Curious about Business Valuation Methods?

There are several business valuation methods that can be utilized
by a business owner.  Which method is used depends greatly on the type and size of the business and most importantly, what is the purpose of the business valuation.

Some appraisals or valuations are strictly used for legals purposes and some are for selling businesses.  

Here are some of the approaches available:

• Seller's Asking Price
• Similar Business Comparison (Comps)
• Sales Multiplier
• Asset Valution
• Return on Investment
• Capitalization of Earnings
• Excess Earnings
• Sellers Discretionary Earnings

Since I am a business broker specializing in valuing and selling business with under $5 Million in Gross Sales, I will focus on what myself and most other business brokers that specialize in small businesses use.

We most commonly utilize the Seller's Discretionary Earnings (SDE) Method, which is based on the restructuring of the businesses' profit and loss (P&L) statement.  

The P&L statement is not a true reflection of the business and does not realistically show what a prospective buyer would net when they take over.  

Most small businesses make deductions to a business that may be considered a discretionary expense that a new owner may not take advantage of, thus this figure is "added back" into the net profit of the business.

An few examples of a discretionary expense are:  "owners compensation", "vehicle leases", "owner's health insurance", and other "Non-Recurring cash expenses".  A new owner may not decide to pay for these items through the business, thus these represent real Cash Flow that a new owner will realize and utilize in another way.

Another area factored as an add back is depreciation.  In some cases it's justified, in some cases it isn't.  A manufacturing company for example may only have an economic life of 10 years before new equipment is needed to stay competitive.  In this case adding back depreciation dollars reflects "real" cash flow even though it may not be a cash expense.

Competent business brokers realize they cannot just randomly add back in frivolous items to the new statement.  What is important to the seller of a business is Market Value.

Market Value is the "probable price" that the business should be able to attract.  Sellers and brokers should not be overly worried about getting the exact asking price, determining a viable range of value is whats important.  Marketing the business, attradting buyers and screening them for qualification will be most important.

According to Tom West, brokerage industry expert, puts it very simply:  "Asking price is what the seller wants, Selling price is what the seller gets, and Fair Market Value is the highest price the buyer is willing to pay and the lowest price the seller is willing to accept."

Other important factors to consider when using any of the business valuation methods to determine an asking price for a business for sale are:

1.  Number of years business has been operating
2.  Number of years the seller has owned the business
3.  Terms offered
4.  Competition
5.  Growth and sales trends of the business
6.  Location and Facilities
7.  Industry - which industry is the business in
8.  Number of employees and skill level of employees
9.  Is the business a seasonal business
10.  Is the business relocateable
11.  How closely are the customer and vendor relationships tied to the Seller
12.  Lease terms or Real Estate value
13.  How accurately can future sales be predicted
14.  Value of the Equipment
15.  Value of Inventory

If the business is losing money or hasn't been around very long, then a common approach will be value of equipment.  In most businesses, equipment value has little to do with pricing -  mainly because the value is really in the Income that the equipment produces.

If there is not much income, then we'll look at the replacement cost of the equipment and possible the build-out of the facility as a starting point for asking price.