DIAGNOSIS

Business Appraisal Explained

By Lakshay Behl on January 4, 2023

If you have just taken the business appraisal questionnaire, and received your business' valuation, this article is for you.

This is a preliminary result, of course. Business Valuation takes weeks if not months of specific analysis.

We would expect you to treat this business valuation as a rather preliminary report. A starting point, if you will.

But Where Are These Numbers Coming From?

If you are wondering where the numbers are coming from, I should tell you that over the last decade and a half I have focused specifically on not just acquiring businesses, but also on building up equity in businesses that I own or co-own.

This particular preliminary evaluation is based on what we have learned. On a business valuation model that we have built, refined and reformatted over the years based on the input we have received from business leaders, brokers and other professionals who focus on business valuation with any regularity, across industries and countries, even continents.

Of course, the valuation may be alarming to you. Or at the very least unexpected.

Therefore, to explain all the results in great detail, we have created this reference article. So let's get started.

Section 1: Age

Age is obviously important. There is a reason why you see "Since 1949" and such displayed with great pride and panache by businesses that have survived for a while.

The longer a business has survived, the longer it is likely to survive in the future. Most businesses perish within a few years of establishment, and depending upon location and industry, only a small percentage of businesses make it to a decade. For instance, the restaurant business in New York City is notorious for being highly susceptible to failure, with fewer than 30% making it across the ten year mark.

Question 1: How old is your business?

Image reference: "Established in 19xx"

Survivorship bias at its finest. Not only has an older business proven through survival its potential for survival, but also has had the time to establish mindshare and gain marketshare, simply by being present.

  • Less than five years old: You get no survivorship equity. Your multiple is 1.0.
  • Five to ten years old: Very little survivorship equity. Your multiplier is 1.01.
  • Ten to twenty years old: Good survivorship equity. 1.02.
  • Twenty to forty years old: Great survivorship equity: 1.03.
  • The business was established more than 40 years ago: Awesome: 1.05.

Note: The Multiplier

The multiplier will come in handy. For now, just take the multiplier and keep it in mind. You will receive several multipliers over the course of this discussion. Keep multiplying them together, and we will multiply them to the valuation based on your EBITDA.

Question 2: How long have you (or the current owner) owned this business?

While the business might have demonstrated its potential to survive, whether you did a great job of it over a long enough period of time is a separate question altogether.

  • Since it was established: It's your baby. You get the highest multiplier of 1.10.
  • I (or the current business owner) acquired the company less than five years ago: Very recent then, and very little to prove that your grasp of the industry, customer base and so on might be limited. Multiplier 1.0.
  • I (or the current business owner) acquired the company less than ten years ago: Decent experience. Multiplier 1.02.
  • I (or the current business owner) acquired the company more than twenty years ago: Great experience. Multiplier 1.05.

In some cases, having owned a business for over a decade, you might have done a better job than the founders did. And such a factor certainly might come into play when you're actually paying someone to appraise your business. Here, however, we are simply looking at a preliminary valuation, and going be the statistically likely conditions.

Section 2: Cashflow

Cashflow is where the valuation primarily comes from, at least in the context of small and medium businesses. Now, before we talk further about valuation, we must clarify that we are not talking about high-growth potential unicorn business ideas here. Those have a completely different methodology for appraisal and valuation.

We are talking about the regular for-profit small and medium businesses with plenty of competitors in an existing industry.

Question 3: Which of the following ranges represent your company's EBITDA*?

*Cashflow for small businesses.

When you answer this question, be sure to answer with your replacement manager's salary taken into account. In other words, if it would cost $100k a year to find a general manager to replace you, then you'd subtract your EBITDA by that much.

  • Less than $100k: This is a micro-business. Not much profitability and chances are that the owner is the operator. There are not very many systems and/or automations here. Multiplier 0.5.
  • $100k - $250k: Another micro-business, but perhaps with a couple of employees. The owner/operator is not necessarily involved with the operations, though they might very well be. Multiplier 0.75.
  • $250k - $500k: A small business with a few key employees, and partly systemized or automated operations. Owner might still be involved with management and/or marketing/customer acquisition. Multiplier 1.0.
  • $500k - $1MM: A small business, but one that does well. Several employees. Quite a few systems even if the business isn't necessarily hands-off. Multiplier 2.0.
  • $1MM - $3MM: A small business that's ripe for scaling. Multiplier 3.0.
  • $3MM - $10MM: This is a very sweet business to sell. The equity is serious and real, and there is a layer of management between owners and employees by the time a business grows to this level. Multiplier 5.0.
  • $10MM - $40MM: A business that's consistently doing over $10 million a year in profitability is well-systemized and scaled. This is of keep interest to private equity firms. Often such a business will employ several dozens of employees and have systemized HR. Multiplier 9.0, and there'll be no dearth of private equity buyers that will pay this amount.
  • More than $40MM: Fully systemized. Growth might be slow, but this is a very juice business. A listed corporation with a P/E of 40 or higher might like to acquire this business to lower their P/E, or to maximize earnings which in turn boosts its marketshare. Multiplier of 11x isn't uncommon here, and sometimes even 15x.

Now, you simply take all the multipliers so far, and multiply them with your cashflow, and this is a preliminary valuation of your business.

For example, if you have a business making $800k a year that you founded 11 years ago, your multiplier would 1.02 (age) x 1.1 (ownership) x 2.0 (Cashflow based) = 2.244.

Take that multiplier and multiply it with your EBITDA which is $800,000 and you get a preliminary valuation of $1.795 Million.

Notice how your multiplier varies with cashflow.

Higher the cashflow (EBITDA), higher the multiplier. This is because higher cashflow or EBITDA signifies how well a business is systemized. It also indicates the presence of a management layer, which at higher cashflows might be self-managing and self-sustaining down to HR and Finance.

Of course, this is not the end of the valuation. There are some other factors at play.

Section 3: Assets

We look at the total equity you have in assets such as real estate, FF&E (Furniture, Furnishings and Equipment) as well as inventory.

Of course, you don't get a dollar to dollar match in appraisal with these assets, but having assets clearly and obviously makes your business more valuable.

Section 4: Operations

Question 7: How many Full Time employees does the business staff?

Employing people with a diverse set of skills and talents is the core of what makes a business strong, resilient to market upheavals and sustainable.

  • Fewer than 5: Your business relies on very few people. If one or two leave, your business might fail. Multiplier 0.75
  • 5 to 10: Multiplier is 1.0.
  • 10 to 20: Multiplier 1.02.
  • 20 to 50: Likely to have a good management layer, multiplier 1.05.
  • 50 to 100: Likely to have systemized HR processes and training, multiplier is 1.1.
  • 100 to 500: Multiplier 1.15.
  • More than 500: Likely to be fully systemized. Multiplier 1.2.

Fully systemized businesses are worth 20% more just by virtue of being systemized.

Question 8: How many Part Time employees does the business staff?

  • Less than 5: Multiplier 1.05.
  • 5 to 10: Multiplier 1.03.
  • 10 to 20: Multiplier1.02.
  • 20 to 50: Multiplier 1.0.
  • 50 to 100: Multiplier 0.95.

Question 9: How many of your employees occupy managerial positions?

A layer of management means you, the business leader/owner are not alone in managing employees and processes. You have managers to help you with the management of people and processes.

The larger your management layer, the more systemized your business is likely to be.

  • Only family members and friends: Multiplier 0.75.
  • Less than 5: Multiplier 0.9.
  • 5 to 10: Multiplier 1.0.
  • 10 to 20: Multiplier 1.05.

Question 10: What is the profit margin on gross revenue?

If your profit margins are too small, say 1%, any external changes to the environment (such as a couple of vendors increasing their pricing) can destroy your profitability.

If your profit margins are too high, say 40%, your industry is ripe for attack from competitors with much deeper pockets. Arbitrage situations do not last forever.

  • Less than 5%: Multiplier 0.80.
  • 5 to 10 per cent: Multiplier 0.95.
  • 10 to 20 per cent: Multiplier 1.04.
  • 20 to 25 per cent: Multiplier 1.05.

Question 11: What percentage of gross revenue are fixed costs?

Fixed costs are what kill a business during economic downturns. You can cut down on variable costs. You can cut down on spending when it's limited to taking care of a larger number of customers. You can cut down on inventory. You can even cut down on your staff, painful as it might be.

But you cannot cut down your fixed costs. In most cases, occupancy costs are fixed, and leases are long term. The consequences of trying to get out of long term leases in many cases are catastrophic.

  • Less than 5%: Multiplier 1.20.
  • 5 to 10 per cent: Multiplier 1.15.
  • 10 to 20 per cent: Multiplier 1.08.
  • 20 to 25 per cent: Multiplier 1.0.

Needless to say, higher your fixed costs (as a percentage of your revenue), higher the possibility of failure. Economic cycles (and consequently downturns) are a question of when, not if.

Section 5: Marketing

Question 12: How many direct competitors do you have in your immediate vicinity*?

*This is geography in most cases, but for online businesses, things can be different.

  • So far I have no direct competitors. I have the lion's share of my market: Multiplier 0.8.
  • Less than 3 major competitors. I am one of the top three major players in my category: Multiplier 1.25.
  • We have more than 3 major competitors, and several minor competitors. We are one of the several minor players: Multiplier 1.0.

Having no major competitors again implies that sooner or later, your industry is going to attract other players. Some with deeper pockets than you inevitably.

Question 13: What percentage of gross revenue do you spend on marketing activities?

This includes advertising, lead generation activities, promotional events, follow up campaigns and so on.

  • Less than 5%: Multiplier 1.0.
  • 5 to 10 per cent: Multiplier 1.01.
  • 10 to 20 per cent: Multiplier 1.05.
  • 20 to 25 per cent: Multiplier 1.03.

Spending too little means you're potentially leaving money on the table. You could have more clients, higher profitability, greater marketshare and so on just by spending more money on advertising and marketing.

But if you're spending too much, then the pace at which you're growing is liable to be unsustainable. Secondly, should the advertising costs increase (which they inevitably do as more players enter the market) your currently-profitable business may lose its profit-potential in its entirety.

Section 6: Systems

Question 14: How much time do you yourself spend running your business?

  • More than 60 hours per week: Your business isn't ready for selling. You're employed by the business, but what is worse is that it is unlikely you will find a manager who can replace you. If you are replaceable, and your business just wouldn't be the same without you, then it's really not a good business for a new owner to buy. Multiplier 0.5.
  • Between 40 and 60 hours per week: Multiplier 0.75.
  • Between 20 and 40 hours per week: You have potentially systemized some of the aspects of your business. Maybe operations, maybe sales. There's more you could do, but at least you're not working on it full time. Thiis adds to the equitable value. Multiplier 0.98.
  • Between 10 and 20 hours hours per week: You have likely systemized a lot. Multiplier 1.1.
  • Between 5 and 10 hours per week: You've almost systemized the entire business. You are still taking care of finances, most likely. And maybe taking care of some big ticket sales or other consequential decisions. Multiplier 1.25.
  • Less than 5 hours per week: As good as it gets. You will never have a business that requires no time at all. If you did, you'd never have to sell it. You could just enjoy the cashflow without any responsibility or stress. You can still be on a vacation for months and the business will continue to function, so the multiplier is 1.5.

Systems are the core of business equity. The better systemized your business is, the higher your equity.

Take all the multipliers and multiply them together. Then take your cashflow (average of last three years works best). Multiply the multiplier to your cashflow, and you've got an appraisal.

We have, in the course of this discussion, covered a lot of aspects wrt business equity. You can see how you can quickly increase your business' valuation just by focusing on aspects such as fixed costs, marketing and systemization.

If you would like us to help you with maximizing your business' value, contact us here for a free consultation.

 

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Article written by Lakshay Behl
Lakshay Behl is the world's leading business systems architect. He engineers and deploys business systems that automatically operate, manage and grow companies. While he typically works with established companies in certain sectors, his strategies are universally applicable.

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