The first question that business owners typically ask when looking to sell their company is: “How much is my business worth?”
Business valuation is both an art and a science. Deals get done and businesses are sold when there is a perception of fair value between buyer and seller. Of course, ‘fair value’ is subjective, with non-quantifiable conclusions being drawn on both sides.
There are also multiple quantitative approaches to valuing a business, each with their own strengths and weaknesses—and the final valuation often utilizes a blend of these approaches before it’s finally pushed and pulled by negotiations.
In this article, we’re going to explore how to value a business, with a focus on valuing small businesses. We’ll walk you through the following:
The three primary valuation approaches—Market, Income, and Asset (or Cost) based approaches—and the benefits and drawbacks of each.
Other considerations that factor into the value of your business.
Helpful next steps.
The Three Main Valuation Approaches
Below are the three most common approaches to valuing a business:
1. The Market Approach: This approach compares the business to recent sales of private and public companies, as well as current valuations of publicly-traded companies. When comparing transactions and valuations, buyers, sellers, and intermediaries will often use multiples of Earnings Before Interest, Tax, Depreciation, and Amortization (EBITDA) or Annual Recurring Revenue (ARR).
Benefits:
Publicly-traded companies offer readily available information—that is, stock prices, which provide real-time valuations and should in theory reflect all current, publicly available information and ultimately reflect the future earnings and growth potential of a business. This is known as ‘the efficient market hypothesis.’ Conversely, acquiring financial information—including purchase considerations—for privately held companies can be challenging. That said, if you happen to stumble across this information, you will find it to be a strong indicator of 'fair value' for a small, privately held business. But don’t get your hopes up—because active markets for niche industries often don’t exist, so there may not be recent and relevant transaction data available for comparison. In addition, intermediaries like business brokers, advisors, and seasoned investors often control this information, creating an information asymmetry in private markets. This is a key reason why business sellers engage intermediaries, a topic further discussed at the end of this article.
Drawbacks:
Publicly-traded companies often serve as useful proxies for the 'best of breed' in an industry. However, when evaluating a small, privately-held business, a direct comparison with a publicly-traded company may not be appropriate. This is due to differences in size, liquidity (with private businesses being harder to buy/sell), product and customer diversification, technology, business maturity, and market share.
Furthermore, while ARR and EBITDA multiples are commonly used to value publicly-traded companies and recent private transactions, they should be considered reference points rather than definitive metrics. This is because companies within the same industry, selling similar products or services to similar customers, can still vary significantly due to unique factors. These can include the business model, management and human capital, cultural differences, and other factors that impact revenue and earnings growth potential, leading to variations in valuation multiples, even among close competitors.
2. The Income Approach: This approach uses a method known as discounted cash flow (DCF) analysis, which estimates the value of a business by calculating the present value of its future cash flows over a specific period, known as the 'hold period.’
Benefits:
This approach relies on the performance of the business itself, rather than comparing it to other businesses where financial information is available. By focusing on the business's own growth potential and future cash flows, the income approach circumvents the drawbacks of the 'market approach,' which may rely on measures like EBITDA or ARR multiples that do not fully capture the unique aspects of the business.
A DCF analysis usually includes an estimated hold period and an assumed exit multiple at the end of the hold period applied to EBITDA (or ARR for fast-growing, often unprofitable software businesses). The hold period depends on the buyer’s investment horizon, but for the purposes of a DCF analysis, it is typically limited to 5 years given difficulties in accurately forecasting performance beyond 5 years. The exit multiple, informed by the market approach, serves as a reference point within the DCF analysis rather than as the primary basis for valuation; however, the ‘terminal value’ derived from the exit multiple often accounts for a large portion of the present value and is meant to represent future cash flow beyond the projection period.
Drawbacks:
The income approach is subject to the buyer’s perception of what the seller could achieve if the seller were to continue to manage the business for the next 5+ years. In other words, what is the status quo? How will the business fare without any of the buyer’s planned operational improvements or changes in strategy?
This requires both the buyer and seller to estimate future revenue growth and profitability, which can vary significantly due to differing assumptions, potentially leading to overvaluation or undervaluation. Generally, sellers tend to be more optimistic, while buyers tend to be more prudent to avoid overpaying, especially since they will always know less about the business than the seller at the point of sale. This is what is known as ‘the valuation gap.’ Buyers and sellers never (or hardly ever) agree on a price at first—but eventually, a compromise is made, or deals don’t get done.
Applying the income approach to small and mid-sized businesses (SMBs) can be challenging due to potential inaccuracies in financial statements. Publicly-traded companies and enterprise businesses usually have stronger financial controls than privately-held SMBs. Therefore, when valuing an SMB, it's necessary to "normalize" the financial statements to reflect appropriate income and expenses. This involves adjusting for any unusual, one-time, or discretionary expenses or income to better reflect the business's true financial performance and earnings capacity.
Additionally, the income approach requires determining an appropriate discount rate, referred to as the weighted average cost of capital (WACC). This rate, which reflects a buyer’s required rate of return from all sources of capital, is applied to future cash flows and will vary depending on the structure of the proposed transaction, prevailing interest rates, and the buyer’s perceived risk-reward tradeoffs.
3. The Asset-Based (or Cost) Approach: This approach values the business based on its net asset value (NAV), which is the fair market value of its total assets minus total liabilities. Perhaps the easiest way to think about this approach is by asking “how much would it cost to build this business from scratch today?”
Benefits:
A company’s assets, especially its tangible assets (e.g., PPE and inventory), are often more straightforward to value than its future growth and earnings potential. As a result, the asset-based approach can be useful when financial projections are uncertain and therefore difficult to predict with a reasonable confidence level (e.g., with startups). This approach can also be useful when valuing businesses that rely primarily on their physical assets to create value, such as with manufacturers and other asset-intensive companies.
You may also think of the asset-based approach as an indication of a business’s downside risk—one that offers a reality check by presenting an estimate of the potential lower end of the valuation range, should the business’s assets have to be liquidated.
Drawbacks:
Perhaps the biggest drawback is that the asset-based approach does not directly account for future revenue growth and profitability, which is often the primary driver of a business's value, especially for high-growth businesses.
The asset-based approach may not be suitable for businesses that are service-oriented and / or built around branding or technology with significant intellectual property (IP). Valuing intangible assets such as branding and IP (including proprietary software code) can be challenging due to their inherent subjectivity and unique qualities, as well as the influence of factors like brand perception, rapid technological change and disruption, customer loyalty, and market trends.
Lastly, the asset-based approach can be time-consuming and sometimes costly to apply, requiring expert appraisals or some other investigation into the market for such assets and their fair value.
While the asset-based approach provides a useful perspective on a company's value, it should be used in conjunction with other valuation methods to provide a more comprehensive and accurate assessment of a business's worth. More often than not, an asset-based approach will result in an undervaluation of a business, given its failure to incorporate future earnings and inability to effectively value intangible assets.
Key Takeaways:
The market approach relies on comparable transactions and publicly-available information, and therefore may be limited by the availability of relevant data and the differences between the business being valued and the comparables used.
The income approach focuses on the future cash flows of the business, but is subject to assumptions about future performance and requires an appropriate discount rate.
The asset-based approach provides a conservative estimate based on the net asset value of the business, but it may not accurately capture the value of intangible assets and does not directly account for the earnings potential of a going concern.
The choice of valuation approach can significantly impact the resulting valuation, and disagreements over assumptions and methodologies can lead to a valuation gap between buyers and sellers.
The process of business valuation is as much an art as it is a science, requiring judgment, experience, and a deep understanding of the business and its industry.
Other Considerations That Factor into the Value of Your Business
Now that you understand the different ways that buyers, intermediaries, and sellers value businesses, and the benefits and drawbacks associated with each approach, it’s important to understand other considerations that come into play when working with a prospective buyer.
Transition Planning: A well-defined transition plan, especially for businesses with complex operations or technical products and a reliance on its management team (‘key person risk’), can enhance a business's appeal to buyers and potentially increase its value—plus give you more peace of mind before handing your business off to a new owner!
Before negotiating with a buyer, it's crucial to have a clear understanding of the role you’d like to (or need to) play, if any, in the future of the business. Involving key employees in the transition plan prior to closing can also add value by ensuring continuity and stability. Some buyers, such as search funds like Paige Pond Partners, offer built-in succession planning, with the fund’s founder(s) intended to succeed the selling owner-operator. This can provide a more seamless transition and help to ensure the enduring prosperity and integrity of the business.
Deal Structure: In general, sellers can expect to receive most of the purchase consideration in cash at closing; however, many transactions will include a seller financing component, and some transactions may include earn-outs and rollover equity, depending on the circumstances.
Seller financing is an arrangement where the seller provides a loan to the buyer to facilitate the purchase, effectively deferring part of the purchase consideration. The buyer repays the seller in installments, with interest.
Earn-outs are contractual arrangements designed to better align the interests of buyer and seller by providing additional compensation to the seller upon achievement of pre-defined financial targets within the first year or two post-sale. These targets are typically linked to financial metrics such as gross profit, ARR, or EBITDA. Earn-outs are particularly effective when the seller plans to stay involved in the business, as they provide an incentive for the seller to continue contributing to the business’s success. They are also employed to bridge gaps in valuation during negotiations, especially when there are material uncertainties or operational risks, or when there is a disagreement between the buyer and seller regarding the future financial performance of the business.
Rollover equity represents a portion of the purchase consideration that the seller has agreed to “rollover” into the new ownership structure, thereby allowing the seller to participate as a minority shareholder in the next stage of growth and upside.
Key Person Risk: In the event of a transaction, it's crucial to assess the likelihood of key employees leaving. This assessment can significantly impact a transaction, as most buyers cannot afford to and do not wish to hire an entirely new team post-sale. To mitigate this risk, buyer and seller may consider strategies such as retention bonuses or equity incentives to encourage key employees to stay. Also, clear communication about the transition can help alleviate concerns among employees and minimize uncertainty.
Business Size: Small businesses tend to trade at a discount relative to their more mature counterparts due to certain perceived risks and challenges associated with buying and operating smaller businesses. While there is no set definition for what constitutes a 'small' business, factors such as the size of competitors, availability of resources, quality of the management team, degree of ‘professionalization’ across the organization, and scalability of the business are often considered. With that said, it is also possible for highly specialized, small businesses to command a premium—for instance, those that have defensible, controlling positions in attractive, niche markets.
Liquidity Risk: Unlike their publicly-traded counterparts, small, privately held businesses are illiquid investments. Buyers of small businesses will require higher returns to account for this risk, which often translates to lower valuations.
Availability of Information: If a buyer senses large asymmetries of information or has unanswered questions that would otherwise mitigate material risks or validate their investment thesis, that buyer will be less willing to pay a premium for the business. While information asymmetries can lead to a more conservative valuation, they won’t necessarily prevent a transaction from closing. Often, mechanisms are put in place to reduce information asymmetries, such as due diligence processes, representations, and warranties. These mechanisms can help to bridge the information gap and facilitate the transaction.
Technological Considerations: For acquisitions involving software, IP, or other technology assets, there are crucial considerations that buyers must account for. All these considerations have potential implications on the value of a business.
One of the most common and significant considerations is technical debt, which encompasses a wide range of risks and issues within the software development ecosystem, including: code quality, architectural and design health, open-source license compliance, open-source code vulnerabilities, and inefficiencies in software development life cycle methodologies and practices. To truly serve this topic justice would require a separate, in-depth article, but this gives you a sense of one of the most important due diligence steps when exploring the sale of a business and its software.
Conclusion
Accurately valuing and ultimately selling a business is no easy feat. An effective valuation framework combines financial analysis, market benchmarks, expert input, and other qualitative and quantitative assessments. For a seller to realize fair value for their business takes diligent preparation, research, clear communication with prospective buyers, and thoughtful negotiations—all buttoned up with legal protections that give both buyer and seller the assurances they need by effectively solving for the unknown.
Of course, valuation is only one of many steps. Sellers need to attract and retain a qualified buyer, which itself is a circuitous and time-consuming exercise. Fortunately, for U.S. business owners who are considering a sale, there are plenty of eager buyers with varied investment strategies, areas of focus, and value propositions. Furthermore, there are many best practices and ways to prepare that help sellers ensure their engagements with buyers do not get derailed prematurely for otherwise avoidable reasons.
In part 2 of this series, we’ll explore some of these best practices and outline how business owners can get their ducks in a row in preparation for selling their business. We will also explore the pros and cons of using a business broker and present alternatives to business brokers.
If you are a business owner considering a sale and you’d like to discuss your valuation options and the best possible approach to market, please click the link below to schedule a complimentary advisory call.
About the Author
Cooper Foster is the founder of Paige Pond Partners. He is an entrepreneur and independent sponsor searching for a small to medium-size business to buy and manage. Before founding Paige Pond Partners, Cooper advised multinational corporations at HSBC, collaborating with leadership teams to secure financing for growth projects and navigate business acquisitions. Cooper is excited to partner with a passionate owner of an exceptional business.
To get in touch with Cooper, please email: cooper@paigepondpartners.com.
About Paige Pond Partners
Paige Pond Partners is a small team of seasoned entrepreneurs, investors, and operators committed to buying and operating one B2B software or services business. We have decades of collective experience growing businesses through leadership transitions without compromising the culture and values foundational to their success.
As your partner of choice, we understand that your business is more than just a business; it's a testament to your life's work, and we're here to ensure its integrity and enduring prosperity.
Additional Resources
If you’d like some additional reading on valuing your business or on other important topics relating to the sale of your business, please visit the Resources Center on Cooper’s website.
