Simple valuation of business for net worth purposes

[SecondCor521]

Hi all!

My son, as it turns out, is an entrepreneur. He is starting his third year in business and things are going very well for him: increasing numbers of customers, increasing revenues, good reputation in the community, adding his first employee, opening up his first physical location, etc.

I help all three of my kids with their taxes, and I'm starting a tradition each year of recommending they track / update their net worth each year after completing their taxes. With my other two kids, it's pretty easy because they have regular jobs with checking / savings / 401(k) / car / house / mortgage etc.

With my son, his business is very clearly worth something beyond book value. It's reasonable, therefore, to somehow reflect the value of the business on his net worth. I'd like a simple way to value the business for him that he can use consistently over the next five years or so.

What I'm thinking of is taking the gross revenue of the business, subtract business expenses/depreciation, and subtract income taxes to get some sort of "free cash flow" number. I know "free cash flow" is actually an accounting term, and my definition may not match the real accounting definition, but for simple purposes let's overlook that.

One key factor is that the "free cash flow" includes employee salaries but not his salary. He's set up as a sole proprietor now and understands but doesn't really draw a bright line between work and personal income and expenses.

The business is a service business. On his 2023 Schedule C had about a 55% net margin before taxes (Line 31 / Line 7). It's approximately doubling top line revenue growth annually.

What multiple of my "free cash flow" metric is a reasonable, conservative multiple to use?

If you know of some modifications to the "free cash flow" metric that aren't too hard to calculate that might make it a much more accurate business valuation metric, I'd be interested in those ideas too.

Thanks!

 

[aja8888]

Service businesses are hard to value. They are usually valued at what you can sell them for since physical assets are small and client lists are the revenue source. When I had my service business, I valued it at 3X revenues. I never tried to sell the business, but shut it down over a long period of time.

Selling a service business usually requires working for the new owners to keep the revenue flowing for a period of time.

 

[SecondCor521]

Service businesses are hard to value. They are usually valued at what you can sell them for since physical assets are small and client lists are the revenue source. When I had my service business, I valued it at 3X revenues. I never tried to sell the business, but shut it down over a long period of time.

Selling a service business usually requires working for the new owners to keep the revenue flowing for a period of time.

3x gross? Or net? Or something approximating my FCF?

I sort of want to encourage him to focus on net after tax revenue, because he really likes spending business revenue on business expenses to reduce taxation.

(You're right, he has supplies and some equipment, but no real inventory, and the business is his skills and knowledge, the customer lists, and *maybe* the shop and his website if you squint hard.)

Thanks!

 

[aja8888]

3x gross? Or net? Or something approximating my FCF?

I sort of want to encourage him to focus on net after tax revenue, because he really likes spending business revenue on business expenses to reduce taxation.

(You're right, he has supplies and some equipment, but no real inventory, and the business is his skills and knowledge, the customer lists, and *maybe* the shop and his website if you squint hard.)

Thanks!

We valued at 3x gross revenue. There's lots of ways to value a service business but it's only meaningful if you are trying to sell it. Otherwise, it's just a financial exercise.

Clients are not forever in this kind of business.

Usually, if you try to sell the business, its to a competitor and they really want your clients and skills. The skills are the people and for them to come along will require contracts.

 

[SecondCor521]

Thanks! 3x gross would be very easy to calculate.

Interestingly he had a number of customers and friends who made fairly serious offers of capital investments and business loans earlier this year. I encouraged him to turn all of those down, figuring that it's pretty easy to undervalue a business of his type at that stage.

I'll be curious to see his exit strategy, which will be many years from now. Selling to a competitor is likely, although he might tend to be an acquirer rather than an acquiree and end up the biggest fish in the area. We'll see.

 

[Koolau]

When we tried to sell the family business (a retail store/service business) we showed our figures to prospective buyers. Their take? "I can start my own business like yours from scratch - just like you did."

One couple did just that and became our competitor. Our figures were what convinced them to go for it!

We heard from more than one business person: "It's a lot easier to get into business than it is to get out of it." More than one similar businesses to ours in town simply shut their doors and quietly disappeared.

Eventually, we (DW and I) valued the business as the buildings, land, equipment, vehicles and stock. We sold it to our niece. She got a very good deal as the business revenues easily exceeded her "indebtedness" to us.

15 years later, the family business is still thriving and (wait for it) our niece is now trying to figure out how to "get out."
My "advice"? It's complicated. You're unlikely to find "comps."

Good luck setting a value.

If virtually anyone with ambition and a little grub stake and a bit of talent can start a competing business, then your actual business value is 1) Indeterminable until you get an offer 2) zilch 3) Maybe what physical stuff you can sell off.

We were totally surprised that the "good will" and customer base were essentially valueless.

 

[aja8888]

When we tried to sell the family business (a retail store/service business) we showed our figures to prospective buyers. Their take? "I can start my own business like yours from scratch - just like you did."

One couple did just that and became our competitor. Our figures were what convinced them to go for it!

We heard from more than one business person: "It's a lot easier to get into business than it is to get out of it." More than one similar businesses to ours in town simply shut their doors and quietly disappeared.

Eventually, we (DW and I) valued the business as the buildings, land, equipment, vehicles and stock. We sold it to our niece. She got a very good deal as the business revenues easily exceeded her "indebtedness" to us.

15 years later, the family business is still thriving and (wait for it) our niece is now trying to figure out how to "get out."
My "advice"? It's complicated. You're unlikely to find "comps."

Good luck setting a value.

If virtually anyone with ambition and a little grub stake and a bit of talent can start a competing business, then your actual business value is 1) Indeterminable until you get an offer 2) zilch 3) Maybe what physical stuff you can sell off.

We were totally surprised that the "good will" and customer base were essentially valueless.

My bold above: It depends on the service you are providing. High value services like medical laser repair (my friend's current service business) are very difficult to start from scratch and building and maintaining a dedicated client base is quite hard to do in a reasonable length of time.

 

[HarveyS]

I would suggest the business value should should be net assets plus a multiple of net profit, not revenue. A buyer would want to acquire the business to make money (profit). Growing revenue is hard in any business, but I feel it's a great deal easier to grow revenue than to grow profit. In my definition, net profit is after all expenses, including taxes and a salary for his role in the business.

 

[Koolau]

My bold above: It depends on the service you are providing. High value services like medical laser repair (my friend's current service business) are very difficult to start from scratch and building and maintaining a dedicated client base is quite hard to do in a reasonable length of time.

Heh, heh, I did mention that anyone with a bit of talent could run the family business - or at least provide its services.

My mom and dad started the business the year I was born for (wait for it) $400. Of course, that was a lot of money at the time. They both had to leave their defense plant j*bs when the war was over, so $400 represented their life savings. Neither was "empl*yable" at the time (She was pregnant and he was disabled.) Staring a business was their only option. Failure was not an option.

 

[USGrant1962]

Just to toss in another rule of thumb for first approximation on a small business that I've heard more than once. ONE year revenue, not 3 years. Now, that is business with revenues in the millions and 10s of millions - not sure how that applies here.

 

[OldShooter]

IMO the method doesn't matter much. If the valuation is simply to allow tracking in future years, then whatever you like, used consistently, will do it.

Where the valuation matters more is when DS goes to see a banker about getting a loan. For that, the bank will use their own methods and have little interest in what you have been doing. For this latter exercise, he should be developing a banking relationship now -- in advance of need. Two biz bankers where he is doing his banking and who know his name at least. Asking the biz bankers about how they would value his business may be an excellent conversation-starter.

 

[RetiredHappy]

2 to 3 times EBITDA is pretty standard for most service businesses. You should not use gross revenue.

 

[427Vette]

I recently sold a service business. Nothing really mattered to anyone other than the gross annual profits. Our broker told us that a business is worth its ability to make money and of course the assets. I don’t think it needs to be a complicated calculation. Throw a close number at the assets and add one years gross annual profit and use that number.

 

[Surewhitey]

An accidental sole proprietor here for ~6 years. I never wanted to grow to have employees although probably could. If I did, it'd be a a "real business" and I just don't want the hassle.

Valuing a biz imo is based on a x multiple of net profit as I really keep expenses max'd for any project. The only way to go larger is employees and you need a market that isn't saturated yet. Ambition is definitely needed too.

I'd probably offer mine to a young fella who can shadow me and build his own reputation over time. Maybe 1x net...

 

[Kings over Queens]

are you looking to value the business for the sake of a number on his financial records as a benchmark, or establish a method of valuation to eventually be used to sell the business? Or both?

If just for a number on his balance sheet that can be tracked for growth, multiple of revenue is fine. Given how early he is in this business lifecycle, establishing a hard and fast valuation for resale feels premature. When the time comes you may find different thoughts on valuation. One buyer may look at number of customers and another gross revenue.

 

[SecondCor521]

are you looking to value the business for the sake of a number on his financial records as a benchmark, or establish a method of valuation to eventually be used to sell the business? Or both?

If just for a number on his balance sheet that can be tracked for growth, multiple of revenue is fine. Given how early he is in this business lifecycle, establishing a hard and fast valuation for resale feels premature. When the time comes you may find different thoughts on valuation. One buyer may look at number of customers and another gross revenue.

Mostly the former. He is young and probably plans to run this business for a long while.

 

[Kings over Queens]

Mostly the former. He is young and probably plans to run this business for a long while.

I did the same thing for years, it was really just a place holder. In the end, when I did ultimately sell, the valuation was much higher than what I used. In my case it was a simple multiple of revenue, and that served the purpose just fine.

 

[pb4uski]

I would look at the most current years cash flow (normalized) divided by (discount rate - growth rate). So if the year 1 normalized cash flow is 100, the hurdle rate is 15% and growth rate of cash flows is 10% then the value would be 2,000.

In calculating the value of the business you should include a reasonable compensation for his personal efforts, because only the excess would be available to investors.

That formula is harder for hyper growing businesses, but you could schedule out cast flows for the go-go years and discount those at the hurdle rate and then use the formula once the go-go years are over, discounted back to the valuation date.

 

[Qs Laptop]

2 to 3 times EBITDA is pretty standard for most service businesses. You should not use gross revenue.

RetiredHappy is on the right path. I'm a small business owner currently shopping my business. I've gotten two offers, which I've rejected and I've gotten two counteroffers which I am currently weighing.

Businesses are typically valued on a multiple of EBITDA. Depending on the business it is somewhere in the 2X to 4X range, with the average being 3X. Furthermore, it's typical to take a three year average of EBITDA and then apply the multiple. Some businesses are valued based on a multiple of revenue, but they are usually high tech companies or else online companies with subscription based revenues.

He (and you) might find this podcast helpful: Built to Sell Podcast

 

[rmcelwee]

We sold our internet business in 1999 for 3X gross.

 

[Patience]

3x annual profit or 1x annual gross. Be sure to keep the owners compensation out of the profit value. Both methods are estimations.

I don't include company values in my networth. Small businesses are hard to sell, and when they do, it's typically for less than the valuation methods. If you do sell, it's just a nice windfall. Don't rely on it.

 

[Koolau]

3x annual profit or 1x annual gross. Be sure to keep the owners compensation out of the profit value. Both methods are estimations.

I don't include company values in my networth. Small businesses are hard to sell, and when they do, it's typically for less than the valuation methods. If you do sell, it's just a nice windfall. Don't rely on it.

Yeah, we finally sold (cheap to niece) but we'd made a lot of money over the years so figured simply shutting down would also be okay if that's what we had to do. (Fortunately, it w*rked out for us and especially for niece.)

 

[Texas Proud]

I am like the others... it is hard to say... one thing is what kind of business and if it is easily transferable to someone else...

My dad had a small service business which I took over when he died and used it to go to college... when I graduated I could not find anybody who wanted to buy it... the revenue per individual was LOW and most people though they could get them for free...