Why is Business Valuation So Confusing?

You are thinking about selling your business, and you want to know how much your business is worth. You go to your favorite search engine and search for “business valuation”, and immediately become overwhelmed by all the business valuation jargon. Discounted cash flow analysis, weighted average cost of capital, enterprise value, leveraged and unleveraged beta…what was that again? For the typical small business owner, the subject of business valuation can seem like a complete mystery.

The good news is that most of the finance jargon used in business valuation do not apply to valuing small businesses. Yes, Warren Buffet uses discounted cash flow analysis when he is looking into buying a company, but he buys sizable companies. According to the 2015 annual report of Buffet’s Berkshire Hathaway, he won’t consider purchasing a business unless it has at least $75 million a year in pre-tax earnings. Most small business owners simply do not have to worry about discounted cash flow analysis because the buyers of small businesses don’t use it either.

The valuation of small businesses is not complicated, but there is a lot of misinformation. Mike Handelsman wrote an article in Inc. Magazine attempting to demystify small business valuation, and Stever Robbins also did a Q&A in Entrepreneur Magazine answering how a business is valued. While these articles do a good job at explaining the various business valuation methods used for small businesses, they also raise more questions than they answer. For instance, Robbins states that businesses are often valued at a multiple of their revenues, so a business might typically sell for “two times sales” or “one times sales”. Handelsman talks about valuing businesses based on a multiple of its earnings, but puts in the caveat that the multiple could range from 1 times earnings to 10 times earnings or more. It is no wonder that many small business sellers are confused. Does their business sell based on a multiple or revenues or a multiple of earnings? Is the multiple 1 or is it 10?

Putting all the rules of thumb aside for a moment, let’s think through the situation from the business buyer’s perspective. Ultimately, a business is worth what a willing, capable buyer is willing to pay. As a sought after business broker who has personally sold over 130 companies, Aaron Muller has seen businesses sold for way more than what the rules of thumb say. Why? Because someone was willing to pay it. Value is in the eyes of the beholder. If the buyers value a business enough to offer a certain price, that becomes the market price of the business.

It follows from this logic that in order to fully understand business valuation, we need to understand what business buyers value. A company looking to gain market share might value revenues the most because it wants to buy out a competitor and gain as much market share as possible. A strategic buyer might not care about the company’s revenues or profits at all. Perhaps the strategic buyer wants the proprietary technology or dedicated audience the company has, and offers a price to buy the company that has little to do with the company’s revenues or profits. To sell your business successfully, you must understand what the typical buyer of your business values.

While it may seem like every buyer values something different, the buyers of most small businesses share a similar set of characteristics. Most buyers of small businesses are not large corporations, but individuals. Maybe they have a corporate job, and are quitting their job and going into business for themselves. Maybe they are entrepreneurs, and want to buy an existing business instead of starting one from scratch. Whatever the case is, these individuals are people with lives to live, bills to pay, and obligations to meet. They may wish they could afford to pay more for your business, but at the end of the day, the price they pay for your business must allow them to meet their personal expenses. In other words, revenues typically matter little in the valuation of small businesses. How much income the owner takes home matters a lot more because that’s what the buyers of small businesses value.

In the business brokerage world, there is a term called the Owner’s Discretionary Income, or ODI for short. It is essentially a measure of the owner’s take-home pay (assuming the business is owned free and clear). Most small businesses sell based on a multiple of their ODI. Think of it this way. In the minds of many individuals, making $100,000 a year is a magic number. If a company’s ODI is below $100,000 a year, the multiple can be hurt. If the company’s ODI is in the $200,000 or $300,000 range, the multiple can really start to grow because who wouldn’t want to buy this business and make $200,000 or $300,000 a year? The exact multiple applied can vary based on the industry and business itself, but the valuation method doesn’t have to be confusing. Small business buyers value the owner’s take-home pay more than any other factor, so calculate the owner’s take-home pay, and apply the correct multiple.

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