While it’s true that business valuations are something of an art, there is hard math to back up the final calculations. In this piece by Bob House in The Business Journals, we learn six key metrics for business owners who are considering selling their companies–whether in the near future or years down the road.[x_blockquote cite=”Bob House” type=”left”]By understanding the metrics that matter most to potential buyers, you can position your business for a smooth and successful transition.[/x_blockquote]
From Facebook’s acquisition of Oculus Rift for $2 billion to Microsoft’s recent purchase of Mojang for $2.5 billion, it’s easy to believe these staggering sums are based on arbitrary deal making.
While it’s true that business valuations are something of an art, there is hard math to back up the final calculations.
Even for small and mid-sized business owners looking to sell, it’s important to know and understand a variety of important figures, such as revenue, seller’s discretionary earnings, and the earnings multiple, which potential buyers consider carefully when making an offer.
Here are six metrics all business owners should know:
Gross revenue is as important a figure as it is obvious, but just as critical to note is the general growth trend. A steadily increasing bottom line signifies a company on the rise, and can justify a significantly higher price. Recurring revenue is also a key consideration, and can reduce the risk to business buyers. Especially for smaller businesses, revenue is a powerful indicator of a company’s size and position within the industry.
2. Seller’s discretionary earnings
Many prospective buyers look at seller’s discretionary earnings (SDE) when determining the value proposition of small businesses. SDE accounts for a business’s net income before certain owner-specific expenses, such as the owner’s salary and benefits, taxes, interest, depreciation and amortization. Buyers can then average this figure over the past three to five years in order to provide a reasonably accurate estimate of the annual financial benefit they can expect after purchase.
3. Earnings multiple
A firm’s earnings multiple is core to determining its valuation in conjunction with its SDE. Most businesses sell for between one and four times their SDE, with factors like brand reputation, core staff and recurring revenue factoring into the final decision. Typically, the higher the current and potential revenue of a business, the greater its earning multiple and final valuation.
Reaching an appropriate valuation is pivotal to ensuring a firm’s realistic asking price and successful sale. Valuation is based on a combination of SDE and the earnings multiple, in addition to inventory and real estate assets. A trusted broker’s expertise and objectivity, drawing from the valuations of comparable sales, can help your business determine the best possible valuation.
5. Asking price
Determining the right asking price for any business is a balancing act. A firm’s asking price should be low enough to remain competitive with other listings and attract suitable buyers, but high enough to ensure the full valuation is realized. Again, consulting with an impartial broker may help to calculate the appropriate asking price for your firm.
6. Net after-tax sale proceeds
Aside from focusing on pre-sale metrics, business sellers have to understand certain post-sale figures as well, primarily tax implications. A portion of sale proceeds will likely be owed through taxes, but these tax liabilities can be minimized. Converting from a C to an S or LLC corporation, using trusts to reduce estate taxes and transferring stock to family members are common tactics for softening the tax hit.
Whether your business is the next billion-dollar acquisition or a small family venture, the business marketplace places a premium on data-driven purchases. By understanding the metrics that matter most to potential buyers, you can position your business for a smooth and successful transition.
Note: To read more financial tips for business owners, read the RL Brown Wealth Management blog 3 Essential Moves for Business Owners Before Retirement.