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.
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.
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.
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.
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.
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.
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.
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.
*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.
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.
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.
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.
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.
Fully systemized businesses are worth 20% more just by virtue of being systemized.
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.
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.
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.
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.
*This is geography in most cases, but for online businesses, things can be different.
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.
This includes advertising, lead generation activities, promotional events, follow up campaigns and so on.
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.
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.
