There are over 30 million small businesses in the US, according to the Small Business Administration (SBA), and upwards of 50,000 small businesses are sold each year. If you are buying a small business, an SBA business valuation can get you the loan you need to buy the business. Here is what buyers and sellers need to know about SBA business valuation.
What is an SBA business valuation?
An SBA business valuation is a formal assessment of a business’s worth done in advance of the sale of a business. Buyers who want SBA loans to finance a business acquisition usually need a business valuation. The SBA guarantees loans from lenders who comply with the SBA program rules. SBA guarantees reduce the risk of loss to the lender encouraging them to lend.
The SBA rules are known as the SBA SOP or Statement of Policy. Any business purchase over $250,000 in value and any business purchase between related parties (family or business type relations) will require a business valuation from a “qualified source.”
Why do I need a SBA business valuation?
As stated in the SOP:
“An accurate business valuation is required because the change in ownership will result in new debt unrelated to business operations and potentially the creation of intangible assets. A business valuation assists the buyer in making a determination that the seller’s asking price is supported by an independent Qualified Source (see definition in Appendix 3).” (SBA SOP p 262)
What are the major points required by the SBA SOP?
The rules outlined by the SBA SOP are specific. Here are the major points for a business valuation required by the SBA SOP:
It must be requested by and prepared for the lender
It must identify if the transaction is an asset sale or stock sale.
It must be specific enough to know what is included in the sale including assumed debt if any
It must provide the valuators conclusion of value
Valuators qualifications
Valuators signature
How does an SBA qualified business valuation work?
First, a valuator with a valuation certification from an acceptable body (ASA, CVA, ABV, are a few of the accepted designations) will prepare a business valuation in compliance with valuation standards. This valuation will determine the value of the asset being purchased, and that it is within the range of a fair market value standard of value. In short, I find that the buyer is paying a reasonable amount of the asset being purchased.
Business valuation is quite complex (as I say, it is an art and a science). But, at its core, we are trying to determine that it is reasonable for the business assets (including people) to keep generating cash flows at a level consistent with the amount a buyer is agreeing to pay.
Because all businesses are unique, we adjust the company financials to be apples to apples comparisons to several different types of models. This is called normalizing the financials.
Business valuation uses comparisons. Market method approaches use actual sale transactions or stock market values to compare. Income approaches look at what an investor would pay. Asset approaches look at what the assets are worth, if sold off on their own. The valuator adjusts the financial information and then selects the base approaches to estimate the value.
Business valuators are not auditors. We are allowed to assume that data being provided is reasonable and true. Therefore, you as a buyer still need to perform due diligence to make sure the data being provided to the business valuator is true. A business valuation does not replace careful due diligence.
What do I need to do to order a business valuation?
In most cases, the lender is going to order the business valuation as this is required by the SBA SOP. (It is certainly appreciated if you ask them to reach out to us.) In most cases, the business valuator is going to need: 3 years tax returns for the company; 3 years internal financial statements; year-to-date financial statements (profit or loss statement and balance sheet); accounts receivable aging; and accounts payable aging; letter of intent or contract of sale. Most valuators have a questionnaire to cover the required management interview and to answer small but important questions. Most businesses will also have one or two other documents specific to their industry. The loan underwriter will also need most of these documents so get them early in order to not slow down your SBA loan underwriting process.
Contact me to find out more about business valuations and buying or selling your small business.
Business valuation market method multipliers are useful as rules of thumb or sanity checks on business valuations, calculations, and estimates. Below, I include many small business multipliers and industry multipliers such as construction, HVAC, plumbing, auto repair, manufacturing, accounting and service businesses, liquor stores, distributors, and more.
Many business owners just want the question answered – what is the business valuation multiplier for my business? Well, hang on. Using multipliers for business valuation is at best a rule of thumb and not a professional business valuation. Although sometimes, a multiplier is all you need.
Disclaimer: These business valuation multipliers are our best belief based on 20+ years valuing hundreds of small businesses and brokering over 60. The typical small business has an SDE multiplier range of 1 to 3, and 2.2 is about average. Again, using these multipliers is a rule of thumb NOT a business valuation. Always obtain a professionally prepared business valuation for major life decisions, tax matters, estate and gift tax planning, succession and exit planning, required fairness opinion or other compliance.
Watch the 1:35 Minute Video About Market Multipliers and
Rules of Thumb Below.
What is a Business Valuation Multiplier?
The market method valuation approach formula for valuing business is:
Future Cash Flow x Multiplier = Indication of Value
Multipliers are estimated by taking reported business transactions and dividing the sales price by the business’s reported cash flow. This is the only method that ties to actual sales in the marketplace. In an actual business valuation, there are several other additions to the formula. These include adjusting the cash flows, adjusting the balance sheet, and taking into account discounts and premiums. All of these can impact value. Business valuation is more than this simple version of the market method formula.
There are several cash flows commonly used including revenues, Sellers Discretionary Earnings (SDE), and Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) in the market method. There are other cash flows occasionally used or used in different industries including gross revenues, EBIT, after tax cash flow and more. I recently shared more about cash flows in “Five Cash Flows Used in Business Valuation.”
It is important to align the cash flow used with the proper multiplier. It is also important to adjust the multiplier based on profitability of the company, systems, employees and contractors, customers, products, inventory on hand, economic outlook, industry outlook, and many other factors. That is why just applying a multiplier to a cash flow without judgment can be so misleading.
How to Select the Right Multiplier
Most business owners select a multiplier that is too high. Certainly there are “high multiplier” companies out there, but often the cash flow multiplier actually drops as the company becomes more profitable. While this seems hard to believe, we have charted hundreds of companies and can assure you it is common.
When the market method is properly applied, multiple data points (usually 10 – 30) are obtained and compared to the subject company. Usually industry, revenue range, date range of transactions, and profitability range are all searched. It is important to chart the data by profitability. Comparables are then examined as a group. When appropriate, they are also examined individually to fully understand how the comparables really compare to the company being valued. We recommend DealStats from BVR as this is the best small business data at this time.
Multipliers Are Not Always Best in Business Valuation
As with all business valuation, professional judgment comes into play. While we are pleased to post these business valuation multiples for your use we highly recommend you have a proper business valuation performed by a professional business valuator–if it is to be used for anything beyond a fun conversation.
We are always available to serve you in that capacity. Contact Greg Caruso for more information about professional valuation services.
No matter what the financing event you are facing is– buying a business, selling a business, getting a loan, or acquiring a partner– you will need a valuation. Understanding how the value of a business is determined is also important because then you can feel confident in knowing what your business or the business you want to buy is really worth. And even if you aren’t ready to sell or apply for a loan yet, knowing how much your business is worth can help you plan for the future.
NerdWallet, a company that explains financial information to consumers, recently published an article that outlines the major things you need to know about small business valuation. Read the full article at this link.
They explain the terms and acronyms you’ll need to know, like SDE and EBITDA and how to organize your finances and determine your assets. They also suggest you do what we always do: find out more about your industry and what businesses of similar size, revenue, and business model are worth. They also outline three approaches for valuation, but if you want more information about these methods, you can read my recent blog post.
As they write, “No matter where you are in your business’s lifecycle, learning how to determine a business’s value is a great way to better understand your own business’s finances and assets within the context of your industry.” We always stress that Business Valuation is both a science and an art. To find out more about professional valuation services for your business, contact me to learn more.
There are three business valuation approaches or methods:
The Asset Approaches are where the individual assets of the business are valued as if they were being sold.
The Market Approaches are where comparable market sales are used to estimate a value of the company.
The Income Approaches are where the risk to investors is compared to all investor investment choices to determine value.
More detail below:
The Asset Approaches are where the individual assets of the business are valued as if they were being sold. This is usually used for non-performing businesses that may be liquidated.
The Market Approaches are where comparable market sales are used to estimate a value of the company. The formula is the cash flow times the multiplier equals the value (or $100,000 cash flow x 2.2 multiplier = $220,000 value). The multiplier is developed by looking at the sales price of the comparable sales data usually obtained from reporting services and dividing it by the cash flow. (Multiplier = Price / Cash Flow or $100,000 price / $50,000 cash flow = a multiplier of 2.) For very small businesses these comparable businesses may be mainly owner operated businesses.
When reviewing the various market methods a major concern is the comparability of the selected comparable companies to the company being valued. Are they similar or very different? In addition the valuator needs to make reasonable adjustments for overall risk of the company being valued vs. the comparable set. For instance a company with two clients each at 50% is much more financially risky all things being equal than a company with 100 1% revenue clients. The multiplier should be adjusted to reflect company risk vs. the likely risk in the comparable set.
The Income Approaches are where the risk to investors is compared to all investor investment choices to determine value. Public market data is used to develop a discount rate. The discount rate is divided (along with present value adjustments) into a projected cash flow in the discounted cash flow income method. This is a quite complex formula. A more commonly used income method with small businesses is the capitalization of earnings method. In this method a capitalization rate which is a discount rate minus a growth rate is applied to historic earnings adjusted by the growth rate for the next year (selected historic cash flow of $100,000 and a 3% growth rate = $103,000 adjusted cash flow / .25 (a discount rate of .28 – .03 growth) = $412,000 value). Discount rates are generally developed for very small businesses using the build-up method (also called the BUM). In short, the cost of capital for different layers of business risk has been calculated looking primarily to public companies and public information.
Each layer of a build-up should be carefully reviewed to make sure it was developed correctly as of the proper valuation date. The last layer in the buildup method is specific company risk which is valuator judgement where all of the specific strengths and weaknesses of the business are accounted for that may impact Risk. Note that Risk for business valuators is the perceived likelihood that future cash flows will not be met.
In all cases there is tremendous judgment in estimating a multiplier, discount or capitalization rate. Which method to use depends on the facts in the case and the available data. For smaller and micro businesses (I define as usually under $10 M revenues) there often is quite a large amount of market data which should favor using that method. For businesses over $10 M in revenues there may not be enough relevant data to use the market method. Then the income method is likely to be the best method. Remember, methods are models and none are perfect. We must select the best method based on all factors. That, is professional judgment at work.
In all cases, use common sense. Make sure the selected value ties into the risk (and has some relationship to a price someone would pay) of the company including likely economic, industry, and other foreseeable changes in the future.
Greg Caruso, JD, CPA, CVA, the author of “The Art of Business Valuation, Accurately Valuing a Small Business” 2020 published by Wiley is always available to prepare (or review) business valuations for all purposes and situations.
After a recent seminar “Valuing Small Businesses in the Shadow of COVID-19”, I took time at the end to answer some questions from the attendees. Here are some of the questions (and answers!) on using the Income Method to value small businesses that I felt might be most helpful for other seminar attendees as well as business valuators, CPAs, lawyers, and consultants that work with business valuations.
Do you believe projections and forecasts for the discounted cash flow income method of business valuation use will be less reliable during the Covid-19 Pandemic than before?
It is very difficult to estimate reliability of projections for business valuation outside of comparing a company’s prior projections with actual results. Most small companies do not have that type of data or the projections prove to be unreliable pretty much all the time. Therefore I do not believe most projections are less reliable due to COVID-19. There are reasons to believe they may be more reliable. I suspect in most cases much more thought and support will be provided in creating the projections and final forecast. For many companies, instead of being a “add 5% to last year” situation (we have all done it) much more strategy and foresight will go into the whole planning and projection process.
In all events all projections and forecasts for use in an income method of business valuation need to be reviewed carefully from the point of view of, “is this the absolute best that can be done” with what is known and knowable. In the “The Art of Business Valuation”, much time is spent on reviewing projections as it is always a difficult area with a high level of professional judgment.
Aswath Damodaran models deal with changing growth rates and discount rates in the future in order to estimate business value using the discounted cash flow income method. See his discussion of the three state dividend discount model and the H model. Do you agree?
Damodaran is clearly a sage in the field of business valuation. He deals almost exclusively with public and extremely large private companies that may go public. That is entirely different from valuing small and micro businesses typically with revenues under $10 million. Certainly if you are working with a company that can provide a quality projection as a base for use in a discounted cash flow analysis, adjusting the cash flows and the discount rates over time is a reasonable way to estimate the value. In fact, if the data is highly supportable, the discounted cash flow method is theoretically the best method. Of course this is fact and situation dependent like all business valuations.
Many Companies and most small companies cannot give you a reasonable starting point projection or forecast. From my point of view, if I do not have a reliable projection to start from, it is usually best to use a single period valuation method such as the capitalization of earnings method with proper adjustments. Therefore in the proper situations, I agree with Damodaran. But for most micro and small business valuations we will not have the starting point data available to us to use the discounted cash flow income method of business valuation.
On last comment. I will frequently run estimated discounted cash flow models with various potential earnings streams to get an understanding of a companies range of values under possible scenarios. But to me, these are sanity checks and/or information underlying my professional judgement not final valuation methods. A useful tool but if I can’t really support the cash flow, it is not a final valuation method.
Have you ever had a situation where the Company Specific Premium in the Income Method of Business Valuation is negative because risk is lower than normal?
Absolutely but it is quite rare. Every now and then we find a company that is so locked in with its customers (often referred to as “sticky” ; for example, credit card processors can be sticky because they are written into your website) and so well organized and profitable that the risk is below the average public company. But, that is very rare. If you find that company, make sure you really build a well thought out case for your adjustment because it is likely to be doubted. Clearly explain why your company is different and why it should stay that way in the foreseeable future.
More webinars on the “Valuing Small Businesses in the Shadow of COVID-19″ topic and other business valuation topics are being scheduled in the upcoming weeks. If you are interested in participating, please visit our Upcoming Events page
“The Art of Business Valuation, Accurately Valuing a Small Business” covers many aspects of small business valuation and market sales including working with business brokers, increasing sales value, descriptions of a well-run sales process, due diligence including a checklist and guidance on SBA loans.
If you value or use valuations of businesses with revenues under $10 million, you need this book on your desk. The book, published by Wiley, is available through your favorite bookseller.
Finally the author, Greg Caruso, JD, CPA, CVA, is always available to assist with exit planning, brokerage, and to prepare or review business valuations with an emphasis on increasing value and likely transaction values and terms.
