Business Valuation – The Best Definition of Earnings For Small Business

Even with the simplest small company, business valuation can seem like an incredibly complex topic. But if your reason for performing the valuation is because you are selling your business, the valuation process should be fairly simple.

Buyers are interested in buying your business because of its profits. That is why I have always advocated using a multiple of proven profits as the best way to come up with a value for your business and a range for your asking price.

But even with this simple method, there are endless ways to vary the outcome: do you use past profits or projected future profits? Before or after taxes?

Come to think of it, how do you even define the word “profits”?

Does it mean the same thing as cash flow?

Let’s discuss all of these questions.

But first, let me point out that the method described here is best for smaller businesses (less than a million in sales) where the owner also manages the business. Also, most of this won’t apply for very new businesses or ones that have no profits. For those types of businesses you should use an “asset based valuation”.

Which Earnings Do You Use?

If you are going to convince a buyer to choose your business over all the other businesses on the market that they can buy, you have to appeal to her motives. Setting your price range based on your actual proven profits (as opposed to speculating about future profits) makes the most sense to the buyer. It directly addresses her main concern – how much money the business actually makes!

Now for the key question: How do we define “profits”? Do we use cash flow? Or do we use something called EBIT(earnings before interest and taxes)?

The best, most logical number to base your valuation on is “Owner’s Benefit”. Accountant types like to call this “Seller’s Discretionary Cash Flow”.

The formula for determining the owner’s benefit is:

Annual Pretax Profit + Owner’s Salary + Owner’s Perks/Benefits + Interest + Depreciation.

This number will tell the buyer how much money the business actually has been generating for you as its owner. Since the buyer’s interest and tax payments will be different than yours, you want to include tax and interest payments in the total owner’s benefit number.

From there the buyer can make their own estimates of what their interest and tax payments will be.

“Perks and Benefits” can include things such as automobile leases, travel expenses, salaries for family members that are over and above the marker rate for the work they perform. Any of the good stuff that you get in addition to your salary that the business pays for should be included in the “Owner’s Benefit”.

But the key concept here is that the owner’s benefit is the amount of money + other benefits the business generates for the owner. And since the prospect is buying the business in order to get that money and benefits, the owner’s benefit number is where any valuation should start.

I suggest you use an average of your last 3 years owner’s benefit as the basis of your valuation.

If last year was a really good one, you may be tempted to use just the owner’s benefit from the most recent year instead of the last three. I recommend you use three years because that creates more credibility with the buyer. Especially if your most recent year has been significantly better than any previous year, the buyer may regard it as a fluke or even worse – they may suspect you have manipulated the numbers.

If your profits have been trending up for each of the last three years you should consider weighting the more recent years more heavily. For instance, instead of adding up your owner’s benefit from the last 3 years and dividing by three, you can take 70% of you most recent year plus 20% of the prior year plus 10% of the year before that.

Source by Patrick Jennings

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