Small Business Valuation

One of the biggest challenges investors in small businesses face is working with sellers who have unrealistic expectations of the value of their business.

In this post, I am going to talk about the four buckets that most small businesses fall into, and how each bucket aligns with the valuation of the business.

First, some definitions (FYI these are my own unofficial definitions for the purposes of this article):

“Small” business – doing less than $10 million in annual revenue/turnover

EBITDA – Earnings Before Interest, Taxes, Depreciation, and Amortization. A measure of profitability.

YOY – Year-over-Year. Financial comparison for comparing two or more measurable events on an annualized basis.

Here are the four buckets and the attributes that businesses in each bucket share:

Rocketship:

• EBITDA as a percentage of annual revenues and YOY revenue growth are both greater than 40%.
• Well-run company.
• Product(s) fit the market and the market is large.

Healthy:

• Slow growth – less than 30% YOY
• Very healthy EBITDA – at least 20% as a percentage of annual revenues
• Well-run, stable company.
• Size of the market may be limited.

Underperforming:

• EBITDA as a percentage of annual revenues and YOY revenue growth, combined, are less than 20%
• May barely be breaking even
• Needs some tweaks to get on the right track

Distressed

• Running out of cash
• External factors such as health, divorce, burnout are forcing a sale
• Some heavy lifting will be required to get the business running well

Notice that we have not talked about how much money the business is making. A “nano”-business – doing less than $500 thousand in annual revenue/turnover – could be a Rocketship (although it probably won’t be a nano-business for very long at that rate!).

Obviously, a Rocketship is worth more than a Distressed business. The following are some rough estimations for what each type of business might sell for:

• Distressed: Zero ($1.00) to 1.25x annual profits
• Underperforming: 1x to 2.25x annual profits
• Healthy: 2x to 4x annual profits
• Rocketship: 4x to 10x annual profits.

The above estimations are designed to give you, as a buyer or seller, a general and realistic idea of what a business may be worth. Of course, when exploring a sale or contemplating the purchase of a business, you’ll need to determine that business’s exact value (to you) based on its specific financials and situation, and negotiate from there.

Finally, if your business is in the Underperforming or Healthy category, what are you going to do to get your business to the next level – Healthy and/or Rocketship?