Frankly, it is almost always a surprise, the value of a business. Owners wanting to sell are often thinking the sale price will fully fund their retirement, the only requirement to continue to live as they have.
Usually this is just not true.
Note: Cash flow to owner is sometimes called discretionary earnings. There are several models for this calculation, all leading to the same end. It is good to know that the calculation is as much an art as a science.
A typical main street business will sell for something less than three times cash flow to owner. There are many drivers for determining the sale price. These are a few important ones:
- Historical cash flow to owner
- Strength of the business model
- The industry
- How neat and tidy the business is
- How large the business is
- What is owner involvement
Historical cash flow to owner is one of the most important features of business value. It is calculated by looking at the profit and loss statements or tax returns for several years. I typically consider the most recent three years. To determine cash flow consider these basic components:
Net income plus
- Owner salary and salary expense
- Non-cash items of depreciation and amortization
- Personal expenses not used to operate the business, e.g. owner’s health insurance, car expenses, dog care
There are many more possible considerations, e.g. paying more or less than market to a family member for their services, the impact of one-time expenses or an owner’s illness, or the excess rent paid to the owner who also owns the building.
Once you have the cash flow to owner, likely over several years, the calculation averages these years, perhaps putting more weight on one year or another. To determine the multiple a capitalization rate is applied. This rate fluctuates by size of business, industry, owner-operator considerations, and more. It is this rate that, when applied to the cash flows, determines the multiple for value of the business.
Business owners should periodically do this exercise and consider how increasing sales and decreasing cost can impact the cash flow and business value. One is likely to also realize that along the way, saving for retirement is a worthwhile investment – considering the sale of the business may not be sufficient.
Have questions about the value of your business? Contact us.