The No. 1 Indicator of Your Company's Value

There are many methods for establishing business value. But only one gets to the heart of what a buyer is willing to pay

Written by Bill Sivell

When you decide to sell your company, establishing fair market value is one of the most difficult issues a small business owner must face. There are so many options involved in valuating a business—the capitalization rate method, the debt capacity method, the critical factors method. But the reality is a business is worth what a buyer is willing to pay and a seller is willing to accept.

One of the most effective methods of getting to this number is the “cash flow” method, which takes the business’s net profit and combines it with the owner’s salary and personal perks. Plus interest and depreciation. Buyers are typically comfortable with this method because when they are buying a business, what they are really buying is its cash flow.

When a company’s cash flow is identified, different multipliers can be applied to then determine a fair market range for the business. A business multiple is a measure of return on investment.  Most people are familiar with the term “capitalization rate,” which is commonly used to establish the value of income-producing real property (the land and anything attached to it).

For income-producing businesses a multiple is the same, but inversely related. A business selling for a multiple of 1.5 would generate a 66% return on investment for a buyer, while a business selling for a multiple of 4 would offer a 25% return. A manufacturing facility, for example, would likely have a higher multiplier than a service business because it’s easier to enter into many service sectors than to open a manufacturing facility.

One key factor affecting the multiplier is excess earnings. If you look at two businesses in the same industry, each will have dramatically different multiples if one has a net cash flow of $100,000 and the other has $1,200,000. A good general rule of thumb is that the higher a business’s net cash flow, the higher the multiple.

Many other things can also affect the multiplier, in both positive and negative ways. New product development, strong market share and a diversified customer base (i.e., having no one customer represent more than 10% of sales) can positively impact the multiplier. Conversely, outdated inventory, declining market share and risk that key personnel could leave the business and disrupt operations might have a negative impact.

In addition, business owners frequently don’t give enough consideration to the impact the transaction terms can have on a deal. An all-cash deal or one with a large down payment will give the buyer a reason to expect a discount on the sale price, while a smaller down payment will cause the seller to expect a higher sale price.

For many owners, one of the most troubling aspects of the cash flow method is assets, such as furniture, fixtures, equipment or inventory, are not taken into consideration. While those items do contribute to establishing cash flow, they have limited individual value. There is an exception to this rule: assets are considered when a business is being sold that has no profits or cash flow. Typically, buyers usually aren’t interested in buying these businesses because the seller has proven that the company isn’t profitable, but, in those cases, assets would be used to determine the value of the business.

When an owner is considering selling his or her business, looking at different evaluation methods may have some merit, but the cash flow method tends to be the most practical. Many even find understanding the impacts on value can improve both the desirability and the worth of their business.

Bill Sivell is a salesperson with VR Windsor Inc., which sells businesses to buyers across Canada and around the world. His 14-year career includes diverse senior management positions in marketing, advertising, sales management and operations management. He blogs about business sales at Maxbizvalue.blogspot.ca.

More columns by Bill Sivell

Originally appeared on PROFITguide.com