assets.

  2. Historical trends of revenues, expenses, and cash flows.

  3. The value of rights, privileges, and knowledge.

  4. Estimated stability in the future.

  5. Esthetic appeal.


Approaches to Valuation


There are three general approaches to determining the value of any asset:

  1. The cost approach which considers the cost of purchasing or producing the asset.

  2. The market data approach which values the asset based on current sales in the marketplace for the same or similar commodity.

  3. The income capitalization approach, translating potential future income into an estimate of market value by analyzing risk rates, the cost of capital, and the marketplace.

Each of these approaches contains several methodologies. The accuracy of each method is affected by current economic factors, industry dynamics, and a company’s uniqueness.


It's up to each investor to weigh the relevant facts, and determine their aggregate significance.


I generally use several business valuation methods, and then compare them against each other for a sanity check.


Real World Application


A business is worth whatever someone is willing to pay for it. The business risk is weighted against expected returns of other investments, like commercial real estate or what someone might expect to make in the stock market. Investing in a publicly traded company is considered less risky than buying a small business, so the average returns for investing in the stock market are proportionally lower.


If I was trying to value a large or a mid-sized business, I'd probably rely most heavily on the discounted cash flow (DCF) method of valuation to determine if I should be DTF. (DCF would fall under the income capitalization approach.)


But pricing a small business is usually wayyyyy simpler than doing DCF analysis. Let's start by saying, a small business will often sell for about 2.5x its annual net income.


(I'll revisit this 2.5x multiple and expand on it below.)


Basic Net Income


Getting a clear picture of net income can be tricky. Here's where most people start:


REVENUE - COGS = GROSS PROFIT

GROSS PROFIT - EXPENSES = NET INCOME


Remember when I said a small business will sell for 2.5x net income? Well actually, by net income I meant net adjusted owner benefit.


OWNER BENEFIT = NET INCOME + DISCRETIONARY EXPENSES + NET GAIN FROM DEPRECIATION & AMORTIZATION + EXTRAORDINARY EXPENSES.


It might sound complicated... but it's not that scary. I describe each one below.


Manzanas to Apples


When comparing the income of different businesses, we also wanna make sure we're comparing apples to apples. And with small businesses, owners/accountants/brokers are notorious for calculating things in their own special way. So when trying to understand value we need to adjust for that...


When a business is listed for sale, the standard practice is to represent net income as the owner operated net income. Meaning, how much the business would net based on the owner working a 40-hour work week. But a seller might represent what the business nets with an owner working 80 hours a week.


When you're considering buying a business, you've gotta level the playing field between different claimed net incomes... and sometimes you find hidden value and other times you find hidden costs.


Let's use an ice cream shop to understand this. Let's say this ice cream shop has an owner-operated net income of $150k per year. This could present in a few different ways:

  1. The ice cream shop shows a net income (on the books) of $150k per year, and the owner works 40 hours per week.

  2. The ice cream shop shows a net income (on the books) of $90k per year, the owner does not work in the business, and pays a manager $60k per year.

  3. The ice cream shop shows a net income (on the books) of $190k per year, but the owner works 80 hours per week, and reducing an owner to a 40 hour work week would require paying an additional $40k in wages to other employees.

Each one of these business I would consider as netting $150k.


Now let's talk about DP.


By "DP" I mean depreciation. (Wink.)


If the above ice cream shop owns $70k in assets (furniture, fixtures & equipment) then if you bought it you might depreciate those assets over 7 years. (Actually, ever since the 90s you can also depreciate intangible property... but that's a topic for another day.) Depreciating $70k in 7 years gives you a depreciation expense equal to $10k per year. If the business has a 30% tax rate, then reducing the business taxable income by $10k per year (due to depreciation expense) would give the owner a net benefit of $3k. (30% of $10k = $3k in tax savings.) So in our ice cream shop example the adjusted owner benefit goes from $150k to $153k.



Discretionary Expenses


Discretionary expenses are just expenses that aren't considered essential. These can include all sorts of owner perks, but let's just use a simple one as an example:


Our owner operated ice cream shop is now netting $153k, including the $3k benefit we earned with a depreciation expense. If we also find out that the shop owner is using the business to pay $500/mo towards a car payment (and maybe auto insurance), then that $500 per month adds an extra $6k per year in owner benefit. (It's discretionary cuz an ice cream shop doesn't need a car.) So now our adjusted net owner benefit goes from $153k to $159k.


(Even if there aren't obvious discretionary expenses (like a car for the owner), new owners can often identify several non-essential expenses that the old/current owner is incurring. It can be a good place to find value, and effectively increase your return on purchase price.


Extraordinary Expenses


Adjusting for extraordinary expenses just means adjusting for one-time or non-recurring expenses. Maybe this ice cream shop spent $10k last year on a new sign for the building. Or perhaps it purchased a new piece of equipment. Or had to fix a bigass broken window (and insurance didn't cover it). Well, that $10k expense would be added back, making our new adjusted net owner benefit increase from $159k to $169k.


Putting it all Together


With a few simple calculations, we just took the "net income" - by which we mean adjusted net owner benefit - from $150k/year to $169k/year.


The above exercise makes a big difference when trying to calculate the potential return on different businesses.


If we're expecting a 2.5x multiple:

  • $150k per year would be worth $375k

  • $169k per year would be worth $422k.

When small businesses want to sell, they often go to their attorney or to business brokers for advice, and often these advisors don't go a great job pricing a business appropriately.


If advisors (or sellers) are relying on rules of thumb, and priced the above business at $375k:

  • assessing the deal based on a $150k net would look like a 40% annual return;

  • assessing the deal based on a $169k net would look like a 45% annual return.


Why do people invest in the stock market and hope to get a 10% return when we're seeing a 40% annual return for buying an Ince cream shop?

First, this example is make believe.

Second, returns in that range would be reasonable to expect.

Third, there's a lot more risk investing in an ice cream business than in Tesla stock.)


The above valuation exercise helps us spot cases where net income is over-represented innocently (by having a workaholic seller doing 80-hour work weeks) or unscrupulously (by an owner under-spending in the prior 12 months in an attempt to leverage those 'saved' dollars into that 2.5x multiple for themselves).

Often, businesses are priced based on a standard multiple of gross revenue rather than a multiple of net... but even in those situations, you've gotta be able to calculate the adjusted net owner benefit if you want to evaluate and compare the potential returns.


MANUFACTURING & CONSULTING BUSINESSES


For simplicity, when I refer to net income below, what I actually mean is adjusted net owner benefit, as described above.


If you recall, we talked about a business being priced at 2.5x net income. The actual multiple will depend on the size of the business, how dependable the cashflow is, and the type of business. (And on other things too, like how sexy the business is, but I'm not gonna get into putting a value on sexy. I'll save that for one of my psychology rants.)


How Business Size Affects Value


Generally, business with a larger net income earn a higher multiple.

  • A business that nets $100k might sell for 2.5x = $250k

  • A business that nets $50k might sell for 1.75x = $87k

  • A business that nets $300k might sell for 5x = $1.5MM

When I've started businesses I've tended to own them for longer periods. When I've purchased businesses, I tend to sell them in 2-3 years. (That's not a rule or a goal, just how it's worked out.) If someone is wanting to flip a business you can see how increasing the net income not only increases the potential sales price by the current multiple, but if you pay 2.5x and drive the net up you might be able to sell at 3.5x. It's like double jeopardy! You don't just 2.5x in value for every additional dollar, you get 3.5x (in business value) on every additional net dollar plus every existing dollar.


That sounds convoluted... so this'll help:

  • Say you buy a business that nets $50k and pay a 1.75 multiple, or $87k. Then you get the net up to $75k, and sell for a 2.2 multiple, or $165k. In addition to earning the extra $25k per year in cashflow, you practically doubled the size of the business. If you owned the business for 2 years you'd have made $75k * 2 = $150k in net income + sold it for $78k more than you paid for it. That's $225k in profit in 2 years for a business that you paid $87k for.

In reality, instead of working full-time in the business you might hire a manager and that would cut into your profits. And I'm not sure "flipping" small businesses makes a lot of sense as a strategy. Actually, it can make financial sense but imagine how shitty it would be if a ton of people started trying to professionally flip local businesses. But buying a business, and making good decisions that increase the value is good for everyone... even if life circumstances or other interests mean that you end up selling after a couple of short years.


How Cashflow Dependability Affects the Multiple


If the business has a 10 year history, and financials for the last 2 or 3 years look consistent, it'll go for a higher multiple. In other words, I wouldn't pay a 2.5x multiple for a business that someone started 12 months ago.


(Startups often build excitement and increase valuation multiples by achieving high early growth rates... but this doesn't apply when talking about small (Main Street) businesses.


How Type of Business Affects the Multiple


The 2.5x multiple that I've been using in the above example is realistic for an ice cream shop, depending on the size and some other factors as discussed.


A stable manufacturing business that makes coasters (or widgets) and sells them to some random distributor(s), is going to earn a higher multiple than an ice cream shop even if they both net $150k. I'm totally shooting from the hip here, but I'd probably expect to see a 4x multiple instead of a 2.5x multiple. The two businesses have very different industry dynamics, likely very different asset values, barriers to entry... and also the market sees manufacturing widgets as less of an art than selling ice cream. It's just a manufacturing line, that prints widgets that it then turns into cash. ACTUALLY it might be lot more complex than that and require specialized knowledge, but that's the overly simplistic reasoning that is often applied. An easier (and arguably more appropriate) example would be to consider a coin-op laundromat. Those sell for higher multiples that ice cream shops too. Vending machine routes go for even higher multiples... though I've never dabbled there cuz it feels like a hassle and there's nothing in vending machines that I'd feel great about selling.


A consulting business on the other hand relies entirely on the consultants, and is often largely dependent on the owner. I'd be harddd-pressed to pay more than 1x annual net income for a consulting business. I've been offered consulting businesses for 1/2 of the annual net income, and walked away. Too much risk of losing existing clients... and buying a small consulting practice is like buying yourself a job.


Purchasing other service businesses, like hair salons, can be similar. Especially when they're small. Doesn't mean it's a bad deal, just means its more risky.


There are ways to mitigate that risk... like negotiating to buy the business based on an earnout. That would mean negotiating for the purchase price to be a percentage of revenue over a percentage of time. That reduces risk for the buyer, and increases his for the seller (cuz the buyer might run the business into the ground). Alternatively, the buyer might grow the business and increase the seller's gain. Or the earnout could be calculated based on revenue from existing clients. There are a thousand ways to make a deal work, and while it can sometimes sound complicated, it often just requires a conversation between two reasonable parties.


If you'd like to talk to more about business valuation, give us a ring or shoot us an email.

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