Larry’s Exit Strategies, Inc.Posted on June 12th, 2016
Owner / President
Outsourced Accounting Department, Inc.
Let’s continue now with this series of articles on Larry’s journey through the various stages of business growth (or perhaps in his case, his “learning curve?”). In my last article, “Financial Planning or Business Turnaround – Your Choice,” we assumed that Larry managed to survive his previous mistakes and was able to restore profitability and cash flow. So now we’ll look at how he can reach his ultimate goal of selling the business and retiring.
To begin, we need to introduce a new financial term: “Earnings Before Interest, Taxes, Depreciation, and Amortization” (EBITDA). This is an extremely important number that is widely used by prospective buyers to determine a business’ value. One common way a business’ sales price is determined is based on some multiple of this number which will vary depending upon several factors, including things such as the company’s historical and expected growth rate, etc.
Below is a pro forma financial statement which assumes Larry’s company reaches $ 1.0 Million in sales and achieves a 30% net profit, or $300,000. Of course in reality this would most likely not occur in just one year, but rather, over a period of say three to five years, and that profitability trend is also what a prospective buyer wants to see.
Larry’s Company is assumed to be an “S-Corporation” for tax purposes, which means it’s profit is taxed through the owner’s personal tax return rather than on the company’s P&L. So that leaves us with just his net profit, interest expense (which is assumed to go away upon sale of the business), and depreciation expense. Based on these pro forma numbers, Larry’s EBITDA would be his net profit of $300,000, plus interest expense of $1,324, plus depreciation expense of $575, or $301,899.
Now, let’s assume a commonly used capitalization rate of 15%, which is equivalent to a price-earnings multiple of 6.7 (= reciprocal, 1 divided by 0.15). Based on the above EBITDA, the value of Larry’s business would then be approximately $2.0 million (6.7 x $301,899). If the business has excellent growth potential, then the capitalization rate might be lower meaning a higher multiple and, therefore, higher value. Or conversely if the business is mature with limited or no growth potential, a higher capitalization rate (lower multiple) might be used. (And of course, once again, if you’ve been focused on showing losses in order to avoid taxes, you have now also established the value of your business – it’s zero).
Exactly where the final sales price comes out in the above range is where the due-diligence and negotiating process come into the picture. There are certified business appraisers who do these kinds of business valuations, and it may be well worth your while to consult one. (Our firm currently does not provide this type of service but we know professionals who do.) But the important point I’m making here is, most often, it’s your historical earnings and cash flow that determine the value of your business.