Portland Business Broker Thoughts

One of the most common questions I get from owners of small businesses is “what’s my business worth?”  The answer I too often hear from others in the industry, CPAs, or other business buyers is something like “your business should sell for 3 times Seller Cash Flow” or “businesses in your industry sell for 1 times revenue” or “a rule of thumb for your industry is 5 times EBITDA”.  I cringe when I hear people look at value in such a simplistic manner.  The approach to value they are using is a basic form of a market comparable approach, where value is based on comparing data such as sales price, revenues, and cash flow from other similar businesses that have sold.  For example, if the average business in industry XYZ had a sales price of $1 million, had revenue of $1 million, and had $500,000 in seller cash flow, than the industry would be said to have businesses that sell for 1 times revenue, and 2 times seller cash flow.  If your business had $400,000 in revenue and $150,000 in seller cash flow than it would be estimated to be valued at approximately $300,000 to $400,000, with some people averaging it to be $350,000.  

Many people are familiar with this approach to value since it is commonly used for more homogeneous assets like real estate.  However, the approach doesn’t work nearly as well for more unique assets and businesses that have greater variability and more moving parts.  Some of the things that make a market comparable approach problematic for determining value include:

• Is the business really an average business that has very similar characteristics to the businesses that have sold?
• How much data was collected to establish the multipliers, and is it complete enough and representative enough of businesses similar to the business being valued to make a valid comparison?
• Is your business model truly the same as those used by other businesses in your industry?  For example, if the majority of businesses in your industry sell their products wholesale to retailers, but you sell the majority of yours retail, direct to the public via a web site, then you may not have a similar business.
• Are the rates of growth similar?  If Company A and Company B both have $500,000 in Seller Cash Flow in 2007 and a market comparable multiplier of 2 would indicate a value of $1 million you may have overpaid for one business and underpaid for the other.  For example, let’s say that Company A had an average and projected growth rate of 5%, while Company B had an average and projected growth rate of 15%.  If someone paid $1 million for each business in 2008, then two years later Company A would likely have $551,250 in seller cash flow, while Company B would likely have $661,250.  Yet, the industry comparable businesses may have had an average growth rate of 10%, so the average business in the industry would likely have $605,000 for the same time period.  Different growth rates warrant different prices.
• Are there different risk factors?  An example of this would be if Company A had one client that provided 40% of its revenue, whereas the average business in the industry had diverse clients with the largest average client providing only 5% of a typical comparable business’ revenue.  If Company A lost their top client it would be devastating to the business.  This level of comparative risk should result in a price that reflects that risk.
• Did the comparable businesses sell during the same type of economic cycle?  A dot com business that sold in the giddy late 1990s would likely sell for a much different price than a similar business that sold in 2002.
• Are the sold businesses of a similar size?  If, for example, the average comparable business had seller cash flow of $80,000 and your business has $200,000 in cash flow than your business should command a higher multiple.  The reason is that if you were to hire someone to run the business you may be able to do so for around $80,000.  If you had to pay a replacement $80,000 and the business only had $80,000 in seller cash flow than if you were to treat the business as a passive investment you would only break even, but if you started with $200,000 in cash flow you would still be left with $120,000 after paying a manager.
• Does the business have initiatives underway that will likely lead to significant future increases in business?  A market comparable approach is a backward, rather than a forward looking approach to value, so it will not take into consideration strong unproven increased future earnings potential. 
• Does the business have un-utilized or under-utilized assets?  For example, if a business acquired a $200,000 piece of equipment but then decided not to utilize it but had it sitting in the warehouse, a market comparable approach to value will not recognize the additional value of that non-income producing asset.  
• Were comparable business’ financials reported accurately?  When a business is sold, usually the financial statements have been re-cast to reflect adjustments for non-recurring or personal expenses.  However, those aren’t always accurate adjustments.  For example, a business owner may have failed to accurately adjust the financials to reflect the under-payment or over-payment of compensation to him or herself.  A business owner who only pays himself a $40,000 annual salary, when the market replacement cost for his position would be $90,000 who fails to make this adjustment on the financials would show EBITDA that is $50,000 more than it should have been if an owner were being paid a market rate of compensation.  If an EBITDA multiplier were utilized this may produce an inaccurate estimate of value.

These are just some of the types of issues that make the use of a simplistic market comparable multiplier not an appropriate method of establishing a price for a business.  A business seller who wants to price their business in such a way that it is marketable but also doesn’t leave money on the table should look beyond a market comparable approach to establish a price.  A knowledgeable business appraiser, business broker or investment banker can help you explore other approaches to value and examine issues that may impact valuation and marketability.

If you would like to learn about more rigorous valuation methodology, as a starting point, I would recommend the book Valuing a Business : The Analysis and Appraisal of Closely Held Companies (3rd Edition)

Codiligent Business Brokers – Portland, Oregon based business brokers representing sellers of businesses with $500k – $20 million in annual revenue. To schedule a free consultation to discuss the possible sale of your business you may contact Eric Williams at 503-535-8817 or E@codiligent.com