I often get calls from business owners asking if I could tell them how much I think their business is worth. They often make outlandish claims, e.g., “I heard two times revenue” or “ten times earnings.” I explain to accurately estimate their business’s value requires a deep dive into their financials, assets, and value factors. This article will discuss how a business’s value and price are calculated.
Approaches and Methods
In general, there are three approaches to valuing a business: the Market Approach, Income Approach, and Asset Value Approach. Together these approaches have eight methods for valuing a business: the Direct Market Data Method, Guideline Public Company Method, Merger & Acquisition Method, Capitalization of Benefits Method, Discounted Future Benefits Method, Multiple of Discretionary Earnings Method, Net Asset Accumulation Method, and Excess Earnings Method.
A combination of any number of these eight methods are used, depending upon the business’s particular situation, to estimate value. The Most Probable Selling Price (MPSP) is then calculated by weighing each of the methods used.
There are many valuation tools to assist in valuing a business. They include sold databases and valuation software. Sold databases include BVR, BizComps, PeerComps, and BBF MLS. Valuation software is offered by many providers. These tools are used to calculate the MPSP.
Adjustments to MPSP
Once the MPSP is calculated, adjustments are made based on value factors to determine the adjusted MPSP. There are fifty-four value factors that can affect the value of the business. Some of the more important value factors internal to the business include the reliance on the owner and/or a few key employees, concentration of sales in one or a small number of customers, age and quality of assets, inventory adjustments, and lack of diversification in product selection or geographic areas served. Other important value factors external to the business include the present and future state of the industry and susceptibility to changes in laws and regulations that affect the business.
The adjusted MPSP is then tested using two tests. The first test is to ensure the business will qualify for a loan as per the Small Business Association loan guidelines. The second test is to ensure the buyer of the business can pay themself fair compensation for their time, adequately cover any debt they incur to purchase the business, and earn a strong return on investment (ROI) based on the risk incurred when acquiring the business.
Pricing is dependent upon the supply and demand of the business type, amount and type of financing available, and in some cases interest from strategic or synergistic buyers.
In conclusion, estimating the value of a business and determining the price of a business is not simply accepting a business owner’s desired price or using hearsay. A thorough valuation and pricing analysis is required. Doing so will greatly increase the chance of the business selling in a timely matter and at a fair price.