If you are thinking of selling your small business, one of the most important questions you need to answer is: how much is it worth? Valuing your small business can be challenging, as there are different methods and factors to consider. In this article, we will explain some of the common ways to value your small business and how to choose the best one for your situation.
One way to value your small business is to compare it with similar businesses that have been sold or are for sale in the market. This method involves finding out the sales price, revenue, profit, or other metrics of comparable businesses and applying a multiple or ratio to your own business. For example, if the average sales price of similar businesses is 2.5 times their annual revenue, you can multiply your revenue by 2.5 to get an estimate of your value. The advantage of this method is that it reflects the current demand and supply in the market. The disadvantage is that it may not account for the unique aspects and potential of your business.
Bank lenders use multiple methods to approximate the value of a small business being acquired. Historical financial statements are analyzed for revenue and profitability trends and benchmarks. The buyer's future performance forecasts also impact valuation projections. Comparable market sales provide valuation multiplier guidance. Goodwill and intellectual property strengths are evaluated. By blending financials, growth plans, market value, and intangible assets, lenders derive a worth estimate to properly underwrite lending for the buyer. A rigorous yet nimble process enables prudent lending decisions.
One of the major flaws in the market-based method is that details of small business sales are not always readily available, and they don’t occur as often as home sales. When searching for comparability, consider factors like industry, the number of employees, and the number of customers. The value of a business will fluctuate depending on what’s going on both inside and outside of it. Also, it's important to keep in mind that most small business valuation methods don’t consider the volatility in the economy.
If you're valuing a business to sell, then market comparisons are valuable, but they need to be transparent. Two companies with similar turnover and profit can still be run in very different styles. One which is very sustainable and set up for growth, one which is constantly firefighting in order to maintain that profitability. It is imperative that market valuations look behind the profits to these other factors.
Another way to value your small business is to project how much income it will generate in the future and discount it to the present value. This method involves estimating the cash flow, growth rate, and risk of your business and applying a discount rate to calculate the net present value. For example, if your business is expected to earn $100,000 per year for the next five years and the discount rate is 10%, your value is $379,000. The advantage of this method is that it reflects the profitability and potential of your business. The disadvantage is that it relies on assumptions and forecasts that may not be accurate or realistic.
It is clear that one way to really be "built to sell" and to reduce buyers risk is to try to guarantee that revenue as much as possible. Membership payments or ongoing d/d revenue with agreements in place holds a lot of weight with buyers over ad hoc purchases. This is commonplace in the spaces where we work with owners (health and wellness) but the "membership mindset" can actually be applied to many businesses.
Great point on the income-based approach. Assessing my small business' future earning potential through discounted cash flow analysis is crucial. Estimating future income based on current profitability and reasonable growth projections, then applying an appropriate discount rate, allows me to quantify the present value of future gains. While forecast assumptions may vary from actuals, this method incorporates my business' full financial potential into its valuation. Evaluating from multiple perspectives provides a comprehensive estimate to inform negotiations. A multilayered process empowers informed, strategic decisions.
This method will appeal to buyers. It’s a straightforward way for them to determine how long they have to run your business before their investment is laid back to them. Even without saying it, most buyers will take this approach.
A third way to value your small business is to calculate the total value of its assets minus its liabilities. This method involves adding up the fair market value of all the tangible and intangible assets of your business, such as equipment, inventory, goodwill, trademarks, and patents, and subtracting the total amount of debt and obligations. For example, if your business has $500,000 worth of assets and $200,000 worth of liabilities, your value is $300,000. The advantage of this method is that it is simple and objective. The disadvantage is that it may not capture the earning potential and competitive advantage of your business.
This method won't work for a professional services company, where the greatest asset is the knowledge and experience of the service provider. There is no objective way to measure the value of a person's professional training, except how they apply that expertise to the business and the results it has achieved.
The asset-based method offers a straightforward way to value a small business based on tangible and intangible property minus liabilities. While simple in calculation, assessing each asset's fair market value takes due diligence. We must remember that there is much intangible assets in consulting and service businesses where this method would not work. We must also understand in consulting and service based businesses, who holds the relationships with the customer base. The seller? A key employee? Due diligence to dig in what the actual end story will be for the proposed new owner. Many service businesses today fail to train up key employees. There is no value when the owner exits the business. He or she is the business.
There is no one-size-fits-all method to value your small business. The best method depends on the type, size, stage, and industry of your business, as well as the purpose and context of the valuation. For example, if you are selling your business to a buyer who is interested in its future earnings, you may want to use the income-based method. If you are selling your business to a buyer who is interested in its assets, you may want to use the asset-based method. If you are selling your business in a competitive market, you may want to use the market-based method. You may also want to use more than one method to get a range of values and compare them.
Seek out specialist help. If you want a valuation for sale, talk to an experienced broker in your area. If your valuation is because you're issuing shares to employees, talk to your tax accountant. If your valuation is needed because you're struggling to keep going, get help as soon as possible from an insolvency practitioner. Get the advice you need for the situation you are changing.
When considering the value of your business, you should consider it's value to you but also the value to others. If a plc is offering you a multiple of 4 X earnings but their own valuation offers a multiple of 18 X earning then you know you have room to negotiate.
It's important to note that valuing a business is subjective, and the final value will depend on multiple factors, including the purpose of the valuation, market conditions, growth prospects, industry trends, and the specific characteristics of your business. Consulting with professionals and considering multiple valuation methods can provide a more comprehensive view of your business's value.
Valuing a business from a financial aspect has merit. However, some intangibles make it challenging to price. The historic district of Tampa preserved property that a property appraiser might say is better torn down for the land beneath, yet the history is a nostalgic valuable beyond any price. I keep reminding those I coach that there is a gap between price and value. We can come up with any price, but value is in the eye of the beholder. A verse in the Bible says, "Again, the kingdom of heaven is like a merchant seeking beautiful pearls, who, when he had found one pearl of great price, went and sold all that he had and bought it" (Matthew 13:45-46). If no one knows the pearl is hidden there, they will undervalue the land.