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Factors affecting small business valuation

There is only so much that a new buyer can afford to pay for your existing business. The financing environment is not as friendly as it once was – business owners face stiff opposition from banks disinterested in taking new risks.

Small businesses typically sell for low earnings multiples due to owner participation. Thus, buyers have to approach the deal as if they are purchasing a job.

Businesses where the owner is actively-involved typically sell for 2-3 times the annual earnings of the company. A business that earns $100,000 per year should sell for $200,000-$300,000. This is consistent with most listings on BizBuySell, a small business brokering site with thousands of companies available for sale. Of course, these multiples expand with annual earnings. Businesses that earn millions of dollars per year with paid management and “hands-off” ownership fetch much larger multiples.

Valuation influencers

Banks participating in the Small Business Administration’s lending program typically want to see that new owners pay no more than 3 times annual earnings for a small business. As many buyers will be using some form of financing, smaller owner-operator businesses will find it difficult to fetch a price larger than three times earnings for this very reason.

Owner-operator businesses do have one advantage, however – immigration. The fastest way into the United States is to buy or start a new business that employs at least 10 people. In rural areas, or where unemployment is 150% the national average, foreign investors and operators need to invest only $500,000 to obtain an EB-5 visa. Elsewhere, the minimum qualified investment is $1,000,000. Suffice it to say that EB-5 visas are the best deal going for wealthy, foreign investors seeking entry into the United States.

How to get the best possible price for your small business

  1. Value it with EBITDA – Earnings before interest, taxes, depreciation, and amortization is the most common way to value a small business. As your earnings from the business are based on your personal income taxes, it is best to value the company in a way that removes personal tax inputs. This is especially true for businesses formed as a sole proprietorship. EBITDA does have some “curb appeal,” though, in that it is often higher than true, after-tax net income.
  2. Use intangibles as an advantage – Intangibles can be just as important as bottom line profits. A business that is well-known in the community with a long list of customers naturally carries more value than a newly-established business with the same earnings. Cite the amount of time in business, as well as the diversity of your customers and a realistic look at local competitors. Businesses with long track-records and limited competition obviously earn values toward the higher-end of the spectrum.
  3. Separate assets as needed – Some businesses are capital intensive, from storefronts to company car fleets. Capital intensive businesses are attractive only to people who have strong financials to purchase both the assets in the business, as well as the future income stream of a business. Attracting the most bidders requires that you have something for everyone. Consider offering the business with and without major assets like real estate. Selling the business free of large capital investments like real estate makes the deal more digestible for buyers on the lower end while earning you a stream of future lease income. Alternatively, commercial real estate brokers are usually very interested in purchasing commercial property with long-term leases in place.
  4. Sell to a competitor – As the saying goes, “if you can’t beat ‘em, buy ‘em!” A competitor is already acutely aware of how your business works, and may be willing to pay a premium over another bidder if given the opportunity to reduce local competition. Other intangible data points like market share and mind share have more value to a competitor than to a new business owner.
  5. Sell strategically – One local entrepreneur built a business from a small steak restaurant into a collection of different eateries. Friends who worked for his businesses made his advantage pretty clear: sourcing new workers. Part-time workers would shuffle between the many different eateries. A Saturday might involve fixing fine dining foods whereas the following Sunday night would involve shoving pizzas through a pizza oven. Strategic local owners are a boon for business owners looking to exit. Not to mention, the transition from owner to owner should be relatively free of headaches – the buyer knows exactly what he or she is getting into.

Is this a good time to sell out?

BizBuySell logs historical sales price data as a function of annual income. The site notes that the average business sellf for about 0.6 times its annual revenue and for 2.5 times its annual earnings.

In 2020, banks issued a total of $114.3 billion in loans to businesses in the U.S. that had revenues of $1 million or less. Despite this, the Wall Street Journal notes that rising interest rates is impacting small business growth, as loans are now more difficult to payback.

The right time to make a sale, of course, is when you have an offer. Given economic uncertainty, and the rigidities in small business acquisitions, “timing” the market for a modest increase in multiples seems like an unsure bet with major consequences.

Do relatively low small business valuations surprise you as much as they surprise me?

About the Author

Jordan Wathen

Jordan Wathen

Freelance Contributor

Jordan Wathen is a freelance contributor for Moneywise.

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