By Rayanna Anderson, MBA
In 2008, 60 percent of small business owners reported they wanted to leave their business within 10 years and 70 percent revealed they wanted to leave their companies by 2020, according to the Apogee Center, a nationwide group that works with businesses to complete business exit or succession plans. History reveals that one-third of these owners will sell their business, one-third will transfer the business to a family member and one-third will close their doors. The first step in planning to leave your business is determining the value of the company. Many times, valuing someone’s business resembles telling someone his or her baby is ugly. Understanding the valuation process is the starting point to improving the business appraisal price in advance of a sale.
A certified valuation, a valuation prepared by someone certified by one of the national certifying agencies, will likely be a requirement or recommendation at the time of the actual sale. In fact, any SBA-guaranteed financing for the sale of a business with goodwill value over $250,000 now requires a certified valuation. Goodwill value is determined by subtracting the market value of any hard assets of the business from the purchase price. However, prior to that time, there are several key contributors to pricing methodology that should be reviewed years in advance of the sale.
A starting point for your business valuation may include researching general rules of thumb for the particular industry of your business. Consider this a gut evaluation check or sanity check on your way to a fully certified valuation. Rules of thumb generate a quick-sale price, providing an approximate value of a business. This is a popular method in many industries including restaurants, manufacturing, service and retail. Despite all the cautionary limitations in using rules of thumb to price a business, they are a lot more common than you might think and, if used correctly, do surprisingly come close to what a company’s selling price turns out to be. The reason behind this correlation is that most rules of thumb are market driven (i.e., industry experts base the rule of thumb calculation on actual business sales). Nevertheless, a business is worth what a buyer is willing to pay for the business.
Generally, rules of thumbs offers two different methods to determine a company’s value — the Percentage of Annual Sales method or a Company’s Earnings Multiplied method. Let us look at the Percentage of Annual Sales method first. Many experts consider this calculation more reliable than the Company’s Earning Multiplier rule because there are usually no adjustments made to the annual sales figure, just a determination of what percentage to use. An industry expert typically provides that information.
My favorite resource for rules of thumb is the “Business Reference Guide, The Essential Guide to Pricing Businesses and Franchise” written and compiled by Tom West. The publication updates annually and is available in printed or electronic form.
As an example, for full-service restaurants, the rule of thumb for the Percentage of Annual Sales method from West’s publication suggests estimating, “30 to 35 percent of annual sales plus inventory” as the business value. In addition, included with rules of thumb for restaurants data are caveats of pricing tips that include everything from adding a liquor license value to suggestions of variances based on different categories of sales levels. Mathematically, if a restaurant produces $500,000 of sales annually and maintains $10,000 of inventory, this rule of thumb would estimate a selling price of $510,000.
In contrast, the Company’s Earnings Multiplied method uses several judgment calls to establish a market price. The most common uses a multiplier between zero and four times the Seller’s Discretionary Earning or SDE. Calculate SDE by adding back in, to the annual net profit of the business: income taxes, nonrecurring and non-operating income and expenses, depreciation and amortization, interest expense or income, and the owner’s total compensation package.
Returning to our full-service restaurant, the SDE multiplier is 1.8 to 2.5 times SDE plus inventory. With an average after-tax net profit of 6.3 percent, the suggested business value could climb substantially after adding back in all of the above expenses before increasing the total by the prescribed multiplier.
Critics of the rules of thumb pricing guidelines argue that it does not allow for variations between businesses, instead presuming an average business. Despite the fact that there is no such thing as an average business, the rule of thumb methodology is a noteworthy starting point for small business owners as it introduces them to the fundamentals, techniques and theories of business valuation.
This article appeared in the December 13, 2014 issue of the Springfield News-Leader. It is available online here
Rayanna Anderson, MBA, is director of the Small Business Technology Development Center and the Management Development Institute at Missouri State University’s E-Factory. Anderson writes about issues she sees regularly in her consulting with small businesses in Springfield and the state of Missouri. Email: firstname.lastname@example.org.