Business Valuation Questions - Rules of Thumb & The Balance Sheet

I received quite a bit of feedback about last weeks posts on valuation. Much of it was about the definition of different term and also a lot of questions about how the balance sheet affects the selling price. So today I though I'd address the most common valuation questions I've gotten.

What is the difference between what you call "Owner's Benefit" and EBITDA?

EBITDA (Earnings Before Interest Taxes Depreciation and Amortization) is an earnings figure used to value larger companies. The Owners Benefit figure is used to value small, owner-managed companies. The main difference between EBITDA and Owner's Benefit is that the earnings in the EBITDA figure does not include the salary paid to the manager of the business. The "Owner's Benefit" does include the salary paid to the manager because the owner (or business buyer) also manages the company so that salary is a benefit enjoyed by the owner.

What is the difference between "Owner's Benefit" and "Seller's Discretionary Income"

Nothing. I use the term "Owner's Benefit" instead because I feel it more accurately describes what we are talking about, namely, what is the business worth to it's owner. Also, it's better from a salesmanship perspective when dealing with the buyer. After all, the buyer wants to be an "Owner" not a "Seller".

How does the value of items on the balance sheet - inventory, equipment, cash, accounts etc. - affect the valuation if you are using a multiple of earnings?

Some of the items on the balance sheet such as machinery, vehicles and equipment are required in order for the business to produce its earnings. So the value of those assets is already reflected in the earnings figure you are multiplying. The cash and receivables are usually kept by the owner after the sale so they wouldn’t affect the price.

If the buyer is going to take over the receiveables than you and the buyer will have to agree on a fair value for them. Your receiveables represent money you have already earned so the buyer would have to pay extra for them. Exactly what your receiveables are worth today and just how collectible each account is may be something you and the buyer don’t agree on. That’s why it’s simpler for the seller to just retain the receiveables.

In most cases, the inventory is valued at its replacement cost. Not at what the seller paid for it or what it can be retailed for, but what it would cost the new owner to go out and replace the inventory.

Where do "Rules Of Thumb" come from?

Most are derived from survey's that industries do with their members. Other information comes from surveys of business brokers about deals they have closed. It's important to note that these rule of thumb calculations are based on the actual selling price, not the asking price. These same surveys show that most businesses sell for an average of 75-80% of the original asking price. So no matter how you arrive at your asking price, make sure that it includes a cushion of about 20% above what you actually hope to sell for.

So don't make the mistake of advertising a rock bottom price hoping it will attract more buyers. No matter how low you set your initial asking price, buyers will always test it by asking for a lower price. If you don't a budge at all off your initial asking price buyer's will not feel like they are getting a good deal and it will be much harder for you to sell. So always begin with an asking price at the very top of the price range.