We explored 8 common reasons why owners sell their businesses previously

Now, when a business owner is ready to move on, 2 key questions always come-up:

1. How much is the value of my business? 

2. How much can I get if I sell my business?

We will address “Question 1: How much is the value of my business?”  in this article

For small and medium-sized business valuations, EBITDA Multiple method is most often used. 

Here’s the formula:

Estimated value of business = Multiple x EBITDA

EBITDA means Earnings Before Interest, Taxes, Depreciation, and Amortization

The actual Multiple used will depend on industry and size of business:

• Higher growth industries and larger businesses may get higher multiples.

• For businesses with annual revenues of USD 1 million to USD 10 million, the Multiple is usually 1 to 3

Here’s an illustrative example:

• Annual Revenue = USD 5 million

• EBITDA = USD 500,000

• Multiple = 2

• Estimated value of business
  = EBITDA x Multiple
  = USD 500,000 x 2
  = USD 1 million 

Why are Multiples higher when a business has higher EBITDA?

• Limited supply of high EBITDA businesses

• Greater demand for businesses with greater EBITDA

• So investors are willing to pay higher multiples

Why Multiples differ across industries for the same EBITDA?

• Some industries have higher growth and profit margins

• Greater demand for better potential businesses

• So investors are willing to pay higher Multiples

There are several other common business valuation methods:

1. Asset-based valuation method: Calculates a business's net worth by subtracting its liabilities from its assets

2. Earnings multiple valuation method: Determines a business's value by applying a multiple to its earnings or revenue

3. Discounted cash flow (DCF) method: Calculates the present value of future cash flows of a business, using a discount rate

4. Market-based valuation method: Determines business value by comparing to similar businesses in its industry and location

5. Precedent transaction analysis: This determines a business's value by comparing it to similar businesses sold in the past

These methods are not mutually exclusive.

• More than one method is often used to arrive at a comprehensive valuation

• It is helpful to triangulate and estimate the value of a business using various methods. 

At the end of the day, investing in small medium businesses is both Art and Science. 

• EBITDA multiple is a simple tool to get an initial estimate of business valuations

• Estimating the value of a business is only one small step in a thousand mile journey. A lot more work is still required

This may be one of the reasons why many people avoid this investment asset class.

Leaving best opportunities to those willing to learn, be patient and stay committed.

The answer for “Question 2: How much can I get if I sell my business?” will depend on a lot of factors. We will attempt to answer this in another article.

Read more:

• Work-life balance for business owners

• 8 common reasons why owners sell their business

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