What’s the value of your small business? Simple answer: whatever someone will pay for it.
The valuation of your business tells the story of its financial success. Even if you’re not planning to sell your small business, you might need to know its valuation when applying for a loan or seeking a potential investor. And if you are looking to sell, setting the right price is critical to a timely selling process that also provides you maximum value.
Experts will argue on how best to value a business, but these are three of the most popular ways:
Method 1: Assets after debt
One of the most straightforward ways to appraise a business is to examine the value of what the company owns – but don’t forget about what it owes.
Accounting 101 tells us that assets are anything of value that a company owns, and liabilities are anything that it owes. Under this method, the business valuation will be the difference between the two.
While simple, this method isn’t perfect because it doesn’t explicitly consider profitability or growth opportunities for the company. Still, retail businesses are a good fit for this method because they have more substantial assets on hand compared to service businesses. Service business owners, skip to method two.
It’s also the best method for companies looking to close down shop and sell all of their assets individually, called liquidation. Think of this as the equivalent company valuation method to calculating the cost of a car that’s only good for spare parts.
A company’s balance sheet will show asset book value, which is how much the business paid for the assets less any depreciation, but remember, some assets might not be worth the same today. These assets will need to be adjusted from book value to market value.
Assets like inventory probably won’t need any adjustment, but others, like land and accounts receivable, might need a second look. Find out the current selling price for assets similar to yours to find the market value.
Let’s say you own a small boutique that makes and sells women’s clothing and accessories with a balance sheet that says assets are worth $600,000. You bought the land your boutique sits on five years ago for $300,000.
Since land never gets depreciated, its value on the balance sheet hasn’t changed since then. But an empty lot next to yours that’s similar in size just sold for $500,000 last week. When calculating business value, your land will count for $500,000, its market value. That increases your total assets by $200,000.
Asset-based valuation doesn’t expressly incorporate a company’s profitability or its opportunity for growth. Still, it can be expressed through intangible assets, things of value you can’t see or touch. Certain intangibles might not even be on the business’s balance sheet before valuation.
For example, over the years, your boutique might have accumulated a list of 2,000 customer email addresses for your monthly newsletter.
A potential buyer of your business will want that contact information and might pay $5 per name to own it, so $10,000 gets added into the market value of your company’s assets.
Goodwill, another intangible asset, also gets added to the valuation of your small business. If your boutique is widely recognized in your community, a potential buyer will want to pay an extra $50,000 to buy your store because of its proven track record and loyal customer base.
That additional $50,000 they’re willing to pay is your company’s goodwill.
The reason intangible assets might not already be on your books is that you created them: Unless you bought someone’s customer list or entire company, you wouldn’t find these items on your balance sheet.
Now that you’ve tallied the adjusted value of your assets, round up all debts: accounts payable for bills from vendors; notes payable for written promises for payment; and any other outstanding liabilities.
Liabilities rarely need to be reassessed, so this part should be easy if the company has mastered the bookkeeping basics. For the boutique example, let’s say liabilities add up to $35,000.
After calculating the adjusted value of the business’s assets, subtract all debts to arrive at the company’s value.
With your boutique, your book value started at $600,000. Add the adjustment to land for $200,000, a customer list for $10,000, and goodwill for $50,000.
The market value of your assets is $860,000. After taking out the company’s debt, which is $35,000 according to the balance sheet, the company’s worth is $835,000.
Method 2: Seller’s discretionary earnings (SDE)
The SDE method emphasizes profitability and cash flow, often seen as the pulse of a small business.
This method works well for service companies because the calculation does not favor businesses with lots of assets, like retail businesses. Instead, it focuses on a strong income statement.
According to accrual basis accounting, which most businesses should employ, revenue and expenses are recorded when earned and incurred, not when money comes in or out.
SDE refers to the company’s annual income before tax, noncash expenses (think depreciation), nonoperating expenses (think interest on loans), large one-time expenses, and the owner’s salary.
SDE ignores expenses that either don’t affect cash, are unusual, don’t affect the main course of business, or would otherwise artificially deflate how profitable a company appears.
To find the value of a small business, multiply SDE by a number between 2 and 3.5, depending on a variety of factors that include market risk, the company’s future profitability, and an industrial or geographical standard.
Imagine that a hair salon in a large metropolitan area is looking for a buyer, and you’re interested. According to its income statement, the owner reports annual revenues of $500,000 and operating expenses of $300,000 for an operating income of $200,000.
By looking at the company’s general ledger, which lists all company transactions, you learn that the owner’s salary is $100,000 per year, and the company bought 10 new industrial hair dryers last year that cost $15,000.
The company’s SDE will be $200,000 + $100,000 + $15,000 = $315,000. We’ll conservatively estimate that SDE is 2.75, which is right in the reference range.
Under the SDE method, the company’s valuation is $315,000 * 2.75 = $866,250.
Method 3: Market comparison
Valuing your business can look a lot like determining your home’s list price. If similar businesses have recently sold in your area, their selling prices will show you how to value your company. It might even be the most accurate yardstick you can find to value a business.
Close comparisons are tough to find, though. Details of small business sales are not always readily available, and they don’t occur as often as home sales. It’s still worth talking to a business broker who might have some of that information.
When searching for comparability, consider factors like industry, the number of employees, and the number of customers.
Consider two dentist offices with suites next to each other in a medical office building. Both dentists do the same work, employ the same number of people, charge similar rates, and have the same traffic.
One dentist retires one month before the other, and her practice sells for $500,000. It’s likely the other dentist will sell for a similar amount.
Consider the market
The value of a business will fluctuate depending on what’s going on both inside and outside of it. Most small business valuation methods don’t consider the volatility in the economy. In recessionary times, the value of most small businesses will decline, and in expansionary times, the opposite is true.
What remains constant in these methods is the importance of solid financial accounting practices, which can be honed through using accounting software and studying bookkeeping basics. Accurate financial reporting gives you the best shot at a reliable business valuation.