A business holds value for various reasons: it generates income, builds wealth, and offers owners a sense of purpose and fulfillment. Small businesses are also crucial to the United States economy—97.6% of companies in our country have fewer than 20 employees (99.9% have fewer than 500).
Consequently, the question for a business owner isn't "is my business valuable?" but rather, "how valuable?" Beyond that, the question becomes "how can I make my business more valuable?"
Addressing the first question of how valuable a business is, the short answer has always been "however much a buyer is willing to pay for it," but that poses a challenge in a market characterized by low liquidity and significant differentiation. The long answer is not that complex; it's a simple mathematical equation you have probably encountered before with an online business value calculator:
Value=Income x Multiple
This equation, however, is incredibly nuanced and often misunderstood. Because it answers one of the most critical questions a business owner will ever ask, it is worth understanding—especially from the perspective of an influential yet frequently overlooked party: the buyer.
Starting with income, if you're an owner reading this, you're likely laser-focused on this metric. You might even use it as a proxy for value, which isn't entirely incorrect. If you brought home $3.25 million last year and that number grew to $3.5 million this year, that could indeed suggest that your business has increased in value. Even using the equation above, with all else being equal, an increase in income implies an increase in value.
Bear with me as I clarify some technicalities before we explore the concept of income:
First and foremost, income (for the sake of the strategic value equation above) can assume various forms, such as EBITDA, SDE, EBIT, or even revenue. The suitable figure depends on factors like industry, size, and may even require a combination of different variations. For our discussion, I will continue to refer to it simply as 'Income.'
Second, this number must be adjusted or re-casted. If you are like many business owners I know, your business and lifestyle are closely linked. Expenses such as travel, vehicles, insurance, and particularly salary, are routed through the business; however, in the event of a sale, those expenses would cease. If a sole proprietor generated $500,000 in net income last year but spent an additional $100,000 on insurance premiums and purchasing a vehicle, the buyer of that business would need to consider a multiple on $600,000 in income since they will not incur the current owner's expenses.
This is generally good news for business owners wanting to assess their company's value. I encourage any owner reading this to work with your CPA, CFO, controller, etc., to provide both a real number and a tax number each quarter or year concerning income. It constitutes half of the equation and can significantly influence your business's strategic value.
The second half of the equation is the multiple, or how many times the buyer is willing to multiply your business's income by to purchase it. The multiple used to value your business is best thought of as a range and, as uncomfortable as it may be, the range is beyond your control. Factors such as private capital market liquidity, interest rates, etc., are in the driver's seat here (notice how I make a point of saying the range of multiples is out of your control, not necessarily the multiple itself--tuck that piece of information into the back of your mind for future discussion).
Adding to the unease, the default multiple for valuing a small business is zero. Only about 20-30% of businesses end up selling, which means the probable multiple of your earnings is substantially zero. The multiple is why an increase in income doesn't guarantee an increase in value. While $3.25 million growing to $3.5 million is impressive, with a multiple of zero, the business still doesn't sell. Let's examine a quick example:
Frank owns a roofing company in Northeast Ohio with five full-time employees and around 20 private contractors, generating $12 million in annual revenue. In 2022, his EBITDA was $900,000. He requested a re-casted EBITDA number from his CPA to exclude vehicle expenses, insurance premiums, and salaries paid to family members, resulting in a re-casted EBITDA of $1,050,000. His business advisor connected him with a certified valuation expert who determined the multiple range for a business of Frank's size in the local roofing market to range from 2.47x to 3.55x EBITDA.
Value=$1,050,000 x (2.47-->3.55)
If Frank's business were to sell successfully, private market comparables suggest a business value between $2,593,500 and $3,727,500.
I reiterate: IF FRANK'S BUSINESS WERE TO SELL SUCCESSFULLY, this would be the value range that the private market is currently paying for a business like his.
Frank's primary concern, which I know I've emphasized, should be the 70% chance his business sells for exactly $0.00.
What does Frank need to do to ensure his business sells successfully? Before addressing this, I want to stress that this topic isn't exclusive to owners looking for an immediate transition but is relevant for any owner wanting to build value in their business. What tools and strategies does that cohort need to concern themselves with? Spoiler alert: they are the same as the owners who are near the finish line.
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