Sooner or later, you’re going to want to know how to value a business and calculate what your small business is worth—or even what other businesses are worth. Regardless of whether you’ll need to value a small business for sale, to sell your own, to raise a round of financing or just figure out how to compensate your employees, if your valuation of a company is off, you can lose out on a lot of earning potential.
Not many small business owners are well-versed in how to appraise a business, but it’s easier than you might think—even if you aren’t a so-called “numbers person.” Here are the basics, and then we’ll explore four different models you can use to establish your business’s value.
Small Business Valuation 101
Determining the value of a company is a process known as “valuation.” The valuation process will produce an estimate of your business’s worth that will serve as the starting point in your negotiations with an investor or buyer.
There are several key pieces of information embedded in your business’s valuation that are crucial for the transfer of ownership. These include:
- The earnings an investor can expect to bring in from buying your company
- The total share of the company that the investor is willing to purchase
- The total amount that the investor will pay for said shares
When a prospective buyer considers your proposal, one of the first figures they look at is your business’s value. Ultimately, this sets the stage for the entire bargaining process and gives them an idea of whether your business is a sound investment opportunity.
Knowing how to determine what a business is worth is a critical skill that every business owner should have. To help you figure out the valuation of a company, follow any of the methods outlined below.
Asset-Based Valuation Methods
A good starting point for figuring out how to calculate what a business is worth is to master the asset approach. This technique involves taking the sum of the assets your business owns and placing a combined market value on them.
Virtually anything that can be bought or sold in the possession of your business can count as an asset under this technique, including:
- Real estate
- Company vehicles
- Patents and trademarks
- Digital accounts (e.g., URLs, social media)
There are two main techniques to the asset approach to valuing a small business: “Going Concern” and “Liquidation.”
1. The Going Concern Asset-Based Approach
Under the going-concern approach, it is assumed that the business will continue to operate into the future and remain profitable.
Understandably, this varies from an approach that assumes that all assets will be liquidated upon purchase because this would preclude the business from gaining value through future operation.
The going concern approach includes intangible assets in the company’s valuation, which has the effect of raising the company’s valuation compared to a liquidation-based approach.
For instance, a company’s total tangible assets may put it at a value of $5 million, but with its reputation as a regional leader in the commercial printing industry, it can be valued as high as $30 million based on projected future cash flows.
2. The Liquidation Asset-Based Approach
By contrast, an asset liquidation approach involves valuing the total worth of a business’s assets when it files for bankruptcy or goes out of business. Since future cash flows and intangible assets are not counted here, the liquidation sum is lower than going concern calculation methods.
Market-Based Valuation Methods
When it comes to finding how to determine the value of a small business, market-based approaches are often the easiest to learn. This is because the market-based technique involves simply comparing your business to other businesses of the same size within your industry that have recently sold for a disclosed amount.
Predictably, there are several drawbacks to market-based valuation approaches. For instance, sole proprietorships can be very difficult to compare to one another since they are beholden to the skills and expertise of a single individual.
This method only works well if there are multiple similar businesses in your area that you can compare your business to.
Income-Based Valuation Methods
The shortcomings inherent to market-based valuation lead many business owners to income-based valuation techniques. These methods pin the value of a company to its expected capacity to earn revenue in the future.
One of the most common forms of income-based valuation is the Capitalization of Earnings method. In short, this technique calculates a company’s worth by taking the business’s discretionary cash flow and dividing it by the capitalization rate.
If this sounds like a bunch of technical mumbo jumbo to you, don’t worry. To make it simpler, you can think of discretionary cash flow as simply the capital available to a business that, if withdrawn, will not impact the operations or longevity of the business.
The capitalization rate, on the other hand, refers to the net income that an investment property is expected to generate.
Although the Capitalization of Earnings method may be the most accurate method of finding how to valuate a small business, it should only be done in consultation with an accounting professional. Since the slightest miscalculation of your cash flows or cap rate can result in thousands of dollars in lost revenue, you should leave this method to the pros.
What You Need to Know: Tips and Tricks
Most business owners already have enough work on their hands—the last thing they need is more technical work to add onto their growing list of responsibilities. That’s why we put together this quick breakdown of some of the most important business valuation tactics to help you make an informed valuation without any hassles or heavy lifting.
Know Your SDE
One of the most under-appreciated aspects of business valuation is a tool referred to as a Seller’s Discretionary Earnings (SDE). Similar to EBITDA, a business’s SDE provides a snapshot summary of a business’s true value. However, unlike EBITDA, SDE adds in the business owner’s salary and benefits. For this reason, SDE figures are always higher than EBITDA.
Your business’s SDE says a lot about the profitability of your small business. We emphasize the term “small business” here because, unlike EBITDA, SDE is commonly used by startups and new businesses because small business owners often expense their personal benefits. When buying or selling a small business, SDE figures must be included.
Know Your Assets
You can’t possibly know the true worth of your company without taking stock of your assets. The combined value of your assets should provide you with a crude estimate of your business’s value, which you can then use as a starting point during negotiations with buyers or investors.
Start by making a detailed list of the resources that comprise your business. This list should include everything from standard tangible assets and liabilities to intellectual property, investments, and cash reserves. If you’re unsure of what to include, consider running your list by an accountant to get an objective, outside opinion.
Ensure that you also round up the various liabilities that your company may have. The value of these liabilities should be subtracted from the total value of your business’s assets. Common business liabilities include:
- Business loans
- Outstanding credit card debt
- Notes payable
- Accounts payable
- Unearned revenue
- Accrued expenses
Know Your Market
Knowing how to value a business begins with understanding the value of similar companies within your industry or niche.
Fortunately, you don’t need to spend all your waking hours investigating how much companies are going for in your industry. Instead, there are handy tools available online to help you find out the going rate among comparable businesses.
If you’re a public company, you can review other publicly-traded business’s quarterly and annual financial reports online. However, industry-specific databases like Crunchbase regularly post updates on business ownership transfers in the tech industry—tools like these provide a competitive edge when learning about your market.
Master the Multiplier
The final step in learning how to value a business is to find out what your SDE multiplier is. This figure ranges between one and four and is the amount that you should multiply your SDE by to find out how much you should sell for.
The exact figure will vary by industry type and company size but will likely require consultation with an external expert to arrive at.
However, once your SDE and multiplier are narrowed down, you can find your business’s estimated value by simply plugging the figures into the formula below:
Estimated Value =
(SDE) * (SDE Multiplier) + (Accounts Receivable) + (Real Estate) + (Cash Reserves) + (Other Assets) – (Total Liabilities)