The definition of fair market value is a business is worth what a willing buyer is willing to pay. Too many people believe that their business is worth more than it is. Unlike a house, you cannot compare your business to the one down the street. No two businesses are identical. Even franchises are different, one location has more sales, more profits therefore the valuation will be different for each separate business. All you can go by is ask a reasonable amount based on the valuation methods traditionally used in the marketplace.
A business is not worth more because you have a client who an exceptional client however if the sales are only $10,000 per annum, it is not a big account. Your company is not worth a premium because you have a premium client but does not generate a lot of sales. Yes, they may buy more in the future but you are selling the business based on what it did in the past and not what the new investor can do in the future.
Some businesses have huge cash flow however their financial statements may show little profit. Why – the company has significant assets which are being depreciated annually The assets were purchased in prior years but the amortization reduces the profits of the company. Banks look at the cash flow the business and can see that it is positive however they still look at retained earnings and if depreciation reduces retained earnings, the banks factor that into the borrowing ability of the business. The banker may say that they look at cash flow only but if you find out about their lending model, it is based on the balance sheet and the income statement, not just the income statement.
The value of your business is based on your businesses’ ability to generate a stream of profits. The seller will project the stream of cash flow over a few years to calculate what they are willing to pay for that stream of profits/cash flow. Some buyers will discount the future earnings which takes into consideration the time value of money. If the business generates large cash flow but low profits, the discounted valuation method may be a better way to value the company.
Other investors look at normalized EBITDA (earnings before interest, tax, depreciation and amortization). Normalized means that all the personal expenses which were expensed in the business have been added back to get a truer earnings of the business. Many investors will use a multiplier which is a judgemental number. The smaller the business, the lower the multiple, the larger the business, the more someone is willing to pay because a business with $50 million of sales may be a more stable than a business with $100,000 of revenue.
What affects the multiple; proprietary products, strong brand recognition, patents or trademarks, diversified customer base, strong management team (other than the owners and this is more likely to happen in larger businesses), weak competitors, healthy market share for the business, no law suits against the company or tax audits. These all affect the multiplier positively. From a negative side, your products are similar to competitors therefore you have no competitive edge other than pricing, all your competitors are large and very strong, you products are mature and they are nearing the peak, if they have not already done so in their life cycle, you need to upgrade your equipment and reinvest heavily in the business.
All these factors must be considered in the valuation of your business.