How Much is a Business Worth
The short and quick answer to the question “How Much is a Business Worth?” is that it is worth the greater of the value of its earnings (further explained below) or the fair market value of its assets.Whether you are a prospective seller, a prospective buyer, or an investor, it is important to understand how business worth is determined. Rest assured, it is best for each of the aforementioned parties if the business valuation determined using the multiple of earnings method exceeds the fair market value of the business’ assets. That means the business is profitable and the assets are being used efficiently to create more cash flow than the assets themselves are worth.
Determining Business Worth
Profitable companies are valued using a multiple of earnings. For smaller businesses (with earnings between $50,000 and $1,000,000), a multiple of 1 to 4 is applied to seller’s discretionary earnings. For larger businesses (with earnings between $1,000,000 and $10,000,000), a multiple of between 4 to 8 is applied to EBITDA. Seller’s discretionary earnings and EBITDA are indeed related to each other, though there is a slight difference. EBITDA is defined as Earnings Before Interest Taxes Depreciation and Amortization. Seller’s discretionary earnings is equal to EBITDA plus owner’s compensation and owner’s perks. There can be the need for further adjustments to either EBITDA (known as Adjusted EBITDA) or seller’s discretionary earnings to “normalize” a company’s operating results. There are many factors that go into this calculation, so it is important to learn more by reading about Add Backs for Business Valuation, Earnings Multiples for Small Business, and EBITDA Multiples by Industry.
Implications of not Understanding Business Worth
For prospective sellers, it’s critical to determine the fair value of your business. If you underprice the business vs. its fair market value, you’d obviously be leaving money on the table. However, there are downsides to overpricing a business, which may be contrary to immediate thought. As a business owner, you may think: “I’ll start with a high price to provide negotiating room.” But that approach can be counter-productive because serious buyers tend to simply pass on businesses that are overpriced due to fear the seller has unreasonable expectations. For more information, read Issue #11 – The Importance of Setting a Realistic Offering Price. Ultimately, the best course of action is to price a business realistically and facilitate the transaction process. Sellers should consider reaching out to business brokers, many of which offer no charge, no obligation evaluations to determine how much a business is worth. To identify qualified business brokers, read Issue #13 – Choosing a Business Broker/Intermediary. For buyers and investors, undervaluing a business runs the risk of insulting the business owner, which may preclude the possibility of acquiring a good business. Obviously, buyers and investors must know how much business is worth to avoid overpaying and adversely affecting the return on their investment in the company.
