How to Value a Small Business
Whether you’re looking to sell your business, apply for a small business loan, or raise additional funding, it is important to know how to value a small business. The same goes for buyers interested in purchasing a small business. There are many pieces that go into the valuation of a small business, and it is important to understand everything that is included in this complex calculation before setting a price or making a bid.
Methods of Small Business Valuation
There are three primary ways to value a small business:
- Market Approach – The company value is derived from what others are willing to pay for similar businesses.data from the sale of similar businesses in the same market can be studied,
- Income Approach – The company value is derived from its ability to generate cash.
- Asset Approach – The value of the company is its assets minus liabilities.
The income potential is further broken down depending upon whether the business has a consistent pattern of earnings which can be projected forward with confidence, or is newer and will require a projection taking risk into account.
Valuing a company is not a simple or straightforward task, and should generally be performed by a professional specializing in such valuations. While one of the following calculations may be the most appropriate for your company or the company you are looking to acquire, most of the time, each calculation will be done and a value will be reached based on these and other factors.
This is a very popular method of calculating the value of a small business. It is based on recent purchases and sales of comparable companies in the same industry as the small business you are valuing. The only limiting factor here is the availability of such data, as the calculation hinges entirely on these values. For small businesses, these values are usually only available in a subscription database.
If you are a rapid growth company you will probably be valued based on a multiple of revenue. This is usually the highest and most favorable valuation.
Most companies are valued based on Earnings Before Interest, Taxes, Depreciation, and Amortization. This is a calculation to approximate cash from operations without the influence of ownership structure. EBITDA is not a standard metric on the income statement, and usually contains additional adjustments besides those listed in the acronym.
Seller’s Discretionary Earnings (SDE)
If you are a closely held pass-through entity like an LLC you can also utilize something known as Seller’s Discretionary Earnings, or SDE.
You have likely heard of EBITDA – earnings before interest, taxes, depreciation, and amortization. This figure is commonly used when valuing a large business. Seller’s Discretionary Earnings, or SDE, is a value that serves the same purpose as EBITDA, but for small business valuation.
This figure is the pre-tax earnings of the business before owner’s compensation, non-cash expenses, interest expense and income, and one-time non-recurring expenses. The owner’s compensation is included in this calculation, while it is not included in EBITDA, because it is assumed that the buyer will replace the owner.
There are various worksheets online to help you calculate your business’s SDE, or you can reach out to an accountant or other business valuation professional to help you determine the figure.
An SDE multiplier (or SDE multiple) is a figure that you multiply by your SDE to determine what your business should sell for. It is dependent upon your industry, and varies based on location, tangible and intangible assets, company size, and market characteristics and volatility.
Owner risk also plays a role in determining your specific multiplier. This means that if the business will lose value as a result of the owner leaving, this factors in.
One potential business valuation can be achieved by taking the SDE, multiplying it by the SDE multiplier, adding in assets and subtracting liabilities.
There are several methods for income-based valuations. The proper model depends on your business:
Discounted Cash Flow
This calculation estimates the value of the business based on its future cash flows. The present value of these anticipated future cash flows is found using a discount rate to account for the time value of money. The appropriate discount rate will also take into account risk involved in the investment. There are various discount rates that can be applied dependent upon your market and industry, and this calculation should be determined by a professional.
Capitalization of Earnings
This method of calculation is also based on estimated future profitability, but is more precise as it is based on historical earnings. This calculation takes into account cash flow, ROI, and expected value. A single recent period is chosen and the financial statements for that period are used to calculate this value.
Sometimes seen as a worst-case scenario liquidation-based valuation, this figure is generally used for businesses with many tangible goods and/or little profitability. Both tangible and intangible assets are used to calculate the net value of the business, and liabilities are subtracted.
Other Things to Note
When you’re looking to determine the value of your business, knowing the valuation methods is important, but there are some other important things to consider.
For Sellers: Organize Your Finances
It may seem obvious that your business valuation will only be as good as the veracity of the financial information you put in, but particularly for small businesses, or those that have recently undergone a growth spurt, getting finances in order can be a daunting task.
Important documents and information to have on hand include:
- Detailed annual financial statements
- Profit/Loss statements
- Balance sheets
- Statement of cash flows
- Tax filing paperwork and returns
- Financial forecasts
- Receipts and deeds pertaining to assets
- Copies of any existing contracts and leases
- Ownership paperwork
Essentially, you must get together any paperwork you have, and expect to spend some time compiling financial reports if you have fallen behind. The more together you are in this regard, the less time a professional coming into your company will have to spend trying to piece this information together, and the more accurate your ultimate valuation will be.
For Buyers: Do Due Diligence
Both buyers and sellers have to do their homework when it comes to valuing a business, and of course no buyer should just go in trusting 100% of what they’re being told. Even the most trustworthy of business owners may see their business as worth more than it is, or overvalue things for a variety of reasons.
“Buyer beware” is especially important when making a purchase of this magnitude, and buyers need to look out for a variety of red flags. The existence of one or two of these issues does not necessarily mean the whole conversation should be halted, but if these aren’t even being discussed, or if many of these issues arise, there may be cause for concern.
- Does it seem like the financial statements have been put together in a misleading fashion? Does it seem like something is missing or being hidden?
- Are there obvious risks that are not being openly discussed and considered in the valuation?
- Have all liabilities been accounted for?
- Is the owner a linchpin, whose departure will likely lead to the end of the business’s profitability?
- Does the business’s wellbeing hinge on one or two large customers? Are there contracts in place or might these customers leave with the sale?
Final Thoughts on Valuing a Small Business
Small business valuation is both an art and a science, and takes a great deal of information and skill to do well. As a buyer or a seller, it is important to have all of your ducks in a row, as either undervaluing or overvaluing the business could lead to problems with the sale.
If you are looking into buying or selling a business, it is advisable to bring on an expert in business appraisal. At CFO Share, we can provide guidance through every step of the business valuation. Let us use our expert business acquisition analysis to help ensure your business valuation is accurate and your sale successful.