How To Value A Business

I recently was looking at a business plan for a new venture that came across my desk. The two individuals involved are trying to raise money for a bar in South America that they will manage. It’s one of those businesses that most people dream about – a foreign country with lots of sunshine, lots of friendly travellers, and evenings spent sipping beer on a patio. Sign me up!

As part of their business plan, they needed to come up with a value for what this new business would likely be worth once it was off the ground. The reason you need to have a value is that when you are trying to solicit investments from people, they need to understand how much of the company they will own. So if a business is worth $500,000, and an investor puts in $100,000, it wouldn’t be unreasonable for them to own 20% of the company with their investment (although most owners would likely resist giving that much away).

The value of the business as listed in the business plan was $800,000.

First, to come up with a value on a business, you need to understand why people would buy it. For most business purchasers, a business represents a consistent income stream. So instead of buying a “business” what many people buy is a revenue stream that’s tied to a specific product or industry. So in terms of business value, most people look at a business in terms of how much money it can generate yearly vs how much money the initial investment (i.e. the purchase cost) is.

A standard method used to value a small business is to look at the yearly profit of the company and use an industry specific multiplier to come up with a rough price. For example, a retail computer shop may have a multiplier of 1.0, while a software company with internet based sales may have a multiplier of 3.0. Multipliers typically take into account the inherent risk in a business vs its ultimate profit potential. For example, it’s much easier to grow an internet based software company’s sales than it is to attract more customers to a retail location, which is why an internet based software company may have a multiplier of 3.0 compared to a retail outlet of 1.0.

So if an internet based software company is netting $100,000 a year in profit, and it has an industry multiplier of 3.0, a rough estimate of the sale price would be approximately $300,000. Likewise, a retail computer shop that has about $50,000 a year in profit and a multiplier of 1.0 would only be worth $50,000 to a perspective owner.

One aspect to keep in mind is that profit should be the reward of ownership, not payment for work performed on the business. If a business owner works on the business (i.e. puts in time running it), they should draw a salary from it. If you work full time on the business but don’t pay yourself, and simply take the $50,000 profit at the end of the year and live off of that, ultimately what it’s saying is that your business isn’t worth anything, since it takes a person being paid $50,000 a year to run it. So you need to get into the habit of paying yourself for work you do – if you can’t afford it, you need to brainstorm ways to increase revenue or provide more value so you can start to.

Many owners sit down and start doing math like this and are immediately depressed – how is it that something they’ve spent 10 years building is worth so little? But the reality is most people who buy businesses simply look at them like investments, and all the blood, sweat, and tears the owner has put into it simply doesn’t factor in.

Likewise, many business owners think they have intellectual property or specific know-how that will command a much higher price. But for most business purchasers, the belief is that any intellectual property will already be contributing to the profit of the company. If it isn’t contributing to the profit of the company, then it’s not worth anything. The same can be said for email lists, social media accounts, etc. – if they are worth anything, they will be contributing to the profit of the company.

In many ways, knowing this ahead of time can be a blessing. If your plan is to ultimately sell your company, then you can simply put effort into increasing profitability which ultimately increases the sale price. If you have an email list or social media accounts, you can spend time figuring out how to generate revenue from them.

In terms of the business plan I recently looked at, it showed approximately $50,000 a year in profit after it was all built, and about $200,000 in real estate (the actual property). A bar likely has a multiplier of around 1.0, which places the real value of this company probably around $250,000 (the combined price of the property and the revenue stream with a 1.0 multiplier) – this is a very long way off from the estimate of $800,000, and makes it highly unlikely they will raise the $400,000 they want.

In addition, the business plan shows they are only putting up $50,000 of their own money. While it’s an non-trivial amount of money, it’s roughly only 10% of the total costs they need to start the business. If they didn’t want to keep ownership of the property, they may be able to raise some of the rest of it. But asking investors to put in 90% of the development costs for a project, but only be entitled to less than half of the reward (assuming the owners want to retain a controlling interest) is asking a lot of most investors, and I suspect most of them will walk.

Obviously there is a bit more involved in valuing a business if the intention is to sell it, but this is a rough overview that people should be aware of while they are building it. If anyone has any questions, feel free to drop me a line.