How To Value A Business
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If you are a buyer or seller who is wondering how to value a business, you have come to the right article. Accurately valued businesses benefit both seller and buyer, because they are more likely to sell and are also more likely to be a good investment. We’ll show you how to accurately value a business, explaining which numbers matter most. When you are finished, you should have all the tools you need to conduct a basic business valuation.
How To Value A Business: Family Restaurant vs. Franchise Restaurant
Let’s walk through two examples together as we discuss each aspect of how to value a business. We chose to compare a franchise and an independent restaurant because while on the surface they are similar as they both are in the food industry, they have different valuations. In short, an independent business has many more risks and therefore a lower valuation, on average, than a franchise business.
Example 1: Joe’s Family Restaurant and Cafe (MO)
- $528,747 – Annual Revenue (Total cash generated by sales)
- $80,799 – Annual Seller’s Discretionary Earnings (SDE) (What’s left over after operating expenses. Owner’s salary/compensation is not subtracted as an operating expense and is therefore included in the SDE number)
- $234,000 – Real Estate (Estimated worth of property and buildings owned by business)
- $31,950 – Furniture, Fixtures, and Equipment (FFE) (Refrigerators, fryers, booths, counters, etc)
- $3,500 – Inventory/Stock (Food, napkins, ketchup, etc)
Example 2: Subway Franchise (NJ)
Calculating an Average Value to Get Started
Ultimately, a small business is only as valuable as the price a buyer is willing to pay for it. Using a Seller’s Discretionary Earnings (SDE) to business sale price multiplier, commonly used in small business valuation, we can calculate an average value for each business. SDE is basically a business’ total revenue – operating expenses. Using statistics from restaurants sold in 2013, bizbuysell.com determined that the average sale price of a restaurant is 1.89 x SDE.
Using this figure, we can calculate a general value based on industry norms for each business, as demonstrated below.
$152,710 – Family Restaurant and Cafe ($80,799 x 1.89)
$144,154 – Subway Franchise ($76,272 x 1.89)
Revenue vs. Seller’s Discretionary Earnings
People often look to revenue as an indicator of a business’ success/overall value. However, this can be deceiving, because a business may have a high cost of operation. Both of the restaurants above are perfect examples. They both gross over $300,000 in annual revenue, but their operational costs are high as well. You can’t live off of revenue.
When you buy a small business, it is both an investment and a job.You have to be sure you can cover business costs and make a living wage for yourself. This is why it is better to use seller’s discretionary earnings (SDE) as the base to determine how to value a business.
SDE = Total revenue (pre tax) – operating expenses (does not subtract owner’s salary or owner withdraws/payments that are not operational related, like personal insurance premiums). This is basically the sum of money you actually have to work with each year, after you have paid off all your business costs.
It is important not to confuse the term SDE with the term “cash flow.” This is difficult, because Bizbuysell.com’s listings and reports define the term “cash flow” exactly the same as SDE is defined here. The SDE is the standard and most accurate method for small-business valuation used by professionals and is therefore the method we use throughout the article. In common usage, cash flow is simply the amount of money that is coming in and going out of the business during a specific period. Just watch so you do not confuse BizBuySell’s definition of cash flow with the common usage definition.
The real question: How much money can I actually put in my pocket?
Ultimately, if you buy a business, your primary valuation question is: How much money will this business actually put in my pocket? You want to know what you can expect to earn after expenses. I talked with David Coffman (CPA and Certified Valuation Analyst). Richard Parker (Business valuation expert and Founder of the Diomo Corporation ), Barbara Schenk (Author of “Selling Your Business For Dummies”), Gregory Caruso (CPA, CVA, and Founder of Harvest Business Advisors ), and David Perkins (Business buying expert and Founder of Acquisition Advisors, LLC ). all who recommended the SDE x multiplier method as the primary small business valuation method.
Factors That Influence the Multiplier/Base Value
Calculating the average value of a business using the SDE multiplier method can be a good first step. In the restaurant industry, the average cash flow to business sale price multiplier is 1.89, as mentioned above. Using this multiplier, Joe’s Restaurant and Subway have similar values.
However, there are lots of different factors that affect whether a specific business’ multiplier is above or below industry standard. Think of the industry standard multiplier and the specific business multiplier as two separate numbers, one giving you a general value based on industry averages and another giving you a more specific value based on variable factors of each individual business. In most cases, small businesses are given a business specific multiplier of 1 – 3.
From David Coffman and Richard Parker
For around $145, you can get the Business Reference Guide. a book that contains an exhaustive list of business types, valuation rules of thumb, and specific business multipliers. It is a quick way to get an SDE multiplier that is likely to be fairly specific to the business you are interested in buying. This is important because similar restaurants in New York City, NY and Raleigh, NC may be priced very differently. Richard finds the Business Reference Guide to be fairly accurate, although at times a bit high. David said that his own research generally confirms the business reference guide values.
Here are the main factors that influence a specific business’ multiplier/business value:
Assets add value to a business. The more assets a business has, the more it will be worth on the market and the higher the multiplier used for valuation. There are two main kinds of assets: Physical and non-physical. Normally, non-physical assets are a bigger component of business value than physical assets.
By David Coffman, Business Valuation Expert (David’s Website )
Here are some common percentages based on David Coffman’s valuation experience. The lower end percentage is for older equipment, the higher for newer:
- Manufacturing equipment – 30-60%
- Office equipment – 10-20%
- Restaurant equipment – 30-50%
- Vehicles – Find equivalent vehicle estimates
- Heavy Machinery – MachineryTrader.com
- Regular vehicles – Kelley Blue Book
When using the SDE method, physical assets are understood primarily as tools for making money. They are included in the SDE estimate under the cost of doing business. They should not have any major effect on a business’ multiplier.
However, in reality, owners sometimes want a higher multiplier if they have recently purchased new equipment. Let’s say a restaurant has just purchased a whole new set of friers and stoves. That means that equipment will not have to be updated in the near future, cutting down on future costs, which can raise present value.
Joe’s Restaurant vs. Subway
Let’s get back to our example. Subway has around $119,000 more in physical assets than Joe’s restaurant. The odds are that Subway’s multiplier will be a little higher than the industry standard 1.89, due to its high level of physical assets. Joe’s restaurant however, has nothing special in physical assets, so the industry standard is still a pretty good benchmark for business valuation at this point.
Non-physical assets are all of the positive aspects of the business that are not material in nature. These include but are not limited to a business’, brand, reputation, recipes, “trade secrets” and other factors, also known as “intangible assets” or “goodwill”.
Why do Non-physical Assets Matter?
Non-physical assets are the biggest influencer of
a business’ individual SDE multiplier. A wealth of non-physical assets means a much higher multiple. A lack of non-physical assets means a much lower multiple. Why? Because the wealth or lack of non-physical assets often determines whether or not a business transitions successfully to a new owner.
Will the Business Work for You?
If a business does not transition successfully to a new owner, than all of the business’ assets and income projections are pointless. In the business buying industry, this is referred to as the “transferability” of a business. The higher a chance of successful transferability, the higher a business’ value.
Joe’s Restaurant vs. Subway (Independent vs Franchise)
In most cases, buying a franchise is considered a much safer bet than buying an independent restaurant, because of the wealth of non-physical assets that inherently come with a franchise and the fact that these non-physical assets are not tied to the owner (more on this later).
Getting back to our example:
Subway Franchise Non-Physical Assets
- Nationally Known Brand
- History of Financial Success
- Informed Marketing Strategy
- Standardized Operating Procedures
The non-physical assets above benefit every Subway franchisee, regardless of location, demographic, or owner charisma.
Joe’s Non-Physical Assets
The fact that Joe’s restaurant has been relatively successful as a business for 35 years is great. But, there is no guarantee that the restaurant will be successful once Joe leaves. Here are some big risks.
- Customers may start going to another location – Many times, local customers choose one establishment over another because they have a personal relationship with the owner. If Joe leaves, customers may as well.
- Older employees may retire – If there are employees who were hired by Joe and are loyal to him, they may decide to leave when he goes. Or, if they agree to stay, it may only be for another 6 months or a year. If these employees hold crucialsitions in the business,like
- Supplier relationships may end or deals may change – If Joe had relationships with his suppliers, they may have been giving him an extra good deal, like lenient credit terms. When Joe leaves, those deals may dry up, or the suppliers may see it as an opportunity to back out altogether, which means of lots of extra work, effort, and time to find new suppliers.
In other words, the non-physical assets associated with Joe’s restaurant are much more closely connected to the owner of the business, making it less likely to transfer successfully to a new owner. This is often referred to as “owner risk”
Owner risk is one of the biggest, if not THE BIGGEST, single factors influencing business value. If a business has so much owner risk it cannot survive an owner transfer, than all other aspects of a business’ value are pointless.
What are the business’ future prospects?
Industry and geographic trends also influence how to value a business. This is often referred to as “market risk.” If an industry is booming and trending towards your particular business, the higher your multiplier will be. In the same way, the more the population growth and popularity of a business area is growing, the higher your business specific multiplier will be.
The truth is, people are never going to stop eating fast food. Also, fast food is trending towards healthier food, which is a major part of Subway’s brand recognition. So, as far as industry trends are concerned, Subway has good prospects. Geographically, New Jersey is staying pretty steady economically (Of course, specific geographic regions within a state can often have very different trends than the state as a whole, so it is also important to research local area trends).
Although Joe’s restaurant has had success in the past, David Coffman explained that restaurant success is trending away from independently owned businesses and toward franchises. So, the industry outlook is shaky, at best. Geographically, Missouri is actually doing pretty well, with dropping unemployment rates and a rise in entertainment and leisure jobs. So, Joe’s business specific multiplier might be a bit above the industry average of 1.89 due to the state’s positive economic trends.
In nearly 80% of cases, a business has some kind of owner financing option available to the seller, typically around 40-60% of the business value. If a business does not offer owner financing, they generally do not sell very well, and their value is decreased.
In this case, both businesses offer owner financing, so value is not affected.
(Financing Tip For Buyers: One major potential source of capital that many business buyers don’t consider is their retirement account. There are many pros and cons of this approach Learn More )
Real Estate and Lease Terms
The last main factor that can influence how to value a business is related to the property and building side of owning a business. If a business leases a building, lease term length is an important factor. If the lease still has 3-5 years on its term, then you should be good to go. But, if your lease ends in a year or less, that is a big headache you are going to have to deal with, and can at times lower the multiple of a business, because it affects the likelihood of successful transferability from owner to owner.
If a business actually owns it’s own property and building, then the value of that real estate is estimated separately and added onto the estimated business SDE value.
In this case, Joe’s restaurant owns it’s own property and buildings estimated at $234,000 in value. So, that number is added onto the value of the final SDE x multiplier value.
Subway’s lease terms still has 4 years left on it, so the value is not significantly affected.
Final Values/Multipliers (Based on Valuing Help from David Coffman)
Joe’s Restaurant – 2.0 Multiplier
Estimated Business Value = $161,598
Estimated Real Estate Value = $234,000
Total Estimated Value = $395,598
Although Joe’s restaurant has had reasonable success in the past, the industry is trending away from independently owned restaurants. Also, the likelihood of new owner success is questionable, due to the high level of owner risk associated with family owned businesses. However, due to Missouri’s positive economic climate, Joe’s business specific multiplier is a little higher than industry standard, at around 2.0. Although it does not have a very high multiplier, the real estate value actually makes the investment a pretty major one.
Subway Franchise – 2.8 Multiplier
Estimated Value = $213,561
Subway’s business specific multiplier well exceeds the industry average multiplier of 1.8. There are several reasons for this. First, the industry is trending toward franchises, meaning market risk associated with the business low. Second, being a franchise, Subway has a lot higher chance of transferring successfully to a new owner, meaning owner risk is low. Considering all of these positive factors, Subway’s business specific multiplier is a whole point above the average industry multiplier of 1.8.
More complicated business valuation methods, such as the excess earning method and discounted cash flow method are often used to evaluate bigger businesses. If you have a business that averages over $750,000 in annual revenue, check out Axial.net’s Company Valuation Tool for a discounted cash flow valuation.
Several of the valuation professionals I talked to stated that, “Business valuation is more of an art than a science.” Many of these professionals, said that it could be good to compare several methods of valuation. When calculating how to value a business, the truth is that it can be tricky. But, by using the SDE method of valuation as explained above, you should be able to arrive at a pretty good estimate of a business’ worth.
Peter Creyf said on
Jason, in the text under the heading SDE, the last sentence says, if one is wants to get an in-depth explanation of cash flow, click here, but the “click here” is not a hyperlink. Just a heads up on that.Source: fitsmallbusiness.com