How Do Buyers Determine How Much Your Company Is Worth?

For entrepreneurs and business owners beginning to think about an exit, it’s essential to take an objective look at your company’s potential valuation and understand the factors that impact that figure.

Some are simply objective measurements—say, company financials, market share, and comparative performance. But there are also a host of subjective factors that acquirers and investors consider as well.

Possessing an awareness of both the objective and subjective factors that inform an accurate valuation not only helps ensure you’ve got realistic expectations heading into the process, but also that you are ultimately not too far apart from a potential buyer when it comes time to negotiate a deal.

The fundamentals

For a private company, part of your valuation is derived from your earnings before interest, taxes, depreciation and amortization (EBITDA) or, in some cases, Seller’s Discretionary Earnings (SDE).

While most components of your EBITDA should be easily found on your balance sheet, it’s important to recognize this measure doesn’t include non-recurring expenses or income adjustments.

Small business buyers and sellers may in lieu of an EBITDA lean on an SDE figure which includes items such as a business owner’s taxable income and the value of any benefits that the owner receives.

To calculate an SDE, begin with pre-tax, pre-interest income. Now, add back in your salary, benefits, and expensed items such as travel, vehicle purchase or use, lodging and more. The final figure offers a more realistic look at what the earnings of the company would be for a new potential owner.

Remember to consider your earnings in context. For example, earnings may not always be the best way to asses a company's value if your company is early stage, not yet profitable, or has negligible EBITDA. In these cases, a buyer may look at gross revenue or year-over-year growth as a more appropriate starting point.

The role of multiples

Once you’ve established a solid EBITDA or SDE, it’s time to determine a purchase multiple. This is a figure used to determine your business's value; buyers will multiply your EBITDA, SDE or whatever financial metric they're using to gauge the financial performance of your company by a specific multiple to arrive at a total valuation.

Understanding what informs your multiple is key to getting to a valuation that matches with your expectations—as well as those of a buyer. Multiples vary by industry and, of course, by company size and stage. Business owners should note that the multiples of public companies are often very different from those of private business.

In determining an appropriate multiple, a buyer will evaluate factors such as your market share, product and project mix, any unique capabilities, your projected growth, and the strength of your management team.

Tangible and intangible company assets factor in as well:

• Value of patents or proprietary technology
• Large and growing customer or user base
• A highly recognized or sought-after brand.

While striving to understand the business and its potential, buyers may also dig into cash on hand, property and equipment, and inventory owned by the company. Each factor is weighed individually and has a positive or negative impact. For example, outdated equipment may be a bit of a detractor, but a solid fulfillment process with low-inventory costs could help push a valuation higher.

The hidden issues

As an owner, you’re likely deeply aware of what drives a positive valuation—from growing revenue to easy scalability to innovative products that have captured the attention of your market—if for no other reason than many of these factors are also what drive a successful business.

However, there are some more subjective factors that could pull a multiple down along with the final figure.

You may, for example, have a solid revenue stream, but if too much of your business is concentrated on too few customers the big picture still can look like a risk to a buyer. The same goes for a lack of a succession plan for team leadership or an over dependence on the owner for building customer relationships. Being aware of these subjective risks early gives you to time to find a solution such as diversifying your customer base or implementing improved sales training.

Having an exit within sight can be an exciting place to be. Spend some time taking an honest look at your company and its value to potential buyers and you'll be that much more prepared to negotiate a deal that works for you.