Even if you are pleased with the results, the value of your business isn’t a vanity metric. Done properly, a small business valuation is crucial if you plan to sell, merge, or buy out partners or other owners.
It can also be beneficial when applying for a business loan, going through a major life event, or offering equity to your team.
The key is to learn how to conduct a business valuation properly. The right method depends on the business size and purpose for the valuation.
Getting to know the most common methods and how the outcomes can differ is crucial for corporate executives, small business owners, and everyone in between.
The Importance of Knowing Your Business’s Worth
There are a few reasons you may need to know your business’s value. These include:
- Full understand business growth
- You are selling your business
- Bank loans are needed for the business
- You plan to sell stock
- You want to attract investors
It’s also important to know business value when you look for franchises for sale. You don’t want to invest in a franchise that’s value is subpar.
The most common reason to conduct a business valuation is for sales and investment purposes. When you have a value put on your business, it means you can tell bankers, buyers, stakeholders, or investors that your business is worth a certain amount.
Once you have the value, you can also let them know what is needed for a certain percentage of the business and other necessary information.
Business valuation is crucial for buyers and investors. It’s also necessary to have evidence of business value to gain interest and attention from those who have the financial capital you need.
If you cannot show an investor what your business is worth, they won’t know what makes a reasonable investment.
Understanding the Business Valuation
If you are a natural-born number or businessperson, you can likely handle the business valuation process independently. For everyone else, this usually isn’t the case.
However, for those who want to try their hand at determining the value of their business, there are a few important terms they must know first. You also need to get to know the various methods you can use, which are highlighted here.
Seller’s Discretionary Earnings
If you understand EBITDA, you likely know what the seller’s discretionary earnings or SDE are. This is true even if you haven’t ever heard the term.
EBITDA or earnings before interest, taxes, depreciation, and amortization is the net profit of your business.
Like EBITDA, you calculate SDE to determine your business’s true value for a new owner. The SDE includes expenses such as the income you are reporting to the IRS, your non-cash expenses, and any other revenue your business earns.
However, SDE can also be slightly different. You will add the owner’s benefits and salaries into the SDE calculation.
Larger businesses and corporations usually use EBITDA calculations for business valuation, and smaller businesses use SDE. That’s because small business owners usually expense their personal benefits.
It is essential that a potential buyer fully understands SDE, too. Usually, business owners will provide this number, so it is important to understand how the business owner achieved the value fully.
Calculating Your Business’s SDE
Begin with your pre-interest, pretax earnings. Once you have these numbers, you can add in purchases that aren’t crucial to your operations, such as travel and vehicles that you report as business expenses.
SDE can also include your salary, one-time purchases, charitable donations, and employee outings. Sometimes, buyers will request information regarding your business’s discretionary cash flow when you provide your business valuation. Make sure you have access to the value of every main purchase or expense.
Also, you need to consider further payments and current debts, which are called liabilities. These are subtracted from your total net income.
The Impact of SDE Multiples
The SDE provides the monetary value of your business. However, the SDE multiple values your business based on current industry standards.
Usually, small business owners need to use SDE for business valuations rather than EBITDA. That’s because most owners will pull a significant percentage of business revenue for their living expenses and salary.
There is a different SDE multiple used for each industry. The SDE multiple you use is based on things like business location, company size, volatility, assets, and the risk associated with ownership transfer.
The higher the SDE multiple is for your business and industry, the more your business is worth.
The market-based valuation method doesn’t depend as much on the actual business as it does on the current market conditions. With this valuation method, your business’s current value is determined by looking at the sale prices of comparable businesses.
It can be challenging to find relevant comps if you run a small business. While this is true, it is still a good idea to search for a few comps if you plan to sell or buy a business.
If you hire an appraiser, they could also access more comprehensive databases with more relevant findings.
Even when the comps are not in the same area, appraisers can find similar-sized businesses in your industry and make area-based adjustments.
Discounted Cash Flow
The DCF discounted cash flow method focuses on your business’s income. It uses your business’s projected further cash flow and the value of the money now to determine its current value.
If you have a business that is expected to grow or shrink significantly in the coming years, using the DCF method is smart.
The time value of money concept focuses on the fact that money is worth more now than it will be in the future. For example, if you have $100 now, you can invest it, earn interest, and have more than that in five years.
The DCF model considers this, which is why it is beneficial when comparing different investment opportunities.
While the calculations to determine this can be complex, you can find online calculators to help with this. You still have to find the proper numbers to use in the calculator.
One place to find these numbers is on your cash flow statement. You can also look at projected cash flows if you have them readily available.
You should also consider the discount rate or the weighted average cost of capital, which requires more complex calculations.
Capitalization of Cash Flow
The CCF method is a simpler income-based method. To determine your business’s value using this method, divide the cash flow from a certain period by the capitalization rate. It’s a good idea to use a single period’s worth of recurring and sustainable cash flow from your business.
You may have to adjust if you had a one-time expense or income event that you don’t want to be considered in the results.
The cap rate (capitalization rate) is your business’s expected return rate. It is the rate of return buyers can expect to see if they buy your business. Usually, for small businesses, this is between 20% and 25%.
Adjusted Net Asset
The asset-based valuation is a fairly straightforward process if you keep your balance sheet in order. This is because it will usually mirror what is on your balance sheet.
The first step in this process is to add up the total value of your business assets and then subtract the liabilities to get the beginning value.
To get a more accurate valuation, it may be necessary to put a bit more thought into the numbers. This method requires you to use your business knowledge and the current market state to adjust the value of your assets and liabilities.
If you value a company that is losing money or that doesn’t have any earnings, using this method is recommended.
Tips to Prepare for the Business Valuation
When conducting a business valuation for informal purposes, having some tips can help.
While this is true, hiring a professional appraiser or valuation expert is also a good idea. This is going to ensure the process is done properly.
Some other tips that are going to help you prepare for the business valuation can be found below.
Get Your Documents Organized
Each business valuation will be based on your business’s finances (to some degree). This is true regardless of what business valuation method you use.
Because of this, you need to have three to five years’ worth of financial statements and business tax returns. Other documents you may require include your cash flow statement, income statement, and balance sheet. Make sure you look over these documents to ensure everything is updated and accurate.
Take an Inventory of Your Business Assets
You may believe you can determine the value of your business and have a specific number. However, it is really more of an estimate.
As the seller, you have to put some type of number on your operations. This is especially the case if you want to receive fair compensation for what you have worked hard to build.
The best thing you can do is to make a list of your resources, property, and production assets. You should also include any intellectual property, employees, investments, and cash.
You can use the list you create as the “cheat sheet” for your business’s projected value to potential buyers. This is yet another chance to get help from professional advisors. They can provide more insight into your business assets from a third-party, objective viewpoint.
You have two basic types of assets to consider. These include:
When you begin the business valuation process, you will have to determine your business’s material holdings and resources. Some examples of this include:
- Cash on hand
- Real estate or property
- Stock or inventory
- Means of production or equipment
Each of these plays a huge role in your business valuation.
Intangible assets are non-material assets that add value to your business. These are an essential part of determining your business valuation.
Some of the intangible assets to consider include:
- Subscriber base or customer loyalty
- Trademarks, copyrights, and patents
- Reputation and brand
- Other intellectual property
Along with assets, you must also figure your liabilities.
Learn More about Your Industry
Being familiar with your industry is essential for sellers and buyers. Before someone can make an offer on a business, they must understand the industry.
Understanding industry trends will help sellers reach an accurate valuation that reflects their assets and the current market.
Looking at comparable businesses will help you better understand the market and provide more context about this sector. Also, understanding like companies will help you assess the market share and your overall growth potential.
At this point, you can show potential buyers why your business stands out from others.
Now You Know How to Determine Your Business Valuation
If you need to determine your small business valuation, the tips and information found here should help you with this. While the process will require time and effort, taking the right steps and using the right methods will pay off.
If necessary, hire a professional to help with this determination. This is going to ensure you determine an accurate and fair valuation for your business.
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