Businesses of all sizes, especially those that have existed for decades, impact their communities in their own way. But, despite their positive influence, the value of a business will increase and decrease over time owing to various economic, social, and political factors.
Appraising a small business's value should not remain a mystery to any business owner. Knowing the numbers, even if there is yet to be a current plan to sell the business, is the key that opens future opportunities. It becomes hard to make strategic decisions without understanding how much the business is worth.
If you’re in the market to understand the valuation of the business, there are different approaches to consider, all with pros and cons.
Read on further to learn about these valuation approaches, what they entail, and how they will impact your business.
Why is a business valuation important?
First, many business owners' biggest question is why this business valuation is so important. What can it do for the business? It boils down to the fact that a business valuation is a good indicator of the company's health.
Of course, it’s the key to fair pricing for those looking to sell the business. If the business is not getting sold, there are other situations where having a business valuation is essential:
Planning for retirement
Strategic decision planning
Increasing the value of the business
Securing funds from potential investors
Creating employee ownership plans
Determining estate value (family-owned businesses)
Methods for Business Valuation
There is no “one size fits all” way to valuing a business. Ultimately, the value of the business comes down to how much someone is willing to pay for it, which will change from person to person. However, knowing your company's valuation will be the first step toward more productive negotiations with prospective buyers or investors.
On the other hand, as a prospective buyer, it’s important to prepare a potential independent valuation for a business you hope to acquire. Having such information prepared before any meetings with the seller will help come to an agreement faster.
So, while considering all of this, let’s review the most common approaches to valuing a business.
Asset-Based Method
This simple approach is calculated by taking the assets' value and subtracting the liabilities' value. It boils down to finding the difference between what the company owns and what it owes. A good place to start is the balance sheet which will provide asset information such as machinery, automobiles, and inventory.
The idea behind the asset-based method states that to start the same business, you’d have to buy the same items. As a result, the value of the business should be at least the replacement cost of those items - almost like liquidation.
Though the method sounds simple, it is not used for businesses with a healthy cash flow. Profitability or growth opportunities present in the company is not considered, making retail businesses better for this method.
Seller’s Discretionary Earnings
The most common method, SDE, finds companies with similar size, revenue, profit, and in the same industry and at the price they’ve recently sold for. This gathered information helps make correct comparisons and come to the industry multiple. From there, the industry multiple is applied to the adjusted earnings to get an estimated baseline valuation.
The risk profile will change the multiple, directly affecting the company's desirability. Company risk is influenced by:
Business age
Growth profile
Scale
The time necessary to manage the business
Predictability of revenue
Capital intensity
Customer concentration
Margins
Since this is the most used method, it’s worth taking the time to run through an example.
Let’s assume the company has a net income of $2 million, and the business owner pays themselves $200,000, with an additional $100,000 in add-backs - personal one-time expenses not necessary to run the business. Most of these expenses include owner’s health insurance, retirement contribution, and others - including depreciation and interest. This makes the seller’s discretionary earnings.
Armed with the information above, the adjusted earnings comes to $2.3 million. For the sake of the example, let’s assume market research led to a hypothetical 3.25 average multiple, making the valuation a total of $7.48 million.
Though the example above may be oversimplified, it provides a good understanding of how the method works. Of course, the various valuation methods are not perfect, and neither is the market approach, but it does provide a good high-level perspective and starting point for negotiations.
Income Method
The income method is best for businesses with high projected earnings and lower risk. This method will take the company’s current, past, and potential future earnings and incorporates the underperformance risk.
Using this method means considering many projects and “what if” scenarios, making it not the best strategy in many scenarios.
Market Comparison
This method is akin to figuring out the list price for a home you’re trying to sell. Use market research to find similar companies within the area and the prices they’ve recently sold for.
Finding a close comparison, however, takes work. Small businesses don’t always make certain information available to the public. Small business sales also don’t happen as often as sales of homes, making the information that much harder to come by. A business broker like those with Smobi could point you in the right direction.
While conducting research, the search needs to include businesses with comparability factors. These factors include industry, amount of employees, the number of customers, and the length on the market.
A good example is comparing two dentists in different medical offices or hairdressers in the same town. If one of the businesses sold for around $600,000, it’s easy to assume that another would also.
Do Business Valuation Methods Have Limitations?
Yes! The first and biggest limitation is the fact that these methods are all based on estimates. Estimates bring a margin of error in either direction, which means a business can be over or under-valued.
The second limitation is that the method produces an estimate rather than an actual amount. The numbers produced by these methods are only a starting point for potential negotiations, whether it’s with a buyer or a potential investor.
Is One Method the Best?
Different factors will determine which method is the best to use. The goals and the type of company are the two largest factors that push toward one method over another.
Don’t discount specific scenarios that push a company toward getting a valuation:
Liquidation
The asset-based method is the best for this since it essentially calculates an estimated amount of worth based on assets and liabilities.
Growth Potential
SDE is the most favorable in this situation because it looks for the company’s future potential.
Accuracy
Businesses prefer to use the income method for this particular scenario since the valuation looks at current and future cash flows.
There is no one right way to answer the question of how to value a small business. The methods available to businesses cover many situations a business might encounter. Business owners need to remember that no matter the number they receive from these methods, they are estimates to bring to negotiations.
Quick Estimate
A couple of the valuation methods mentioned above would work in this scenario, except for the market comparison. This particular method would require more work, unlike income or asset-based.
How to Obtain an Estimate?
Now that you understand the methods available to businesses, the questions turn to the next steps.
Businesses with less complexity and all the documents available may find a do-it-yourself approach a good next step. Of course, this is one of the best options for those looking to go down a cost-saving path, but there are pitfalls.
To help with these pitfalls, plenty of online tools exist to simplify the process. However, don’t pick the first tool you come across. This step will require some research as well. For example, any business owner taking this route needs to ensure the program uses the method they’re comfortable with. Look for reputable sites with years of experience under their belt and a decent client base.
Unfortunately, larger businesses with more complexity may not find this an easy process to work through a do-it-yourself route. Instead, the best route may include professionals with years of experience.
Bottom Line
When all is said and done, business owners will want to ensure their business is valued fairly, especially during an upcoming sale. But, even if it’s for decision-making purposes or to find an investor, valuing a small business is immensely helpful for future growth.
The key is to keep a level head and remove emotion as much as possible from the process. All business owners love their companies after spending years pouring their heart and soul into the business, but others might not see it that way.
For sale situations, the best is to find professionals with the expertise to walk a business owner through the process. Whether you’re a buyer or seller, Smobi has the right professionals to make the sale or purchase process as painless as possible.