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What’s My Business Worth? The Science and Art of Business Valuation.

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Pandemic aside, valuing a business is complicated. Is a business devalued because of short-term disruption in sales? Has there been a fundamental shift in the viability of certain businesses? Sellers may consider some discount for the pandemic’s short-term impacts, but most still believe that the value of their asset is not defined by the temporary adversity caused by COVID-19.

So, how complicated is it? There have been general rules of thumb that brokers follow – three times earnings, or 45% of sales, but each business is unique and no rule of thumb will ever give an accurate calculation of a business’s market value. Buyers generally don’t base acquisitions on estimates or ballpark figures. Business valuation starts with hard numbers. That’s the science. Justifying the asking or sales price comes next. That’s the art.

Sellers Discretionary Earnings or Income

Most valuations start with two or more years of profit & loss statements, supported by both income tax and sales tax returns. But valuation is not based solely on reported sales, net operating income (NOI), or tax returns. These are just starting points.

Most buyers and sellers work with a valuation method based on the “Seller’s Discretionary Earnings” or “Seller’s Discretionary Income” — SDE or SDI, for short. This method is cash-flow based and generally applies to most owner-operated or owner-managed small businesses.

In a nutshell, SDE considers the net profit a new owner may expect, exclusive of the seller’s income taxes, interest, and depreciation expenses. But, in addition to adding these items back to net income, we also add back: (1) extraordinary expenses; (2) expenses unlikely to recur; (3) expenses particular to the owner; and, (4) those expenses that could have been depreciated but were expensed.

While it is easy to calculate income taxes, interest and depreciation, some of the other add-backs are more complicated. For example, did the business have a repair to a piece of equipment unlikely to recur? Was there a casualty loss that year? Was a piece of equipment that could have been capitalized and depreciated expensed to take advantage of a tax break?

Regarding expenses attributable to the owner – did the owner deduct his or her car lease, automobile expenses, health insurance, disability policy and a somewhat inflated salary? Were the owner’s charitable contributions or meals or travel deducted as business expenses? These same benefits and deductions would likely add to the new owner’s income and must be considered and valued accordingly. The “revised” or “adjusted” NOI is called the SDE (Seller’s Discretionary Earnings).

The Art of the Multiplier

Most sellers and brokers instinctively apply a multiplier of 3x to adjusted net income, regardless of the type of business being valued. That is, they value the business at the adjusted SDE multiplied by three. For example, if your adjusted SDE is $150,000, and the multiplier is 3x, the business is valued at $450,000. The goal of the seller or the seller’s broker is to highlight and support a positive deviation from the 3x multiplier and convince a buyer to pay 3.3x, 3.5x or even 4x SDE. With every increase in the multiplier, the higher the price that can be obtained for the business. So, how do we do that? We increase the multiplier by applying fact-based support for a positive deviation. In each of the following categories is opportunity to add value.

Sales – Of course, gross sales is the number most buyers look at, but sales figures should be presented in a variety of ways. At least three years of gross sales figures are generally requested. Five years is better (in an easy to read format), especially if sales have been increasing. Also include year-over-year percentage increases in sales, as well as sales per square foot of leased space. These are metrics that buyers can use to compare not only one business to another, but also how your business compares to industry norms. For example, many restaurants are not considered viable if sales are less than $400/sf. Growing sales support a higher multiplier.

NOI – Gross sales are not the only consideration. In an easy-to-read format, the seller should present major expense categories. Cost of Goods Sold, Labor Costs, Rent, Utilities, Insurance, and Net Profit.  These numbers should be presented over the same period of time as gross sales, or at least over the last two to three years. Again, these numbers enable a buyer to not only compare your business to another but also to consider industry norms. For example, restaurant buyers generally prefer rents to be less than 8% of gross sales, and occupancy costs (rent, utilities, insurance) to be less than 12% of gross sales. Having control of your costs compared to other businesses and your industry in general support a higher multiplier.

Demographic Trends – Sellers should present at least two types of demographics to buyers, population and income. These two categories also need to be presented in trends and projections. For example, buyers generally shy away from shrinking population demographics. Flat population demographics aren’t usually a problem (especially in an environment of growing sales), but it is not a strong selling point either. Income demographics need to be presented separately from population. Is the community strong, stable or in decline? Positive demographics in these categories support a higher multiplier.

Age demographics are specifically important in restaurant offerings. Millennials spend twice as much of their discretionary income on food than Baby Boomers.  Sellers should also present traffic demographics, especially proximity to major intersections, main streets, highway exits, and this sort of data should be presented in map form for ease of presentation. Younger populations and increasing traffic counts generally will support a higher multiplier. Also, don’t forget about foot traffic and walkability indexes available from most commercial real estate databases.

New Developments – A quick review of local planning board agendas reveals newly proposed projects that will either add potential customers, housing units, complementary uses, etc., and should be presented in a positive light. That said, in this world of caveat emptor, it may be incumbent on the buyer to discover commercial projects that may dilute earnings or siphon sales to a nearby development. When positive, new developments should be stressed in the offering memorandum, as new potential customers support a higher multiplier.

Unexploited Opportunities and Trends – Most restaurateurs and consumers are tuned in to UberEats, DoorDash and its competitors. Your restaurant may not yet be fully exploiting these opportunities for extra income.  Your kitchen may be under-utilized and can support additional income through delivery services or outside catering. These additional income opportunities will be attractive to buyers, and will support a bump up in your multiplier.

Lease Considerations – Issues like the assignability and/or restrictions on assignability, remaining term, number of remaining options, below-market rents, caps on pass-throughs like taxes, insurance or common area maintenance costs can make or break a business sale. Few buyers have the stomach to buy a business knowing that there is little life left on the lease, and that the landlord holds all of the cards when the lease expires in the next year or two. Month-to-month tenancies present their own problems and opportunities. Most savvy buyers will condition the purchase on their ability to extend the existing lease, renegotiate unfavorable terms, or obtain landlord concessions. Factors like low rents and extended remaining terms, particularly where the buyer is not offering a personal guaranty on the lease make a business more valuable.

Social Media – The reach of social media cannot be overlooked. For each major social media site, the seller should highlight its reach. How many likes or followers does the business have on Instagram, Facebook, LinkedIn and similar sites? Include positive customer comments in your sales offering brochure. Where does the business come up on searches, Yelp and similar sites?

There are simply too many factors affecting value for any one article to cover. In each category, the task of the seller or the seller’s broker is to highlight those factors that support a valuation above the normal three times SDE. With each of the above, a clear case should be made that the business offered is comparatively more valuable than other similar offerings and better situated compared to other like businesses. A strong case, highlighting favorable conditions, can support a higher multiplier, a higher selling price, and a better brokerage experience for your client.

Rick Tannenbaum practiced law and real estate development for almost 30 years and now works full-time brokering food, beverage and hospitality properties for Houlihan Lawrence Commercial Real Estate. He can be reached at 917-689-1799, or at rtannenbaum@hlcommercialgroup.com.

Original Link: https://www.linkedin.com/pulse/whats-my-business-worth-science-art-valuation-rick-tannenbaum/