There comes a time for every business owner when you must take stock of what you have built and use that information to guide your next steps. Valuing your company can be a vital part of that process, and while the math can be relatively straightforward, there is often more to it than meets the eye. To show you what I mean, in this post, I will explain how to value a small business.
Note: aside from a few nuances (which I will point out), these valuation methods apply to companies of every size. What matters is why you want to perform a valuation in the first place because your answer will affect your approach.
Reasons for a Small Business Valuation
Business valuations are useful for many purposes. And it is always best to be reasonably confident in your findings. But in some cases, a ballpark figure will do. In others, it is vital to consider every detail. For instance, here are a few situations where a valuation might be necessary, loosely ordered from those where a relaxed approach might do to those that require rigor:
- Internal use – as part of your key performance indicator (KPI) dashboard
- For insurance, estate, or gift tax planning
- Exit planning
- Transfer of ownership – between family members or partners, for instance
- Proposed merger or acquisition
- Business loans
- Legal purposes – litigation, arbitration, divorce proceedings, etc.
- Venture funding
- Establishing a price for employee stock options
As you may imagine, the need for accuracy quickly ramps up with the stakes. For instance, a rough estimate might be fine for benchmarking or estate planning. But when determining how to value a business for sale, diligence is critical because your decisions today can dramatically affect future outcomes.
How to Value a Small Business – 3 Business Valuation Methods
Valuing a small business is part art and part science (math). The methods below explain the science. After we go through the math, I will provide insight into the art side of the process and what that entails. But, for now, let’s dig in.
Assets Minus Debt (Adjusted Net Asset Method)
One straightforward approach for estimating a company’s worth is to add up the value of all business assets, then subtract any liabilities. Here is a very simple example of what this might look like for a small retail business:
(Cash + Inventory + Real Estate + Depreciated Equipment Values) – (Accounts Payable) – (Outstanding Debts Owed) = Company Value
Although this method can be helpful in some circumstances, it is important to understand that all you are doing is calculating the company’s liquidation value. In other words, this is the amount of cash you would have left if you had to sell everything.
Suppose you do not plan to liquidate and are trying to determine how to value a small business in preparation for a sale, transfer of ownership, or capital-raising event. In that case, this valuation method will not accurately reflect business worth. Potential buyers or investors will be more interested in your company’s trajectory – the factors affecting its ongoing operations and success. The asset minus debt method ignores such factors.
For public companies, a comparative approach is market capitalization. That is where you estimate a company’s value by multiplying the number of shares outstanding by the current stock price. Again, this is a decent method for getting a ballpark, but it doesn’t account for debt or other issues that could affect the company’s future.
Market Comparison (a.k.a. the Multiples Method or Market Approach)
When deciding how to valuate a small business, many rely on market comparisons, looking at similar businesses recently sold for price guidance. This method works as follows:
Step 1: Divide the selling price for a similar business by its revenue or a profitability metric, like EBITDA (earnings before interest, taxes, depreciation, and amortization). That will result in a “multiple.” For example:
- Comparable Company
- Selling Price (valuation) = $10.0MM
- EBITDA = $2.0MM
- Multiple – $10MM/$2MM = 5.0x
Instead of EBITDA, some small, owner-operated businesses can use Seller’s Discretionary Earnings (SDE) as a profitability metric. SDE = net income + owner’s salary + non-cash expenses + interest and taxes + other non-recurring expenses – non-discretionary expenses.
Step 2: Apply the multiple to the company you wish to value to get an estimate. To illustrate:
- Your Company
- EBITDA = $3.0MM
- Estimated Sales Price = 5 X $3.0MM = $15MM
Although this logical, rule-of-thumb approach works beautifully in some cases, you must use it cautiously. Here is why:
- The comparable companies must be quite similar. Those lacking valuation expertise may not have the insights necessary to confirm that this is the case.
- This method works best when you can develop an average multiple by looking at several equivalent companies, but that is not always possible.
- In certain situations, the multiples approach cannot work at all. For instance, some companies have tremendous potential due to intangible assets like proprietary methods or ground-breaking technology but no revenue. Zero times any multiple equals zero.
Income Potential (a.k.a. the Discounted Cash Flow Method)
The discounted cash flow method is arguably the most reliable approach to estimating a company’s value. It involves looking at a company’s cash flow projections, applying a discount rate to account for the risk of investing in the company vs. stashing those funds in the market, then working backward to calculate the company’s value in today’s dollars. The basic formula is as follows if you base it on three years of future cash flow.
Company Value = (Cash Flow Year 1 / (1+discount rate)) + (Cash Flow Year 2 / (1+discount rate)) + (Cash Flow Year 3 / (1+discount rate))
The discounted cash flow method is great for companies that expect to grow and scale because it is flexible and allows you to factor in future earnings. That is important if you are raising capital or selling the business because you must show potential investors that they will receive an ROI.
Of course, the challenge with this approach is that it requires realistic cash flow projections and an appropriate discount rate. Arriving at these figures is not easy.
Although discounted cash flow works well for growing businesses, for companies with more stable and reliable profitability projections, we sometimes prefer simpler methods, such as capitalization of earnings.
The Art of Small Business Valuation
The art side of small business valuation comes into play when a ballpark figure won’t do. When this is the case, consider working with a professional who will know which mathematical approach is right for your situation and how to improve accuracy by weaving in other factors.
Those offering business valuation services typically have first-hand experience. They have bought, built, and sold their own businesses or worked as business brokers, so they understand what you are going through and know when and how to get creative. They will walk you through their process, but below are a few things you can do to prepare. And if you have hung with me this far, congratulations because you have probably already taken the first two steps.
1. Familiarize Yourself with the Lingo
When pursuing a small business valuation, you will encounter many terms you may not have heard before. Skimming through the methods above will help you become familiar with those terms. That will empower you to enter conversations with a professional from a place of knowledge.
2. Set Realistic Expectations
Even if you know you will need help, it is good to do some light research beforehand so you can come to the table with relevant information and smart questions. Explore similar businesses in your industry and perform simple calculations. Then, connect with a professional when you are ready to test your assumptions and potentially move forward.
3. Perform the Necessary Prework
The main challenge with a purely mathematical approach to business valuation is that you only get part of the picture. To pursue funding or put your business up for sale, you must scrutinize the company through the lens of a potential investor. A professional will help, of course. Here are some questions they might ask to explore your company’s health and growth potential.
Do you have a strong, reputable management team, or does it need work? Do you expect this situation to change as your company evolves, potentially acquiring funding or selling the company? Whatever the case, document your strategies and plans for easy sharing.
Do you have the right infrastructure to keep your business running smoothly today and in the future? For example, do you have a reliable system for maintaining and producing accurate financial records (income statement, balance sheet, cash flow projections, etc.)? Know your strengths and vulnerabilities and be ready to explore them with your advisor.
What does your customer mix look like? How do you price your products or services? Do you have a large amount of recurring revenue? And what are the strengths and weaknesses of your approach? Factors like these affect your valuation, so it is best to think this through.
- Products and Services
What do you offer that your customers cannot get anywhere else? What is your vision for the future? Update your product roadmaps and other plans to show how your business will grow.
Who is your target audience, and what have you been doing to reach them and convert them into paying customers? What has been working, what has not, and which opportunities do you plan to pursue next?
Preparing for these questions before engaging a professional will make the discussion more productive. For more details and insights into what a potential buyer or investor looks for, download our “What Investors Really Want” guide.
How to Value a Small Business: The Bottom Line
Learning how to value a small business is worthwhile for any business owner or CEO, especially if you only want a ballpark figure to benchmark against in internal meetings. But it is best to work with a professional when you are ready to pursue funding, prepare for an exit, or need an accurate assessment for other reasons.