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FAQs About Business Valuation

Business Valuation FAQs

 


How can I determine the business valuation of my company?

We provide no charge, no obligation business evaluations which includes our broker’s opinion of value.  The fastest and easiest way to know the true value of your business is to give us a call at 314-849-769.  To learn more, visit our No Charge, No Obligation Business Evaluation webpage.

 


How are businesses valued?

Profitable businesses are value as a multiple of Seller’s Discretionary Earnings (SDE), which is basically EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) plus owner’s compensation plus the value of owner’s perks.  For an overview, please read How Small Businesses Are Value Based on Seller’s Discretionary Earnings (SDE) on the How to Plan and Sell a Business (HPSB) website.

Determining the value of a company is one of the most important aspects of the business sale process.  To gain a more thorough understanding, in addition to the article linked to above,  there are four additional/sequential articles on the HPSB website which provide examples and more specific information regarding valuing businesses based on seller’s discretionary earnings.  We encourage you to read all five articles.

If the value of a business based on a multiple of its SDE is lower than fair market value of the company’s assets, the higher asset value may be stated as value of the business.

 


When selling my business, do I keep my business’ cash and accounts receivable?

Our broker’s opinion of value assumes you retain your company’s cash and accounts receivable, but it also assumes you are responsible for paying off all your company’s liabilities  as of the closing date.  So if business sells for $1.5M, and you have another $500K in accounts receivable and cash, your net proceeds totals $2.0M (before paying off any retained liabilities and before income taxes).

It is not all that unusual for a transaction to be structured such that the buyer acquires the accounts receivable and the accounts payable as of the closing date.  Unless negotiated differently, at closing, the net difference between accounts receivable and accounts payable would be treated as an adjustment to the previously negotiated purchase price (without the inclusion of accounts receivable and accounts payable).

 


What is the difference between cash flow, discretionary earnings, adjusted earnings, owner’s benefit and EBITDA?

Terminology in the business valuation world can be very perplexing.  The confusion is compounded when someone uses generic terms to describe the “cash flow” of a business.

Cash flow is a very generic term that can mean a lot of different things and requires definite clarification almost any time it is used.  Depending on the context, both discretionary earnings and owner’s benefit might be a substitute term for Seller’s Discretionary Earnings (SDE), but both should be clarified.   Adjusted earnings is similar to cash flow in that it is a generic term that requires further clarification.

EBITDA is a meaningful and common term in business valuation lingo and is an acronym for Earnings Before Interest, Taxes, Depreciation, and Amortization.  Seller’s Discretionary Earnings (SDE), is basically EBITDA plus owner’s compensation plus the value of owner’s perks.  EBITDA and SDE are the foundation for estimating business values and are the terms sellers should concentrate on understanding.

Both EBITDA and Seller’s Discretionary Earnings may require further adjustments for a variety of reasons.  To learn more about EBITDA and SDE read the series of 5 articles on the How to Plan and Sell a Business website beginning with How Small Businesses Are Value Based on Seller’s Discretionary Earnings (SDE).

 


What is goodwill (blue sky)?

When a business is sold, U.S. federal tax laws require an allocation of the purchase price to various classes of assets for depreciation and amortization purposes.  Goodwill is really a mathematical calculation computed by subtracting the value of identifiable/quantifiable assets from the total price paid for the acquisition of a business.

“Blue Sky” is an informal term for goodwill, often used in a derogatory manner to indicate that the business acquisition (or asking) price far exceeds the value of its hard assets.   However, it is not at all unusual for businesses to have considerable “blue sky” or goodwill, especially for businesses with significant Seller’s Discretionary Earnings (SDE) that don’t require a large investment in fixed assets.  Profitable service businesses often have a significant amount of computed goodwill upon being acquired.

 


What other factors contribute to the value of my business?

Other than increasing your Seller’s Discretionary Earnings, there are many more factors that can detract from the value of your business (or make it unsaleable) than things that might increase the value of your business.  However, there are many positive steps that can be taken and entire books are written on this matter!

Two of the most important things you can do to add value are: 1) systematizing and documenting your business operations; and 2) enabling the business to run efficiently without your presence, which means having a strong second-level management team.

Replacing tax minimization policies with profit maximization policies can also contribute significantly to the value of a business.

There are numerous articles on the How to Plan and Sell a Business website addressing this question in one way or another.  At a minimum, we suggest you read: The Top 10 Ways to Increase Your Business’ Value and Preparing to Sell Your Business – Summary – A 50-Point Action Plan.

 


Are the values of my fixed assets a consideration in the overall value of the business?

Not necessarily.  Profitable businesses are valued as a multiple of their Seller’s Discretionary Earnings.  Under that method of valuation, if the value of the business exceeds the value of the fixed assets, because the asset values are not a factor in the business value computation, one could say the fixed assets are not a “major” consideration of the overall value of the business.  However, a seller has the responsibility to include all the assets in a business sale that are creating the cash flow on which the business value is being determined.  In other words, the business value computed on a “cash flow” basis already includes the fixed assets of the business, so the fixed asset value is not added to the “cash flow” computation of value.

Buyers will likely ask about and perhaps independently evaluate the condition of assets included in the sale.  They want to determine if the age or condition of assets included in the sale might require them to replace acquired assets in the near-term.  If additional capital expenditures for asset replacement are needed, it might negatively affect the value of the business.

 


How can I increase my business valuation?

The surest way to increase the value of a business is to increase its Seller’s Discretionary Earnings.  We suggest you read The Top 10 Ways to Increase Your Business’ Value from the How to Plan and Sell a Business website for our suggestions.

 


How is fair market value of a business determined?

Merriam Webster defines fair market value as: a price at which buyers and sellers with a reasonable knowledge of pertinent facts and not acting under any compulsion are willing to do business.  As it applies to business sales, that is a pretty good definition.

When we recommend asking prices to owners who want to sell their business, we are estimating the fair market value of the business.  As explained in many of the questions above, the primary basis for valuing privately-owned businesses is utilizing a multiple of Seller’s Discretionary Earnings.

In residential real valuation, there are two (primary) “common denominators” used to establish a home’s valuation – its location and its size/rooms.  In general, businesses for sale are very dissimilar in nature.  The “common denominator” used to establish a business valuation is Seller’s Discretionary Earnings.

 


How are unreported cash transactions handled in determining the value of my business?

Unreported cash transactions are ignored in determining the value of a business.  Although many owners may claim they have “pocketed” cash that should be counted as additional owner compensation or perks, it cannot be verified by a buyer.  In addition, because it constitutes tax evasion, it is not something that you want to document or verify to another party.  Doing so could lead to future legal problems with the IRS.

Especially in advance of selling a business, our advice is to completely eliminate unreported cash transactions, which will increase your Seller’s Discretionary Earnings.

 


Can all the perks I receive from the business be factored into the value of my business?

Yes, to some extent.  Many business owners run non-business or discretionary  expenses through their business.  To the extent that those expenses would not be incurred by a buyer of the business, those perks could be added into the computation of Seller’s Discretionary Earnings.

However, whereas we can usually succeed in convincing a buyer to accept miscellaneous “discretionary” add-backs (with proper documentation), in most instances the buyer’s lender will not accept miscellaneous “discretionary” expense add-backs booked to the company’s expense accounts.  For instance, lenders will not accept  automobile expense add-backs, nor travel and entertainment, nor dues and subscriptions, etc.  If the miscellaneous add-backs are significant, the lenders computation of business value is based on a much lower “cash flow” number which can lead to a significantly lower valuation.  Once the lender informs the buyer that their valuation is significantly less than the amount the buyer offered to pay for the business, it becomes a huge hurdle to a successful closing.

To see an extreme example of perks, where a lender values a business at $324K, a buyer values the business at $627K, and the seller values the business at $753K, read this article SDE and Business Valuation Variations amongst Sellers, Buyers and Lenders.

 

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If you have a question, send an email to jim@bizowneradvisors.com.

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