Every entrepreneur dreams of seeing their business grow. But keeping tabs on a company’s value may slip to the back of one’s mind during the expansion process.
We get it: There are plenty of pressing issues to address. That said, it’s crucial to know how much your business is worth. We’ll explain how to value your small business based on various factors, including whether it’s for sale.
Why You Need to Know the Value of Your Small Business
Knowing how to determine the value of your small business is important for a number of reasons, but they all boil down to one notion: Opportunity.
Say a potential buyer comes to you with an offer to purchase your business, but you aren’t necessarily looking to sell. If you don’t at least have a ballpark idea of what your company is worth, you might sweep aside a lucrative offer. But if you do have a general idea of your company’s value, you would know which offers to take seriously—and which to dismiss.
You’ll need to assess the value of your small business when looking to borrow or land seed money from investors. Your company’s value tells these entities whether they can trust you with their money both now and in the future. We’ll revisit this a bit later.
Knowing how to estimate the value of your small business allows you to take stock of the overall health of the company. Since you’re assessing your profits, expenses and all things in between, you’ll gain a better idea of what your company is doing right — and learn where there’s room for improvement.
How to Value Your Small Business for Sale
If you’re actively looking to sell your small business, you’ll want to be as specific as possible when determining your company’s value.
Collect Your Company’s Financial Information
To value your small business, gather the following records:
- Income statements
- Cash-flow statements
- Balance sheets
- Seller’s discretionary earnings statements
Your income and cash-flow statements will show how much money your business generates. They help give potential buyers an idea of what the company will be worth in the long run. Your balance sheets and seller’s discretionary earnings statement (and cash flow statement) will provide a general idea of how much they’ll need to invest over time to experience these positive results.
Determine the Value of Your Assets
Next, you need to know how much value your assets add to your company’s worth.
Keep in mind if potential buyers see your assets as valuable, they’ll likely be willing to raise their offers. If they don’t think your assets add much value to their purchase, your best bet is to liquidate these assets for their current market value to recoup missing out on this additional profit.
Prepare Your Seller’s Discretionary Earnings Statement
Your seller’s discretionary earnings documents expenses that a business accrues based on choices and decisions made by the owner.
Examples of Discretionary Spending
- Owner’s salary and benefits
- Rent and utilities
- Legal and accounting fees
In each of these cases, it’s the owner’s decision that determines the cost of these expenses:
- What the owner’s salary will be
- Where to locate the business, therefore deciding the cost of rent and utilities
- Which attorney and accountant to hire
In short, your SDE allows you to value your business as it will exist once your imprint on it has been lifted.
The goal is to remove these expenses from the equation when calculating your company’s value because the potential buyer won’t be accruing these exact expenses once the sale is complete.
Estimate Your Earnings Multiple
Here’s where things start getting a bit more subjective. Calculating your earnings multiple allows you to assess the value of your company’s intangibles, from the perspective of both yourself and your potential buyer.
You’ll need to consider how a variety of factors impact your small business, including:
- Financial history
- Customer base
- “Brandability” and industry reputation
For each of these categories (and others), you’ll want to grade your business on a scale of 1-4, with 4 being the highest. Add these scores together, then divide by the number of categories to find your overall average earnings multiple.
This number, multiplied by your SDE, will provide a clear idea of the value of your business.
Remember: You want to assess these categories from your buyer’s perspective—meaning you need to know how much weight each intangible holds in their eyes. The goal is to find a buyer whose perspective aligns with your own, as this will allow you to increase your selling price substantially.
Compare Asking Prices to the Norm
After getting this rough estimate of your business’ value, you’ll want to see how this number stacks up against businesses in similar scenarios.
There are a number of online marketplaces and directories where business owners can list their companies for sale (and where buyers can purchase them). Browse the directories for businesses that fit “check the same boxes” as your company, taking note of their asking prices and, if available, potential bid amounts.
A third-party consultant can help you value your business objectively as well as based on the market’s current status.
Once you’ve come to a consensus as to the current value of your business, you’ll be ready to start taking buyout offers much more seriously.
How to Value Your Small Business Based on Profit
Another method for valuing your small business is to consider your price-to-earnings ratio, which will lead you to your profit multiplier.
Essentially, this process involves looking at your company’s profits over time to project its potential future earnings. The value of your business will then be determined by multiplying your average annual profits by a determined amount of time.
(Note: The “multiplier” is based on various intangibles, such as your track record, industry trends, and future growth potential for your company. For small businesses, the number is typically anywhere from 3-5.)
If your business made $100,000, $200,000 and $300,000 in three consecutive years, you’d take $200,000 (the average) and multiply it by 4 (a standard multiplier for a business in good standing). Through this method, you’d determine your company’s selling price to be about $800,000.
There are a couple of things worth noting:
- You may only need to calculate your average profit for recent years (from 3-5 years, depending on individual circumstances). Focus on the years your business has been operating up to its current standard. This will provide a more accurate picture of your company’s worth.
- You’ll also need to factor in your SDE, as well as earnings before interest and taxes and earnings before interest, tax, depreciation and amortization information, as well. Again, failure to do so may cause you to undervalue your business drastically.
Additionally, it’s worth noting this method is helpful for getting started in the valuation process — but it’s nowhere near as accurate as the process above. Still, it will give you a decent idea of where your business stands as you begin to dig a bit deeper.
How to Value Your Small Business Based on Revenue
This tactic is similar to the above, with the twist that you use your business’ average revenues (instead of profits) to calculate its value instead.
(It’s worth noting that this method is definitely the most rudimentary on our list.)
When calculating your business’ revenue-based value, you’ll assign a similar multiplier (2-4 for successful businesses, 1 or even lower for struggling companies) to its overall SDE.
The difference, here, is that you’re looking at revenue, not profit. That said, the companies most likely to benefit from this method are those with low overhead, as their revenue and profit numbers may be at least somewhat similar. The same can’t be said for companies with a lot of overhead.
The Value of Knowing Your Company’s Value
Knowing the value of your small business helps you to see where you stand in your industry — not to mention seeing how far you’ve come from and where you’re headed. You can use this knowledge to focus on doing what’s best for your company.