March 31, 2017 | Valuations
Traditional valuation models don’t necessarily work for Maine small businesses and professional practices. Public market data may be less relevant for a small business that functions primarily as a job or steady source of income its owner(s). Instead, business appraisers and brokers typically recommend using an alternate metric for appraising small businesses known as “seller’s discretionary cash flow” (SDCF).
When estimating the value of a small business, it’s important to recognize the nature of the business. Is it a pure investment or a job that provides income and discretionary perks to the owner and his or her family and friends? If the latter description more closely aligns with your investment goals, then SDCF is generally a more meaningful metric of what the business is worth to you.
Computing SDCF starts with earnings before taxes. Then you adjust for:
- Nonoperating income and expenses
- Unusual or nonrecurring income and expenses
- Depreciation and amortization expense
- Interest income and expense
- One owner’s total compensation
- Above market rates paid to related parties
- Discretionary expenses
When attempting to sell your Maine-based small business, it’s important to identify and disclose everything that could be relevant to a potential buyer, including all discretionary expenditures which you, as the current owner, incur in the business. Although these may be legitimate expenses, they might not be expenses that a new owner would choose to incur. All benefits for the owner and other employees should be documented, so potential owners can see not only what benefits are available but also what the approximate annual cost of these benefits is.
When you’ve figured out the SDCF for the company, you can then compare the business to other companies in the same industry that have recently been sold. Look at each comparable transaction and compute its SDCF-to-value multiple. This will give you a good sense of what a particular business might be worth in the current market.
SDCF multiples derive value from all of the cash flows that are available to an individual business owner. Unlike methods used to value businesses that are pure investment plays, the SDCF method captures an owner’s return on investment and reasonable annual compensation. Both elements are valuable to the owner-operator of a small business.
Small businesses can be hard to value, because they don’t fit the traditional valuation model that computes a simple return on investment. Business appraisers and brokers recognize that SDCF is a meaningful metric for owners and prospective buyers of small businesses. They often choose it over more sophisticated methods that are based on public stock returns. Whether you’re buying or selling a small business, it’s important to seek outside professional assistance to determine its current value in the marketplace based on SDCF. Schedule a meeting with Filler & Associates for further information.