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One of the more challenging things I do as a business broker is to present a business valuation to a client who thinks their business is worth more than it is. For years they worked hard at their businesses, putting in countless hours, dealing with employees and their issues, working through tight cash flow and all of the challenges a business owner faces. They were getting ahead and building value. During this time they bought cars, purchased homes and provided for their children s’ education. They supported their lifestyle through the business, and they have been looking forward to cashing out with enough money to fund their retirement. They didn’t stop to contemplate what drives the business sales value.

One measure of that value is derived from the cash flow generated by the business, while another portion is associated with the intangible value the business provides, the value of the inventory and the value of the equipment. In small business transactions the concept of Sellers Discretionary Earnings (SDE) has been developed so that investors can compare opportunities. Simply put, we are looking at the amount of cash flow that a business generates that can go back to the owner. By looking at historical transactions we can see what other similar type businesses have sold for, and get a general idea of the ratio of the sale price to the SDE. Most businesses will sell for 2 to 3 times SDE, depending on the industry, profitability and other factors. Added to this will be an amount for the inventory , equipment and intangibles.

This technique is not applicable in cases where growth is through the roof, or where a new technology or concept allows for the imputation of high levels of profits. But most main street businesses do not fall in this category. For the majority of small businesses, the sale of the business will provide a few years cash flow, not the cash windfall they may have been planning for. Understanding how the business is valued is key to the proper preparation of the business for sale, as well as the timing of when to put the business on the market. A properly prepared business valuation not only adjusts a business owners expectations to the reality of the marketplace, but also provides a valuable tool to use in the decision-making process. Assumptions can be made as to future profits, and utilizing the valuation methodology the future value of the business can be projected. The decision can then be made, based on a logical methodology, whether it is best to continue working for a larger payoff down the road or to sell now.

Steve Barnett has broad-based experience in small to middle market advisory activities.  Prior to becoming a Business Broker, he  served as CFO, Controller and VP Finance of both Manufacturing and Professional Service Companies with expertise in the Aerospace, Consumer Products, Banking and Staffing Industries. Known as “The Valley Business Broker”, Steve serves Los Angeles and Ventura Counties.  Visit Steve’s website at  www.TheValleyBusinessBroker.com.