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I'm trying to learn how to value my small web application development business. I'm about to talk to some financial advisers for their input as well, but thought I'd kick things off here.

My question is: My 3 full time salaried employees want to buy my small web development company from me. How do I place a dollar value on my business when it has made $0 in profit in its 5 years of existence, and only generated a total of $40k total salary for me ($20k year 1, $20k year 2, $0 last 3 years)? Specifically, I'd like to know the name of the "process/method/model" that accountants or business advisers would use to determine the valuation.

More details incase useful

I am the founder and only share holder of this company. The company is incorporated in Ontario, Canada.

THE PAST THREE YEARS

In the past three years, 90% of my expenses have been salaries to my 3 employees who work full time 40 hours per week. So our expenses are like this:

  • $100k to senior developer
  • $80k to intermediate developer
  • $50k to junior developer
  • $30k office rent, server hosting, accountants, etc...

The company retained earnings is $0. Our company annual revenue each of the past three years is about $260k (total of $780k after 3 years).

I myself work on average 60-70 hours per week for which I have made $0 on salary and $0 on dividends. My responsibilities include: Senior software developer, business development, market research, project management, account management, sales, marketing, payroll, book keeping, and dealing with any kind of business complication (eg. working with lawyers to deal with disasters).

THE FIRST TWO YEARS

In the first two years, I was able to withdraw a salary of $20k each year. The company annual revenue was $280k ($20k more than the past year). Everything else was the same as the past 3 years.


I've heard some people say I'm supposed to make my valuation based on the profit of the company. So if that's the process, then things are simple, and I should sell my company to my employees for $0. Is that the right process to valuation?

----MORE NOTES----

To address some comments below, the reason the employees want to buy the company is because they have been friends since elementary school. Keeping the team together is important to them. For me, I can't sustain this business anymore, that's why I want to walk away as soon as I can, but also not look back on my life and think "I've let people take advantage me again and again and again...when will I stand up for myself?" There's a strong part of me wanting to shut down and not sell to anyone, because I want to see things burn rather than see others successful in areas I've failed. If I can't make it work, then I won't let anyone make it work. But then my employees are my friends so I shouldn't burn a bridge that they've been walking on.

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    One way of valuing a company is to multiply annual earnings by some number, based on surveying the values of similar companies (or by making it up). – Pete Becker May 28 '18 at 2:00
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    What does your company own? Computer equipment? Desks? What? How much is that stuff worth? Do you own any intellectual property? – Brythan May 28 '18 at 3:15
  • @Brythan all our other assets are negligible. We have no IP. The only thing of value are the relationships I have with my clients. So if I sell my business to the three employees who have been with me since the business started, I'm selling my approval for them to work directly with the clients without me. – John May 28 '18 at 3:17
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    I find this question very interesting, and think a better answer can be had. How can I add bounty to it ? Cant seem to find the button for that yet. – Leon May 28 '18 at 11:57
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    Have you asked them to make you an offer? You would want to try and independently vet such an offer, but perhaps they may surprise you with their own interpretation of the value of the business. – Grade 'Eh' Bacon May 28 '18 at 12:34
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Why you're leaving

I'm going to start by examining why you might want to leave. As I see it, you have a business that generates 260k in revenues every year (280k twice, but in the first two years) with 30k overhead and 230k salaries. However, if we include your salary at 100k, your salary cost goes to 330k. You're actually losing 100k a year as an opportunity cost.

Now, I can't validate a 100k salary. I'm basing this on your self-description as a senior developer and your description of the 100k developer as a senior developer. It is possible that you are overestimating your worth. But regardless, you are currently drawing zero and the cheapest other developer is 50k.

My concern here is that you seem to have 360k of work for which you are only charging 260k. Obviously that is not sustainable. Either salaries need to go down or charges need to go up. If charges go up, you might get less work. So losing a senior developer may actually help the business. Perhaps removing a 100k salary and increasing the rate will decrease the amount of work just enough for three people to cover.

Why might they want to stay?

One possibility is that with your departure, they can raise their rates and still get enough work to support three developers. Presumably you can't do that now, as you barely have enough work for four developers. Take one of the two most expensive away, and maybe that improves.

Alternately, making them owners may make them take more reasonable distributions. Currently, you pay them, then you. That's great for them but not so great for you. If they can't actually demand 100k, 80k, and 50k salaries elsewhere, then this job may be of outsized worth to them. If their worth elsewhere would be more along the lines of 70k, 50k, and 40k, that would have left 70k to pay you. Going forward, it might allow them enough room to make a profit.

Again, I can't actually say how much any of you are worth as developers. I'm throwing out numbers that make your finances work. Are they correct numbers? I have no idea.

Regardless, this gives them two ways to make a successful business without you. One would indicate that you charged to little. The other would indicate that you paid too much. Obviously, they would prefer that it is the former.

Valuing the business

You currently see the business as having no profit. This is because you start by paying the other developers a fixed amount. However, if you switch them to owners, then their salaries no longer need to be fixed. Instead of being a fixed cost, they can now become profit distributions. That's how they've been treating you for five years. They got a fixed amount while you got the remainder. When selling, you want to flip that around.

Since you are no longer working there, your salary will be zero. Since they will be owners, their fixed salary will be zero. If there is excess money, they can pay it to themselves. This changes everything. By making them owners, you free up 230k in salaries. That's the new business profit. 230k.

You could try to apply a discounted cash flow to that profit, but it would make the numbers rather high. Using a discount rate of 2.75%, I get a valuation over a million for five years. You aren't going to get that much, because they would be better off getting regular jobs.

Assuming you are correct in your evaluation of yourself as a senior developer and that you've been putting in forty hours a week at development, then you have essentially invested 460k over five years (five times your 100k salary minus the 40k you took out). In an ideal world, you'd charge that for the company. However, that's unrealistic. They would never pay it.

A more realistic amount would be 115k. That would require each of them to give up half their salary for one year. In return, they would get equivalent shares in the business: 50k shares, 40k shares, and 25k shares. Going forward they would share any profits with that distribution. Or they could pay themselves salaries, but only out of the actual money.

Alternative valuations

It would be difficult to sell to anyone but them with them as employees. The business is not making a profit if they are salaried. It only works as a business if they can retain the existing revenues while losing your development work. They will also have to replace your other duties.

Any other potential buyer is going to see a turkey. The first thing that anyone else is going to do is lay them off and replace them with cheaper or better developers. For example, a multinational development company with project managers local to you but developers in India, Southeast Asia, or Eastern Europe might be able to make money on your existing work at your existing rates.

Payment plans

I would not try to drag out a payment plan for the long term. A year seems manageable. They make sacrifices in that year, but afterwards they no longer need to pay you. They will likely stick out a year under those circumstances, hoping that once you are paid, things will be better. If you set that for two years, they are more likely to give up. They'll realize that there is only 230k to pay for 330k of work.

If they can pay the 115k out of savings, that's even better for you. That avoids the problem of them alienating some of your clients and losing that business. But I suspect that they won't have that much. Take as much up front as they will give and then collect the rest over the course of the year. The agreement should be that you get paid first. They can take their pay out of whatever remains, either as salary or as distributions.

Making this work

Currently the four of you are working 180 to 190 hours a week, so let's call that 185. That's them working 40 hours a week and you working 60 to 70. Without you, if they each work 60 to 65 hours a week, they can can cover the 185. For the first year, that can keep their income up without making radical changes. After that first year, if they want to get back to forty hour work weeks, they will have to raise the rate they charge or cut back on their salaries.

The only real argument for a positive valuation to them is that they don't have to look for new jobs. That's all the leverage that you have in this transaction. The way that I see it, you might get half of one year's profits out of that. Going forward they will have to find some way to charge more or work more effectively if they want to keep their income up while working normal weeks.

Financially, this is probably a bad deal for them. If they could get regular jobs with the same salary, they would almost certainly be better off. But you spent five years finding that out. You just need them to dream for one year under this plan. And as I said previously, they may get better salaries this way than they would get from regular employment.

Fairness

There is an argument that this is unfair to them. They are doing a lot of work to pay you 115k. However, I think that if you look at the whole history of the company, they are still making out on the deal. They've had jobs for five years where they did only two thirds of the work but reaped almost all of the benefits. Asking them to give you half of the benefits from one year is not unfair to them. You will still be the lowest paid employee for your five years of work, even though you were doing the most work.

If your choices are zero or something less than 115k, you still might take a lower offer. Because something is probably better than nothing. But that's also the argument in favor of taking 115k rather than insisting on being made whole.

Alternative payment plans

Another answer suggests a commission plan above a certain amount of revenue. I would advise against that. The problem is that you will spend all of the up front money on legal fees writing a contract for the plan. And you have very little leverage to get the money if they balk. For example, if they replace you with a 100k project and sales manager, they might pass the revenue target but lose money after their salaries. In that case, they won't want to pay you money.

Another issue is that they might avoid hiring so as to avoid the risk of that happening. A commission is hard to manage if they are losing money. They will tend to put that payment last. That's the problem that you've been having. You've been paid last, which meant not at all.

Such a plan also constrains them. For example, if they want to merge with another company, they would have to get your permission to discharge the obligation.

Your goal should be to get paid first, before anyone else. That way it is on them to find a way to make money. By paying it all in a year out of revenue in that year, it makes it a temporary situation. They can see light at the end of the tunnel. They may not fix the rest of the problems, but at least they can pay off you and stop paying. And you can make them pay for that whole year, as you will own the company until they pay. It's simple and can be written up in a paragraph.

This commission idea does not really allow you to own the company until they pay. It commits them to a longer term deal. You won't be able to walk away until the period is over or until the business goes broke. And it doesn't give you much even if it works. And you have no influence on making it work. It's entirely up to them. If they make it work, they should get all of the benefits. They'll be the ones taking the risk.

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    "You should subtract out their salaries. What you have is a business where there is 230k-250k profit." I'm afraid I don't understand this, though I agree with the conclusions in the rest of your answer. Employee salaries are part of the cost of doing business, not part of the profits. The owner has to pay employee salaries, just as they have to pay the light bill. As far as I can see this is simply not a profitable business. – Charles E. Grant May 28 '18 at 16:16
  • "As owners, they can't pay themselves guaranteed salaries anymore." They can definitely pay themselves salaries! it just depends on how the business is structured. They may choose not to, and in the US there are certainly tax complications that may make that a reasonable choice in some circumstances. In every small business I've worked for, the owner paid themselves a salary. No, the salary is not guaranteed, but neither is the salary of the employees: companies fail to make payroll all the time. I am perhaps getting distracted from the actual point of the post, by technical issues. – Charles E. Grant May 28 '18 at 17:07
  • If the business is incorporated then it has a legal existence independent of the owners, and if an owner also act as employees of the corporation they can sue for unpaid wages. As this article points out, this protection is particularly important for minority owners. As I said above much of this depends on the legal structure of the business: sole proprietorship vs llc for example. – Charles E. Grant May 28 '18 at 18:32
  • The main problem I have with this is it's a bad deal for the buyers, which you admit. It's possible that paying the employees to take over the business is still a bad deal for them, so any amount of money they have to pay is probably not worth it, let alone $115K which seems pretty arbitrary. – TTT May 28 '18 at 18:42
  • HI everyone, i'll add a note that the company is incorporated and Im the only shareholder. Thanks for bringing up interesting points. – John May 28 '18 at 19:22
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At it currently stands the company appears to have no value. It requires more input (the listed expenses plus your time for which you receive little if any compensation) than the value it produces.

2

Since your company has $0 or even negative cash flow, and no tangible assets or IP, it seems like the only value your company has is good will. If you have customers that have worked with you for five years that can be considered to have value. The fact that the business has simply existed for five years and potential customers will be aware of your existence also has value. To a large extent you get to decide how much your good will is worth, but any potential buyer gets to make their own judgment about whether the number you come up with is credible.

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Typically when employees want to purchase the company, it's because they want to keep the company margin (or profits) for themselves instead of the owner taking their cut. It doesn't seem there is (currently) any margin in this case, so I'm not sure what they stand to gain by purchasing from you, unless they feel they can grow the business better than you can. But given that they do want to purchase, and that there are currently no profits, it would be hard for them to justify putting up money for the company in its current state. My suggestion would be an extremely low company value with a commission based payout to you beyond some dollar amount. For example, perhaps you sell the company for $10 (or $1000 to at least make sure they're serious), then set the revenue line at something around $250K. Perhaps your commission payment could be 10% of all revenue above $250K. This way the employees don't have to take a loss, but you still reap the benefit of realizing potential future profits, which is fair considering you founded the company and put in a large amount of sweat labor.

Note, this strategy could also be accomplished by you retaining 10% of ownership instead of the above plan, however, I got the impression you want to remove yourself from the day to day activities, which may be difficult to do if you are still an owner.

  • Usually when employees buy their company it is to keep their jobs. What you are suggesting here is essentially to sell the company for about 6k (assuming the 10% over 250k expires after five years). And it's not a given that he'd get that much. You don't solve the problem of charging 260k for work that costs 360k (including the OP's salary at 100k). I would advise against this. He would almost certainly be better off closing the company than making this deal. I.e. it will cost more than 6k in taxes, legal fees, and aggravation to set this up and do the transfer. – Brythan May 28 '18 at 18:27
  • @Brythan my suggestion of the $250K threshold is arbitrary. Make it $275K or $300K if that makes the numbers easier. The point is that the OP has built something of unknown potential value, which is probably the motivation for keeping it alive this long. The reality is the business needs to close, and this suggestion allows OP to drastically improve his current life, yet still keep the potential of his creation alive with no risk. – TTT May 28 '18 at 18:48
  • @Brythan - I also don't see how you figure 6K in taxes and legal fees. On a $10 (or $1000) sale price there would be little if any taxes. Probably it would be a deductible loss depending on the current basis. Yes, whatever future commissions are paid out beyond the threshold would be taxable income, but that's not a bad thing. – TTT May 28 '18 at 18:49
  • You have to pay 1k for the original agreement (legal fee). You have to review the revenue every year to see if it beat the threshold (250k or whatever--increasing the threshold doesn't make it better). If the sellers don't want to pay the commission, you have to sue them. You have the actual costs of transfer, selling the business. And I think that you are going to have trouble claiming that the commission is a capital gain. All for a business with a pretty well known potential value of zero. Unless the developers are willing to take a pay cut. – Brythan May 28 '18 at 19:08
  • @Brythan - I don't think those things are as big of a deal as you make them out to be, and let the commission be regular income. Even with all of those points, it's still better than nothing, which is what you'll probably end up with otherwise. – TTT May 28 '18 at 19:19
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I suggest using discounted cash flows to do this. To quote some numbers, suppose you knew that your company will make $50,000 next year, $60,000 the year after, $72k after that (20% growth rate), etc, for five years and then stabilizes afterwards into perpetuity. The question becomes how much a buyer should be willing to pay for the company. If the buyer pays $50k, then next year he'll break even, and every year afterwards he makes pure profit. If the buyer pays $500k, it'll be four years before he breaks even, and everything afterwards will be pure profit.

However the buyer can also not buy your company and invest the money elsewhere. For example if the current interest rates are 10%, then the buyer could simply save the money in a bank and reap the interest rates. For the buyer to be willing to pay for your company, he has to earn more than what he can get from the safest available investment. The very conservative buyer would use the the 30-year US treasury bond rate (3.14% as of time of writing) as the benchmark; more aggressive ones might take the S&P500 (~9.8% annual gain historically).

You can use a DCF calculator now to evaluate how much the company should be worth. Earnings-per-share would be 50k/share (since there's only one share), 20% growth rate for 5 years and discount rate of 9.8% gives a price of about $1,124,422.61. Any higher than this and the buyer might as well tack the S&P500. This calculator is not the most flexible of calculators, but the Investopedia article linked above should let you modify the assumptions to your requirements.

Specific to your company: you say it makes $0, which means that strictly, its value is also $0. However, since the company has made profits in the past, maybe it'll do so again in the future. Once the company starts making money its value rises above $0. You know how much profit the company is likely to make in the future better than anyone, which is the basic input into the DCF model.

  • Okay this is a possible method of valuation, but not one that addresses the OP's primary concern of having $0 in cash flows to discount. – Grade 'Eh' Bacon May 28 '18 at 12:22
  • @Grade'Eh'Bacon do you expect OP to have $0 in cash flows even in the future? – Allure May 28 '18 at 12:26
  • That's the entire point of the question - if you believe there is a way to determine future cashflows for the OP, then he is asking about it. As it stands, it seems that the costs of employing staff completely wipes out the business's profit. – Grade 'Eh' Bacon May 28 '18 at 12:33
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The best valuation method is comparative approach using a revenue multiple. There would be some other small companies similar to yours that were recently (in past 2 years) acquired by big listed companies like Amazon, Apple, Alphabet/Google, Microsoft, etc. You will have to do some google search to get the average revenue multiple for these transactions (could be 3.0 to 5.0x revenue). You can simply multiply your 2017 revenues with that multiple to get your company's valuation.

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    Companies acquired by the likes of Google are only good comparatives if you are about to be bought by Google. This would be like saying the best way to value the time of a high school baseball player is to look at the starting contract given to Roberto Alamar. – Grade 'Eh' Bacon May 28 '18 at 12:21

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