Top Ideas for Corporate Businesses Services

Are you looking to start or buy a service business targeted  at Small and Medium Enterprises (SMEs). If you live in an area that has lots of SMEs then providing services to these businesses may be a good option.  The business you select depends on several factors including your skills, talent pool available in your area, capital required to start or buy the business and most importantly the competitive landscape  and demand for the service in the area. Here are a few service businesses to evaluate.

Business Travel Management

Help manage all travel requirements for businesses. Travel management services provided to SMEs can include advising clients with travel safety and security, booking tickets at the optimum prices based on travel requirements, tracking and reporting expenses, managing frequent-flier miles and other related tasks.

Accounting and Bookkeeping Services

Business owners have very little time and knowledge to work on bookkeeping and accounting tasks. Bookkeeping service is a critical service  to business owners. Accounting and Bookkeeping Services typically include Payroll Services, Data entry, Tax planning, Financial Statement Preparation, Audit and Review Financial Statements, Filing tax returns,  Filling state and federal sales taxes, Succession Planning and Income Tax Appeals .

Business Plan Consulting

SMEs usually work on a business plan at several points in their growth cycle and not just in the startup stage.  Business plans are used to track the progress of a company, to provide a roadmap for the future and to raise financing. It is a critical document if customer plans to sell the business. Business plan includes several components.  For example, a typical business plan should include Strategic overview of the business, Marketing and sales plan, Human Resources plan, Operating model,  Financial plan and an appendix to all data (facts and figures) to back up all claims made in the plan.

Corporate Event Planning

Corporate Event Planning refers  to organizing  Conferences and Conventions, Meetings, Fairs, Product launches, Rallies, Shows and Corporate picnics to list a few events. An event planner has to complete several tasks including conducting research, finding a venue, arranging the food and entertainment, decorating the  venue, sending invitations to all employees (attendees), supervising the venue to make sure everything goes as per plan and finally evaluating the event for lessons learnt. SME’s prefer to outsource Corporate Event Planning because they lack the time, knowledge and passion to organize an event effectively.

Copywriting, Editing and Proofreading Service

Copywriting services refers to assisting an SME with writing for websites, newsletters, presentations, proposals and company profiles to list a few. Copywriting services includes business writing which in turn includes assisting a business with business documents like business plan, tender documents, proposals and general business correspondence.

Proofreading service is required after a document is produced for quality control. This step must be completed before releasing a document to its consumers. Proofreading service includes checking the document for grammar, punctuation, spellings  and general “typos”. Additionally, the service also includes checking for consistency of terminology, fonts, references, page numbering, table of contents, glossaries and so on.

Public-Relations (PR) Agency

PR Agencies are the opposite of advertising agencies. They promote businesses by placing stories on websites, new papers, magazines and TV programs. This is the opposite of advertising agencies who place content on paid media. PR Agencies work by developing contacts with reporters and other media outfits. The most common service provided by PR agencies is helping clients develop press releases and going public with the press release. Other services provided include conducting market research for a firm’s messaging, social media promotion and responding to negative opinion online.

Mailing Services

Mailing service businesses provide SMEs services such as parcel shipping, accepting mail, mail merge service, mass mailings and direct mail marketing brochures. Mailing service can be a home based business.

 

Deals Closed in 2014 – Statistical Analysis

Approximately 50% deals took between four months to six months to close in 2014. See illustration below. Based on this distribution, on an average, a business will take 8.5 months to sell. The time required to sell a business depends on a number of factors including type of business and asking price for the business and type of buyer. Types of business include Manufacturing, Business services, Consumer goods & services, Health care & biotech, Wholesale & distribution and several others. There are two types of buyer’s strategic buyer and financial buyer. Understanding the buyer type is perhaps the single most important factor when it comes to engaging a buyer and negotiating a deal.

Time to sell Business

There are several reasons a business transaction may fall through. Top three reasons are valuation gap in pricing (29%), insufficient cash flow (22%), and lack of capital to finance (12%). Valuation gap is responsible for almost 30% deals not going through. Both the buyer and seller must complete valuation of the business independently and come up with a valuation range. If there is an overlap then zone of probable agreement (ZOPA) exists and there is a good chance the two parties will find a number during negotiations.

Insufficient cash-flow and lack of capital to finance is another major reason to deals do not go through. It is important to qualify buyers before negotiating a deal.

Reasons For Failing

Of the 30% deals that did not go through because of valuation gap, 65% of the deals had a gap between 10% and 30%. As expected the numbers deals failing for less than 10% gap is very low. When the numbers are so close the buyers and sellers should generally be able to agree on a number and come to a deal.

About 50% are strategic buyers and 50% are financial buyers. Financial buyers will not negotiate much as they have to stick to their financial models. Strategic buyers on the other hand have longer term view and may have synergies with existing assets. On a an average, 21% strategic buyers paid 0-10% more and 29% paid 11-20% more.

Valuation Gap Business Deals

For these reasons it is critical for sellers clearly understand the buyer persona. Financial buyers look for value and evaluate business financial statements in detail. They leave very little room for premium and remain close to the valuation price. They are driven by Return on Investment (ROI) and use large amounts of financing. A financial buyer may not hold the business for long. They may fix the business, improve the financial statements and sell the business.

Strategic buyers on the other hand tend to stay in the business for long periods of time. They may buy the business to enter into a new market, increase market share or foreclose a competitor from acquiring the business. In terms of duration, strategic deals are also done much faster. Strategic deals are preferred because they are done within six months, there are lower chances of valuation gap pricing issues and seller may walk away with a small premium between 10% and 30%.

 

Business Valuation Considerations

Business value is not a specific number and there is no one absolute value that defines it. But rather business value is range and varies greatly based on assumptions used and factors considered. Market value is one type of business value.

Fair market value is the price at which a business changes hands between a willing business buyer and seller. It is important to keep in mind there is no one true value for a business because the value of a business is influenced by many factors. So rather than think of the value of a  business as an absolute number, one should think of it as a range. There are many reasons owners value businesses including buying and selling businesses, employee stock ownership plans, estate taxes, business equity transfer, financing and so on. Business valuation is also required for tax purpose when a business transferred to the next generation.

One place to start is to engage a professional business appraiser. Appraisers tend to conduct detailed analysis and use intrinsic valuation techniques rather than using rules of thumb because it tends to be overly optimistic.  Business appraisers have their pulse on macroeconomic and microeconomic changes effecting the economy and they can help business owner’s trade-off terms with cash when negotiating a term sheet.

There are two factors that affect small business valuations the most namely cash flow and the value of assets it holds. Cash flow is the amount of cash the business generates. Other factors that influence a business include Supply and demand, Interest rates, nature and history of the business, location of the business and so on. When the number of businesses for sale is large the value tends to be lower and vice versa.  If interest rates go up money gets tighter, interest payment becomes larger and the value of the business goes down.

Some additional considerations for business valuation include:

  • Financial condition of the business. The best measure for this is the book value. Book value is the total assets minus total liabilities of the business. The book value of a business can be determined by analyzing the balance sheet and income statement.
  • Ability of the business to generate cash, pay dividends and so on.
  • Prior sales of businesses in the area. In the best case there would be similar businesses in the geographic location that can be used as comparable.

Following is a checklist of documents a business owner requires to value a business.

  • Financial statements which includes balance sheets, income statements for up to the last five fiscal years.
  • Income tax returns for the last five years.
  • Equipment list, depreciation schedule, Accounts Receivable, Accounts payable, inventory list, lease, and prepaid expenses.
  • List of stockholders or partners, with number of shares owned by each or percentage of each partner’s interest.
  • Description of business including competitive analysis and factors that make the business unique.
  • Regulatory filings, associations the business belongs to and relevant trade publications.
  • List of patents, copyrights, trademarks, and other intangible assets.
  • Is the business at risk from new regulations or legislation.

Private Capital Report (Part 1)

The following are highlights relevant to facilitating private capital deals extracted from the Pepperdine University Private Capital Markets Report 2014. The report covers all privately held companies and not just main street businesses with revenue between $0 and $5 Million.

Business Types

Approximately 20 % of all transactions closed in the last 12 months (from a sample of 120 deals) involved manufacturing, business services (17%) and consumer goods and services (12%).Other business types in the mix included Manufacturing, Business services, Consumer goods & services, Financial services & real estate, Information technology, Health care & biotech, Wholesale & Distribution, Basic materials & energy, Media & entertainment, Construction & engineering.

Closing Rates

More than 30% of deals put in the market were not transacted. The top three reasons for deals not closing were valuation gap (26 %), unreasonable seller or buyer demand (21 %), economic uncertainty (12 %), and insufficient cash flow (12 %). Other reasons deals did not close include insufficient cash flow, Lack of capital finance and seller misrepresentation. For deals that did not close because of valuation gap, the gap was between 20% and 30%. 84% of deals required between 6 months and 12 months. The median time required to complete a deal seems to be between 8 to 10 months.

Typical items required to close a deal include reviewing Business Plans (1st quartile), meeting with the business and all stake holders (2nd quartile), creating proposal letters, term sheets and signing the letter of intent (3rd quartile).

Valuation

The most popular methods used to value privately held businesses were: Recast (adjusted) EBITDA multiple (58 %), Revenue multiple (13 %) and EBITDA (unadjusted) multiple (10%). Other methods used to value privately held companies include cash flow multiple (9%), Net income multiple (4%) and EBIT multiple (3%).  Overall, re-casted EBITDA multiple and EBITDA multiple account for more than 2/3rds of all valuations completed.

For example, manufacturing businesses with EBITDA between $0 and $1 Million had an average multiple of 3.8.  Across all business types the average multiple for companies with EBITDA between $0 and $1 Million was 4.2. The average multiple for a business type increases as the EBITDA increases. For example, construction businesses with EBITDA between $0 and $1 Million had an average multiple of 3, but with EBITDA between $11 and $25 Million had an average multiple of 10.

There was a shortage of capital for companies with less than 10 million EBITDA and excess of capital available for companies with more than 10 million EBITDA.

Deal Structure

Business deals can be structured using several instruments including Cash at Close, Seller Financing, Earn out, Mezzanine Financing and Seller Retained Equity.  Approximately 40% of deals closed included contingent earn-outs covenants. Other financial instruments used to close deals included Seller Financing (30%), lowered multiple of EBITDA (20%), Rollover (17%) and adjusted amount of equity sold (13%).

One must determine the buyer person before negotiating a deal. Buyer personas include financial buyers, strategic buyers, passive investors, life-style buyers and so on.  One would expect strategic buyers to pay a premium, but report found 29% businesses sold to a strategic buyer did not witness a premium. 52% if businesses sold to a strategic buyer witnessed a premium of 1% to 20%.

Business Environment

The most important issues currently facing privately held businesses are Domestic economic uncertainty (34%), Access to capital (24%), Government regulation and taxes (20%), Political uncertainty / elections (9%), Global economic uncertainty (6%) and Inflation (3%). Domestic economy and government regulation are the biggest issues facing private held small and medium sized businesses followed by access to capital.  For smaller privately held companies, one would expect the main issues would be domestic uncertainty, access to capital and competition.

Determine Reason for Selling a Business

Reasons For SellingIn addition to understanding the business buyer persona, It is also important to understand a business owners motivation to sell a business. Business owners put in a of time, sweat and equity into building a business. Therefore, selling a business is could be an emotional experience for the seller. Businesses are sold for several reasons and similar to understanding the buyer persona, understanding the reason behind the sale can go a long way with negotiations and structuring the business deal. Regardless of determining the business buyer type and reason to sell, business valuation is the most important element for setting the price. Business valuation is pivotal and both the business buyer and business seller must get the business values, preferably using an independent business valuation professional. Additionally, both parties must use multiple valuation techniques to determine the intrinsic value of a business. Now that we have emphasized the importance of business valuation, the following are the most important reasons businesses are sold:

Retirement

Many business owners are in the demographic that will soon be retiring. As per US and Canadian statistics agencies, more than 20% of the population will be over 65 by 2026. For Baby Boomers (people born between 1946 and 1964) business owners, selling their business is the most popular exit strategy to retire. As a business owner, there may be a glut of businesses coming to the market, which is good news for business buyers but may reduce valuation for business sellers.

Owner Fatigue

Business owner fatigue and burnout is the most common reason a business is sold. Additionally, business owners who have owned and operated their business for several years are also bored by the businesses operations. Restaurants, Coffee shops are examples of businesses that may be profitable with potential for growth but the business owner may be selling because of boredom.

Personal and Family Problems

Major changes in a business owner’s personal or family life can be an important reason to sell a business. For example, the business owners spouse or kids may be relocating. Divorce may be another reason to seek a business exit.

Divestment

Majority of a business owners wealth is tied up in one company. A business owner may sell a part or all of his company to diversify. A balanced portfolio is a critical risk mitigation strategy.

New Challenges

The business owner may have found other businesses to pursue that have higher growth rates or profitability.

Buyer Interest

The old adage “Everything is for sale at the right price” applies to businesses as well. A strategic buyer may be willing to pay a premium for a business to gain from synergies, eliminating competition, gaining market share or several other reasons. For the business owner it is an opportunity to capitalize their hard work for a premium.

Competitive Threats

The business may be struggling because of competitive threats. In many cases a business has been around for several years and has not innovated. In many cases business owners may exit the business, which creates a good opportunity for business buyers if they can turn the business around.

Market Timing

Business valuation is the most important criteria to determine the transaction price. Assuming costs are constant, valuation is directly proportional to revenue, earnings and cash flow – depending on the valuation technique used. When the economy is strong, businesses have the highest valuation and it is a good time to exit. The best time to sell a business is when a business has been up for three years and the best time buy a business is in the third year of an economic downturn.

Lack of vision

Perhaps the worst reason to sell a business if lack or vision. In many cases business owners go instant gratification and losing out on long-term growth from the business.

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Role of intangible assets in Business Valuation

Business ValuationIntangible assets are assets that are not physical but have legal rights attached to them and create value for the owner. They sometimes make up a very large component of a business but are not factored into intrinsic valuation of the business. A lot of value is created out of the accounting system and intangibles assets could account to as much as 80% of the intrinsic value of a business in some cases. As important as intangible assets are, business owners usually do not have a clear understanding of these assets. While rule of thumb valuation techniques factor in some of these benefits, valuing intangible assets and then adding it to the intrinsic valuation should be the preferred approach to valuing a business.

The time spent in planning, marketing, human capital, building relationships and developing a corporate culture are expensed on the income statement to calculate net income or net profit. While this is appropriate and required from an accounting point of view, cumulative investment in areas like developing an agile and customer focused corporate culture must be identified recognized as intangible assets.

Intangible capital of a business usually falls in the following areas:

  • Brand value which is the Net Present Value (NPV) of the estimated future cash flows attributable to the Brand. A strong brand is a distinct asset owned by a business and can be easily monetized by keeping prices higher than the competition.
  • Systems of differentiation developed by the business to compete in its marketplace.
  • Customer relationships which includes a loyal customer base and loyalty systems. Businesses should leverage concepts such as customer acquisition cost (CAC) and life time value (LTV) of a customer to value its customer base.
  • Business Processes related to customers acquisition including paid and unpaid activities.
  • Internal Business Processes and technical expertise.
  • Favorable location for the business.
  • Patents, Copyrights, Trademarks, Trade names, Non-compete agreements and R&D.
  • Relationships with partners including supply chain related business processes.
  • Supply agreements, Licensing agreements, Service contracts and Franchise agreements.
  • Unique corporate culture and corporate reputation.

When a buyer, seller or investor is conducting due-diligence on a company, he/ she must value at intangible assets in addition to calculating the intrinsic value of the business. All parties must be aware of all intangibles and know if the company has low intrinsic valuation with high intangible assets or vice versa. That said there may be an arbitrage opportunity if one party recognizes an intangible asset that the other party has discounted or not identified. Understanding intangibles also provides a view into the health of an organization.

The process of valuing intangible assets starts with first identifying and listing all intangible assets, which requires thorough understanding of the business. The next step is to attach a fair value to each intangible asset and to estimate the economic life of each intangible asset. Finally, businesses can get a value by using the company’s discount rate to calculate the present value of all intangible assets listed.

Other approaches to factor intangibles into the value of a business are to add a premium to the intrinsic value of the business. The magnitude of the premium will depend on the industry and the sector. Alternatively, a few intangible assets like patents can be added as assets to the balance sheet as long as it allowed by the accounting standards.

Small Business Valuation using Stock Market Data

Business Stock MarketBusinesses must conduct formal valuation before buying a business, selling a business or merging with another business. However, business must also value their company one or two times a year to keep track of progress and for planning. Informal valuations may be completed internally by the owner or his delegate.

The secret sauce for any valuation is coming up with a valuation multiple. Rule of Thumb valuation is one approach to determining a multiple for your business. Rules of thumb are established from previous business sales. Businesses can get the rule of thumb for an industry from the respective industry association or a business broker who specializes in the industry. For example, Grocery stores are valued at 15% of annuals sales + inventory. However, many times the rule of thumb is not easily available or does not exist. Businesses may also not want to use rule of thumb for valuation. Another approach, discussed at length in this post, is to use market based multiples for valuation. In such cases valuation can be based on publicly traded companies within the same industry.

Enterprise Value (EV) is a commonly used for valuation. Conceptually, Enterprise Value is the take-over the value of a company. It is the net amount of cash required to acquire a business. In the event of a buyout, the acquirer takes on the debt and the cash in the business. So, Enterprise Valuation can be calculated using the following formula.

EV = Market capitalization + Debt + Minority Interest + Preferred Shared – Cash

EBITDA (Earnings before interest, taxes, depreciation, and amortization) is fundamental to valuing a business. EBITDA is a rough estimate of a businesses Free Cash Flow (FCF) and is the most commonly used metric for business valuation. Smaller businesses tend to use Sellers Discretionary Earnings (SDE) for valuation, which is also derived from EBITDA.

Once a business calculates its EBITDA the business value can be calculated by multiplying EBITDA with the Market Valuation Multiple. Market valuation multiple by industry is listed in table below. The following steps and assumptions were used to calculate the market multiple:

  1. US public company data has been used to calculate the multiple as such the data may not be relevant in other countries.
  2. Data is used in the calculation is from 2nd-Jan–2013.The EV / EBITDA multiples may have changed in the last few months.
  3. All public companies have been classified by industry.
  4. Step 1: Calculate EV / EBITDA for each company in the US (includes NYSE and NASD).
  5. Step 2: Calculate the average EV / EBITDA for each industry.
  6. Step 3: Public companies are much larger and demand a premium. So, we have discounted the multiple by 25%, 33% and 50%.  The table includes the original values as well, so you may discount it by a different amount for you industry

Market Multiples Business Valuation

Industry EV/EBITDA (EV/EBITDA)  Discount 25% (EV/EBITDA)  Discount 33% (EV/EBITDA)  Discount 50%
Precious Metals 11.370 8.528 7.618 5.685
Financial Svcs. (Div.) 14.660 10.995 9.822 7.330
Natural Gas Utility 9.960 7.470 6.673 4.980
Public/Private Equity 6.750 5.063 4.523 3.375
Shoe 7.130 5.348 4.777 3.565
Investment Co. 15.720 11.790 10.532 7.860
Retail/Wholesale Food 7.360 5.520 4.931 3.680
Packaging & Container 7.200 5.400 4.824 3.600
Entertainment 12.610 9.458 8.449 6.305
Trucking 9.410 7.058 6.305 4.705
Metal Fabricating 8.350 6.263 5.595 4.175
Heavy Truck & Equip 9.530 7.148 6.385 4.765
Semiconductor 16.220 12.165 10.867 8.110
Household Products 11.750 8.813 7.873 5.875
Auto Parts 13.100 9.825 8.777 6.550
Engineering & Const 13.240 9.930 8.871 6.620
Reinsurance 3.310 2.483 2.218 1.655
Metals & Mining (Div.) 16.270 12.203 10.901 8.135
Air Transport 5.960 4.470 3.993 2.980
Electric Utility (East) 9.210 6.908 6.171 4.605
Electrical Equipment 17.900 13.425 11.993 8.950
Retail (Hardlines) 9.340 7.005 6.258 4.670
Office Equip/Supplies 6.340 4.755 4.248 3.170
Petroleum (Integrated) 5.080 3.810 3.404 2.540
Water Utility 10.730 8.048 7.189 5.365
Petroleum (Producing) 14.980 11.235 10.037 7.490
Retail (Softlines) 11.050 8.288 7.404 5.525
Beverage 17.550 13.163 11.759 8.775
Railroad 11.020 8.265 7.383 5.510
Wireless Networking 15.640 11.730 10.479 7.820
Electric Util. (Central) 10.210 7.658 6.841 5.105
Pharmacy Services 11.760 8.820 7.879 5.880
Advertising 5.380 4.035 3.605 2.690
Furn/Home Furnishings 7.950 5.963 5.327 3.975
Retail Automotive 12.090 9.068 8.100 6.045
Insurance (Prop/Cas.) 4.240 3.180 2.841 2.120
Toiletries/Cosmetics 9.480 7.110 6.352 4.740
Steel 10.320 7.740 6.914 5.160
Telecom. Equipment 19.450 14.588 13.032 9.725
Bank (Midwest) 4.590 3.443 3.075 2.295
Telecom. Services 9.160 6.870 6.137 4.580
Telecom. Utility 5.670 4.253 3.799 2.835
Bank 4.590 3.443 3.075 2.295
Oil/Gas Distribution 18.060 13.545 12.100 9.030
Building Materials 21.240 15.930 14.231 10.620
Power 19.300 14.475 12.931 9.650
Electric Utility (West) 8.300 6.225 5.561 4.150
Cable TV 7.430 5.573 4.978 3.715
Healthcare Information 25.140 18.855 16.844 12.570
Oilfield Svcs/Equip. 13.070 9.803 8.757 6.535
Entertainment Tech 13.850 10.388 9.280 6.925
Semiconductor Equip 7.680 5.760 5.146 3.840
Hotel/Gaming 16.440 12.330 11.015 8.220
Retail Store 8.930 6.698 5.983 4.465
Maritime 14.740 11.055 9.876 7.370
Coal 5.850 4.388 3.920 2.925
Thrift 4.390 3.293 2.941 2.195
Publishing 6.090 4.568 4.080 3.045
Recreation 15.070 11.303 10.097 7.535
Chemical (Basic) 7.290 5.468 4.884 3.645
Chemical (Diversified) 9.440 7.080 6.325 4.720
Electronics 13.170 9.878 8.824 6.585
Aerospace/Defense 16.860 12.645 11.296 8.430
Foreign Electronics 4.460 3.345 2.988 2.230
Human Resources 10.380 7.785 6.955 5.190
Computer Software 38.060 28.545 25.500 19.030
Food Processing 11.200 8.400 7.504 5.600
Med Supp Invasive 25.060 18.795 16.790 12.530
Newspaper 8.330 6.248 5.581 4.165
Educational Services 4.760 3.570 3.189 2.380
Industrial Services 20.230 15.173 13.554 10.115
Automotive 8.290 6.218 5.554 4.145
R.E.I.T. 10.460 7.845 7.008 5.230
Insurance (Life) 7.330 5.498 4.911 3.665
Pipeline MLPs 15.630 11.723 10.472 7.815
IT Services 20.350 15.263 13.635 10.175
Chemical (Specialty) 11.380 8.535 7.625 5.690
Funeral Services 11.670 8.753 7.819 5.835
Internet 35.070 26.303 23.497 17.535
Information Services 22.140 16.605 14.834 11.070
Natural Gas (Div.) 14.550 10.913 9.749 7.275
Medical Services 12.410 9.308 8.315 6.205
Securities Brokerage 6.020 4.515 4.033 3.010
Machinery 12.120 9.090 8.120 6.060
Restaurant 9.34 7.01 6.26 4.67

Disclaimer: Businesses must work with a business professional such as a business broker or chartered accountant (CA) to get a formal value for their business. The techniques described here can be used for informal internal valuations.

Business Valuation Metrics (Seller’s Discretionary Earnings)

Businesses exist to make a profit for their Shareholders. Profit is also known as income or earnings for large-cap public companies. There are three terms that represent the concept of profit and it is critical small businesses understand the difference. Profit or earnings can be expressed as Net Income, EBITDA (Earnings before Income Taxes and Depreciation) and SDE (Seller Discretionary Earnings).

Net Income also known as bottom-line is the most commonly used metric to quantify profit for middle market and large cap companies. It can be easily found on the Income Statement. However, Net Income (NI) provides a skewed picture for small business that may be owner operated. Typically, small businesses want to reduce taxes, so they maximize expenses to reduce their EBIT (Earnings before Interest and Taxes). As such, Net Income is not a good metric for small businesses.

Another metric for profit commonly used by large and middle market companies and private equity groups is EBITDA. Private equity groups like to use EBITDA because it is a quick approximation of the businesses operating cash flow. EBITDA is also useful for larger businesses because it expenses the management and operations. Private equity groups do not get involved in day to day management of the company, so it is important to factor in management cost. The rationale that makes EBITDA good for mid to large companies is what makes it bad for small businesses, where the owner expenses must be added back to EBITDA get a true picture for earnings.

Seller’s Discretionary Earnings (SDE) is the mostly widely used metric for small business valuation. SDE represents the earnings of a small business more accurately because it makes adjustments for owner operator expenses. The simplest way to conceptualize SDE calculation is by taking the EBITDA and recasting owner expenses. Owner’s expenses must include owner’s salary, bonus and all benefits. The technique may be used to roughly estimate the SDE for a small business. Conversely, one can conceptually go from SDE to EBITDA by subtracting owner’s expenses. So, EDITDA = SDE – (Owner’s Salary + Benefits) and SDE = EBITDA + (Owner’s Salary + Benefits). When SDE is used with a multiple to value a business it’s called multiple of discretionary earnings. Multiple of discretionary earnings are best suited for owner operated businesses. Besides buying and selling businesses, SDE is also useful for comparing businesses. Seller’s Discretionary Earnings (SDE) is also sometimes called Seller’s Discretionary Cash Flow.

Business deals on the main street (0 – $2 Million) are typically based on SDE. Business deals in the lower middle market ($2 Million – $5 Million) are usually based on EBITDA. For vast majority of main street businesses working capital is not included in the value of the business.

There are several techniques to business valuation including asset based methods, earnings based methods and market based methods. Rule of thumb based valuation of a business is typically a multiple of SDE or EBIT. The multiplier for your business depends upon several factors including sector, industry, location, deal-size, deal structure, economic climate, financing, number of buyers and so on.

Please note / Disclaimer: Business owners must work with a business professional such as a business broker or chartered accountant (CA) to get an exact estimate for their business. The techniques described here is for business owners to conceptually understand Seller’s Discretionary Earnings (SDE), which plays a critical role in business valuation.

Introduction to Business Valuation

Non-Financial Due-DiligenceValuing a business should not be put off to the last minute when a business is looking for an exit. Most business and finance professionals agree keeping valuation numbers current is a good idea. Using valuation as a measurable key performance indicator (KPI) allows the owner to continuously make changes that maximize value. Valuing a business frequently provides the owner several additional insights such as whether selling the business will provide sufficient funds to retire or whether merging a business is a better option to selling the business.

Overall, there are several reasons to value a business where buying or selling a business is the most important one. Reasons to value a business can be summarized as:

  • Keeping score of value created
  • Making changes continuously to maximize value
  • Facilitate business merger or sale
  • Division of assets within a family and estate planning
  • Tax planning and other disputes
  • Litigation
  • Keep track of valuation for retirement

Valuating small businesses is tricky because there is no central database that keeps track of all transactions. Therefore, valuing a business requires a lot of work and information. Both business buyers and business sellers need to value businesses. The business seller usually has completed valuation and has a price. Regardless of the business seller’s price, the buyer must independently value the business as well. Usually the business buyer will value the business a price that is lower than the asking price. If the two valuations are in the zone of probable agreement (ZOPA) then there is room to negotiate and potentially close the deal.

Collecting this information for a business valuation starts from understanding the industry to conducting detailed financial analysis of the company’s financial statements. For industry analysis the evaluator must determine if the industry is growing or declining and how well the business is positioned within the industry. The evaluator must also complete competitive analysis using Porter’s five force analysis. Other elements of due – diligence includes quantifying the addressable market and current market share of the business.

There are several valuation methods one can use to determine the intrinsic value of a company. These valuation techniques are broadly classified as Asset value methods, Earnings value methods and Market Value based methods. The valuation methods listed above are based on discounting future cash flow, discounting future earnings and using industry specific multipliers. Corporate financial statements including the tax returns are the best source for intrinsic valuation and buyers should ask for at-least five years of data before valuing businesses.

Companies should enlist valuation experts for business valuation. Valuation experts can also help business owner’s benchmark against industry best practices and performance. Experts in business valuation fall in one of the following areas:

  • Business brokers
  • Certified appraisers and valuation experts
  • Forensic accountants
  • Attorneys and lawyers

Business owners tend to resist getting their business valued by a professional because of the cost involved. So, while it is important for business professionals to learn how to continuously value their business informally and they must also value their business formally.

Using Rules of Thumb for Business Valuation

Discounted free cash flow (DCF) and earnings excess based valuation techniques are the fundamental to correctly valuing businesses. That said businesses can also use rules of thumb to quickly value their businesses. Using rules of thumb is a great approach to get a quick and dirty estimate before conducting deeper financial analysis.

Rule-of-thumb valuation is a guideline that businesses owners and business brokers use for a particular industry or line of business to value a company. There are rules available for almost every type and size of business in existence. Most of these rules are based upon multiples of an economic benefit such as earnings, cash flow or annual revenue. Check with your industry associations for rule of thumb formulas for buying or selling a business.

Some examples of rules-of-thumb used to value businesses are:

  • Accounting firms are valued at 100-125% of annual revenue
  • Dry Cleaners are valued 2-3 times adjusted cash-flow or 70%-100% of annual revenue
  • Gourmet coffee shops are valued at  40% of annual sales + inventory
  • Food shops are valued at 30% of annual sales + inventory
  • Gas Stations (w/o C-Store) are valued at 15–20% of annual sales + inventory
  • Law Practices are valued at 90–100% of annuals revenues
  • Restaurants (Full-Serve) are valued at 30–35% of annuals sales + inventory
  • Insurance Agencies are valued at 125–150% of annual revenues
  • Grocery Store (Supermarket) are valued at 15% of annuals sales + inventory