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Your business is likely your largest single asset, so it's important to know how much this asset is worth. Knowing the value of your business is especially important if your company is growing. This information might impact the future plans you have for your small business, and you never know when a situation will arise when these details become useful.
- Be patient - It will take time.
- Be proactive - take steps in advance to have information at hand when you need it.
- Be diligent - don’t be afraid to put in the hard work you need to get to where you want to be.
Why is a business valuation important?
Situations arise that require you to have an accurate and up-to-date valuation for your business either for your own awareness or accessing the potential for the business at market value if it were to be sold. It should be stated that this article is a simplistic guide to introduce you to the ideas presented here. When actually working out the value of your business you should be in touch with a professional or an organization that does this professionally.
Some examples include:
- Applying for a business loan, see business acquisition loans for more details.
- Estate and continuity planning.
- You are looking to sell the business, or a buyer is looking to acquire your company.
- You are considering a merger with another company.
- Your company is seeking outside investors.
For these and several other reasons, you may need a current valuation of your business.
Small business valuation methods
Here are some common small business valuation methods:
Seller’s discretionary earnings (SDE)
Seller's discretionary earnings of SDE measure the business's profitability after eliminating certain personal benefit items that owners might expense to the business. The calculation starts with the business's EBITDA (earnings before interest, taxes, depreciation, and amortization).
To develop SDE, you would start with EBITDA and add back non-cash expenses like depreciation and amortization, which are reported to the IRS. You would also add back items like the owner's salary and benefits, plus other expenses that do not impact cash, are unusual or one-time in nature, or otherwise might artificially reduce income for tax purposes.
SDE is a good valuation for service companies because the focus is not on the balance sheet but the income statement. To value a small business using the SDE, you will assign a multiple in the 2.0 to 3.5 times range to this figure.
The multiple will depend upon your firm's industry and is based on your company's location, market volatility for your industry, your company's size, growth potential, and the perceived level of risk or synergies in transferring ownership of the company.
One way to value a small business is to look at the company's net assets. This approach is essentially what the company owns, less what it owes against those assets, also known as its liabilities. This method isn't perfect for an ongoing business as it doesn't consider the value of the company's ongoing revenues and customer relationships.
This approach can be a good valuation method for a retail business with significant assets or for a non-service business looking to shut down. In this case, a buyer might look at the value of assets like equipment, buildings, other real estate, inventory, and other assets the business owns in determining what the company is worth.
This method can apply to a situation where the business is looking to liquidate and raise funds. It could also apply to a situation where the buyer is looking to incorporate the company into its business and is focused on the business's assets as the primary attribute that it is looking to acquire. If you are looking to acquire another business see how to find businesses for sale.
Like shopping for a house, buyers and sellers will often look at comps; this is the price of other homes of a similar size and quality that have recently sold in the area. If similar businesses have sold recently, this can be a benchmark for valuing your company for sale.
While this process is logical, finding information regarding sales of comparable companies can be hard to come by in some cases. This event is a situation where working with a knowledgeable business broker can help as they may have greater access to this type of information than you might be able to get on your own.
When looking for business comps, it's important to consider businesses in the same industry, the same region, a similar number of employees, and other factors. In a service business, you might look at the number of clients or patients the business has and the type of office space they utilize.
Capitalization of cash flow
This valuation method involves calculating the business's sustainable and recurring cash flow over a specified period. If there are any abnormal cash flow items, positive or negative, you should remove them from the calculation.
The capitalization rate used should be the business's expected rate of return. Namely, the rate of return that a business buyer could reasonably expect to earn if they were to purchase the business. While this methodology might be too simplistic for some valuation situations, it can work well for a mature, stable company.
Steps involved in this method:
- Determining a representative earnings level for the business.
- Making any needed adjustments to the company’s earnings to eliminate extraordinary items and items related to specific compensation for the owner.
- Convert these representative earnings to a cash flow number. You should adjust this number to account for capital expenditures, changes in the level of interest-bearing debt, depreciation, and changes in working capital.
- Determining an appropriate capitalization rate for the final cash flow number.
These steps should help you come up with a good estimate for the company's value.
How to Calculate a Small Business Valuation
Depending upon your reasons for doing a business valuation, you might hire a professional for assistance or do it on your own. The latter makes sense if the purpose is to know what your business might be worth.
Start by calculating the SDE for the business. This figure is essentially the EBITDA for the business with the owner’s salary and benefits added back into the calculation. Once you have a good SDE figure for the business, do your homework and research how much other similar businesses have been sold for recently. Also, consider your net assets when coming up with an estimated valuation.
Tips for Improving Small Business Valuation
In doing your business valuation, you might consider hiring a valuation professional to do the valuation. Or you may wish to explore a business valuation calculator. Besides providing the valuation, a professional can often provide tips for improving the value of your business.
Some common tips might include:
- Ways to increase your business cash flow.
- A focus on retiring business debt to shore up the balance sheet.
- Review your business processes to ensure the company runs as efficiently as possible.
- Define and document all processes and procedures.
- Reduce owner’s role in the business, so that if they are removed, there is minimal impact on the operations.
Don’t be afraid to “scout” your competitors to see what they are doing that seems to work for their business, and emulate these practices if feasible.
Do a business valuation, either with a professional or on your own if you feel comfortable doing it, periodically to see where you stand. This process will help you find strengths in the business and areas in which you might need to improve. Taking note of the areas that need improvement and acting upon them can help you improve the value of the business over time.