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There are many ways to compute the value of a business, and an equal number of differing opinions regarding a particular methodology’s relevance to an entrepreneur who starts and grows a viable business. But what seems to truly matter most to the entrepreneur who has sold or transferred his business successfully to a new owner, is just how much cash is left after paying taxes on the transaction. And yes, there are more than a few ways to get to that number.
With that said, the entrepreneur growing a business should find it worthwhile to understand business valuation methods, terminologies, and purposes. And even more important to know what is most relevant when valuing a business for sale and what can be done to improve the business’s valuation.
How is a Business Valued?
While there are exceptions to this rule, businesses are valuable if they make a profit. The more profit they earn, the greater their business valuations.
Yet in recent years two exceptions to this widely accepted measurement of business value have been in the news headlines. Included are stories about businesses in the high tech and digital industries with virtually no revenue being acquired for multiple millions. In some cases, it’s even billions. In such cases, the buyer is not acquiring the business for its profit or cash flow. Instead, for the high tech buyer with deep pockets, the name of the game is acquiring intellectual property and/or human talent. Simply stated, in the constantly evolving technology sector it’s easier to buy than to take the time to develop one or both of these precious and very valuable business assets. Accordingly, acquisitions are numerous in these high tech and digital industries.
But for most industries, business value is based generally on one or more measurements tied to earnings (or in other words, profit) or gross revenues and multiplied by a ‘factor’. The measurements may include one of the following:
1. EBITDA – Earnings Before Interest Taxes Depreciation and Amortization
2. EBIT – Earnings Before Interest Taxes
3. SDE — Seller’s Discretionary Earnings
4. Gross Revenue less sales tax (if applicable)
The factor applied to (or multiplied by) one of the measurements above to compute a business valuation varies widely by industry and with other economic factors. For example, a professional services practice may be valued by multiplying 1.2 (or something similar) by the gross revenues earned in the last twelve months. On the other hand, a retail Pharmacy may be valued by multiplying a factor of 4.0 by EBITDA. Then in each case and in all other cases as well, adjustments are made to the computed value for assets that normally would be included in the sale. Such assets may include the fair market value of fixed assets, inventory, accounts receivable, etc. Likewise, the inclusion or exclusion of the business’s liabilities affects its valuation.
Enterprise Value is a concept used by middle market businesses and businesses poised for an Initial Public Offering (IPO). This valuation concept computes a business value on an enterprise level, meaning its valuation includes the capital structure necessary for operations post acquisition. Enterprise Value often exceeds other business valuation computations due to the inclusion of working and permanent capital.
What Increases a Business Valuation?
For the entrepreneur growing a business, knowing what can be done to increase business valuation should be a priority. In many cases, entrepreneurs don’t focus on increasing the business valuation until they begin the exit planning process. This is not prudent.
It’s important to understand there is more than one way to build or grow a valuable business. In order to understand the reasons for this being the case, it’s best to take a look at what motivates business buyers.
Business buyers are motivated to acquire another business to meet either a financial or strategic goal. If the buyer is motivated for financial reasons alone, he will be looking for positive, consistent cash flow from the business operations and adequate capital structure to sustain day-to-day cash needs. In this case, the buyer will be primarily focused on cash flow. The Mergers and Acquisitions (M&A) industry refers to this type of buyer as a ‘financial buyer.’
On the other hand, if the buyer is motivated to acquire a business to meet a strategic goal, the business’s cash flow may not be important at all. In certain industries, producing sufficient cash flow is unlikely to occur for many years due to the intensive need for capital investments. One such industry would be digital mobile application development. It takes a great deal of cash to develop and operate such a business so cash flow is low and in most cases non-existent. This does not mean that the business is not valuable. In fact, such a business acquisition may be extremely valuable to the right ‘strategic buyer.’
But very few businesses have the luxury of selling to a strategic buyer. So if it is the entrepreneur’s intention to increase their business’s valuation, it is advisable to focus on increasing cash flow and developing the proper capital structure to allow the business to grow over time. Additionally, by developing good cash flow and capital structure, the entrepreneur will experience fewer growing pains.
Business Valuation Reports
There are many forms of business valuation reports and each has its own purpose. A business valuation report associated with a cross purchase agreement is not identical to a business valuation report required in litigation. Business Valuation Reports are customized with the end need in mind.
Tools to Improve the Value of a Business
Learn more about How Entrepreneurs Increase the Value of their Business.