Sometimes it’s nice just to have an idea of what your business is worth… even if you don’t plan on selling it. Admittedly there is a nice feeling associated with seeing the equity value and saying “WOW, my business is worth $X (hopefully many more X’s).
For that we have ‘rules of thumb’, which I am going to break down.
#1 Your Business Is Worth a Multiple of Discretionary Earning.
The valuation of small businesses that are established more than 5 years is heavily weighted on a multiple of their discretionary earnings. As a small business you would expect to get a 2-4x multiple on the average discretionary earning overs the least 3 years.
What are discretionary earnings? This is your taxable earning adjusted by adding back things the business expense that a new owner could do without or that are non cash deductions. A primary example is owner salary. A new owner would fundamentally receive that salary themselves so it is fair to count it in the adjustment. In many cases a vehicle that is used by the owner is a common add back and so is personal cell phone use. Keep in mind these discretionary expenses are often not ordinary and necessary thus not tax compliant by the business owner (you), although they are often too small (immaterial) for the IRS to scrutinize, therefor they shouldn’t be more than a very small percent of the income per the tax records.
Example: a business produces taxable income of $100,000 for the last 3 years and each year the owner has take a salary of $70,000. In this simple example the discretionary earnings for the last 3 years would be $170,000. Multiply that number by 2-4, to get a valuation on the income stream. Valuation multiples can vary wildly from industry to industry and location to location.
#2 You Can Add In The Market Value Of Assets
#3 Businesses With Management Infrastructure Command a Higher Multiple
#4 Businesses With Declining Profits Command A Lower Multiple
As a starting point, you need to know what your sellers discretionary earnings or cashflow is for the last 3 years. The is not your reported income for the business as established by tax filings but rather, adjusted by adding back things the business expense that a new owner could do without. A primary example is owner salary. A new owner would fundamentally receive that salary themselves so it is fair to count it in the adjustment. In many cases a vehicle that is used by the owner is a common add back and so is personal cell phone use. Keep in mind these discretionary expenses are often not ordinary and necessary thus not tax compliant by the business owner (you), although they are often too small (immaterial) for the IRS to scrutinize, therefor they shouldn’t be more than a very small percent of the income per the tax records.
Interest expense is also an add back it does not reflect the operating viability of the business in most cases.
Then there is depreciation. This is a tricky one. In some cases such as an HVAC business that buys trucks and depreciates them rapidly (a 179 deduction) or over a 5 year period, but utilizes them for 15 years, an add back is fair. In a business that is very capital expenditure intensive an Add back would not be fair.