Small Business Expert: How Do I Value My Business?

ENTREPRENEURS 11/21/2014

Editor’s Note: Today is the final response in Forbes’ weekly Ask An Expert series.

Earlier this week, I called out for your most pressing questions about selling a business.

The common theme among the questions raised tells me clearly that many business owners are uncertain about how to establish a value for their business, regardless of its stage of development. In various ways, readers asked me about how to value ideas, start-ups, and mature businesses.

I’ll tackle the various business stage valuations one at a time:

The first question from Edmond from @EBriteOppong is “How do I value a business idea for investors?”

An Idea is Not a Business 
The late Peter F. Drucker said it so eloquently when he declared “Ideas are cheap and abundant; what is of value is the effective placement of those ideas into situations that develop into action”. And without action, an idea has no value. Period.

In my opinion, there is a wide divide between the vast number of Wantreprenurs and the successful Entrepreneur. Until an idea is nurtured and tested, it is virtually impossible to place a monetary or commercial value on it.

If however you are able to successfully file for and obtain a patent for an idea, it may be possible to sell or license the patent to a business enterprise for commercialization. In fact, if you choose to patent an idea, this is exactly what I recommend you do. Otherwise, you will need several hundred thousand dollars to invest in protecting your patent rights. And that’s before you make a single sale.

If you have an idea for a product and/or service and you are seeking investment from friends, family, or an Angel Investor who shares your passion and is confident in your abilities, your first round of investment should include:

• Founder/Inventor’s Financial Capital – without this, subsequent rounds of financing from other sources of capital will be difficult to obtain
• a definition of how the capital raised will be used
• a set of milestones and a respective timeline to achieve them before another round of capital may be raised
• an accountability reporting process for investors
• and lastly, a definition of the roles and responsibilities for the founder/inventor, investors, and other key employees.

In such a situation, the value of a business idea is decided between the parties and is often tied to the limited risk an investor is willing to take to assist the founder/inventor in determining the commercial merit of his or her idea.

Edmund goes on and asks “How do I sell a business when it’s in the start-up stage?”

A Start-up Must Prove its Business Model is Viable

Start-ups are ideas in search of a profitable business model. And until the start-up is profitable, most buyers will discount its value heavily. Unless of course, you’ve developed a product or service that a dominant market player with a lot of cash sorely needs. If that’s the case, and you successfully sell your start-up for an incomprehensible multiple of sales (because you never reached EBITDA), you’re now the equivalent of a rockstar. Congratulations!

But let’s set that notion aside for the moment and talk about how the rest of the world’s start-ups are valued.

Once a start-up has revenue, it’s on its way to determining a level of sales and operating expenses required to reach the profitability point commonly known as breakeven. Knowing when a start-up will reach its breakeven point is key to its success and valuation.

Armed with this breakeven information, the value of a start-up for a buyer or investor will be based on these additional factors: Sales revenue over the past 12 months

• Gross Profit Margin
• Net Profit Margin – although, profitability is not absolutely necessary in a start-up
• Industry Size – Is the opportunity in a $1B market or a $1M market? Are there geographical limitations?
• Overhead Costs – Is this a retail business with real estate requirements or a SAAS business with low overhead?
• Booked Future Sales – Contracts, Purchase Orders, etc.
• Does the start-up solve a customer’s problem or further a user’s passion?
• Is there a Barrier to Entry – How easy is it for others to copy your business model?
• Does the Potential Investor or Buyer bring something to the start-up that’s otherwise absent, such as introductions to synergistic relationships, selling opportunities, and/or reduction of costs

If there are any shortcomings in one or more of the eight factors noted above, the start-up may not be in a good position to sell its business or take on an investor for an attractive valuation. It may be simply be too soon to take on new investors or sell. Or the business model may not be working and a pivot may be needed.

The last question from @brettb13 asks “What is the best way to come up with a fair valuation for my business when I sell it?”

Mature Businesses are Measured by Cash Flow First
Once a start-up has matured and is producing consistent cash flow, proving viability is no longer a concern to a buyer (or investor). Instead, the type of buyer and the business’ cash flow will have the most impact on how a mature business is valued.

A business buyer who is a competitor may desire to acquire your business for strategic purposes. Such a buyer may want to expand into your geographical area quickly or acquire the knowledge and business contacts your employees possess. For these, and many other reasons, your business would command a higher valuation and price from a strategic buyer.

On the other hand, a financial buyer who simply desires a good return on his investment dollar will likely value your business at a lower amount.

Regardless of the type of buyer interested in your business, all buyers first look at cash flow from operations as the main factor in determining value. Depending on the industry and size of the business, cash flow may include measurements such as EBIDTA (Earnings Before Interest, Depreciation, Taxes and Amortization), EBIT, Seller’s Discretionary Income, and in some cases Annual Sales). A ‘multiple’ is then applied to the appropriate cash flow measurement which differs by industry and changes over time. The product of the cash flow and multiple becomes the basis for valuation. Adjustments are then applied based on the particular circumstances and other factors.

In addition to the buyer type and cash flow there are many other factors which will impact the mature business’ valuation. These factors may include:

• Fixed Assets to be transferred to a buyer
• Liabilities to be assumed by a buyer
• Current Assets such as cash, investments, accounts receivable and inventory transferred to a buyer
• Intangible assets used in the business (Patents, Trademarks, URLs, Trade Secrets, etc.)
• Goodwill
• Lease rights and obligations
• Contract rights and obligations
• Pension Plan Liabilities
• Cost of Capital
• Future Industry Growth
• Revenue Growth Record over past three years
• Projected Company Growth one-to-three years
• The M&A Environment

Unfortunately for the business owner, a single formula to compute the value of a business does not exist, regardless of its stage of maturity. Nonetheless,  it’s important to understand how business valuation factors change as the entrepreneur begins with a business idea which evolves into a start-up, and then ultimately matures into a viable business.

As for those who’ve asked other questions about selling a business, I will do my best to reach you and answer your questions directly.

See all our Ask An Expert answers: Building your personal brand, Relationship building, Hiring, Financing, Customer service, Social media and Law.

I’m Holly Magister, an advocate for the Entrepreneur who wants to grow a valuable business.  Founder of  Exit Promise. Connect with me on Twitter and Google+.

Article at:  Small Business Expert: How Do I Value My Business?:



For additional information regarding Florida business sales, acquisitions and valuations, please contact Eric J. Gall at info@buysellflbiz.com or 239.738.6227. Also, visit our Florida Business Exchange website at www.fbxbrokers.com and my personal website at www.buysellflbiz.com.