Tips on Valuing a Small Business When Buying or Selling

Tips on Valuing a Small Business When Buying or Selling

Not sure where to start with a small business valuation? Unless you’re an accountant or specialize in buying or selling small businesses, it’s not something most people will have experience with. Even still, it’s a great skill to have and can be easy to do if you follow a few rules of thumb. In this article, we’ll break down the basics so you can start performing your own calculations right away.

Know When and Why to Perform a Small Business Valuation

There are many reasons you might want to perform a small business valuation. You may need to if you’re:

  • Applying for a loan or line of credit
  • Trying to attract investors
  • Buying out your partners
  • Engaging in tax planning
  • Trying to understand your business growth better
  • Considering selling your business
  • Planning to sell stock or offer employees equity

Gather What You Need to Perform a Small Business Valuation Ahead of Time

Depending on which valuation method you choose, you’ll likely need a variety of documents handy.

  • Three to five years of business tax returns
  • Three to five years of financial statements (balance sheet, income statement, cash flow statement, etc.)
  • List of tangible business assets (cash, property, equipment, etc.)
  • List of intangible assets (copyrights, patents, trademarks, licenses, etc.)
  • Sales reports
  • Business plan
  • Industry forecasting documents

Bear in mind that even things like the business brand, reputation, and customer or subscriber base can have an impact on the overall valuation. You might even be able to argue that your low employee turnover rates increase the value of the business, as a new owner will have highly trained employees on board to create a smooth transition. However, if you’re considering including these and don’t have experience with business valuations, it may be better to hire a business valuation expert or have a professional appraisal performed, as an improper valuation can cause future financial issues or damage your reputation.

Choose the Right Valuation Method for Your Situation

There are many business valuation methods. Each is used in different circumstances and has its own pros and cons. Below, we’ll give a quick overview of the five most popular. The first four work for businesses of all sizes, while the final method is just for small businesses.

Adjusted Net Asset Method

If your balance sheet is well organized, using the adjusted net asset method is straightforward. For example, you might use this method if you’re valuing a company that is losing money or one that has modest earnings. In addition, small-business owners sometimes use the adjusted net asset method to set a floor price when selling a business. It’s also used to determine the value of a company that has real estate or serves as a holding company.

To use the adjusted net asset method, you’ll simply add up all your assets and then subtract your liabilities. However, the “adjusted” component comes in because you’ll also spend more time ensuring your asset valuation is accurate. For example, your receivables are an asset you’d include in your valuation, but if you know certain receivables aren’t going to be paid, you’ll subtract them. You’ll also need to take depreciation into account.

Capitalization of Cash Flow Method

There are two common ways to determine business value based on income. The capitalization of cash flow (CCF) method is the simpler of the two. It’s more often used with mature companies that don’t see significant cash flow shifts and are experiencing steady growth. You’ll need to know the business’s expected rate of return, also known as a capitalization rate or cap rate. You’ll generally narrow your numbers down by a set period of time, such as a quarter or year.

Cap Rate = Net Operating Income / Current Market Value

Most small businesses will have a cap rate of 20-25 percent.

From there, you can perform the final calculation: Business Value= Cash Flow / Cap Rate

Discounted Cash Flow Method

The second and more complex income-based method is the discounted cash flow (DCF) method. It’s unique in that it considers where a business might be years from now, so it’s used more with companies that are experiencing rapid growth and those that are reducing in size. So, for example, if you’re running a startup that isn’t profitable yet, but you think it will be soon, you’ll probably want to choose this method. You might also prefer to use the DCF method if you’re comparing multiple companies and want to gauge which one will deliver the most return on investment (ROI).

This calculation typically uses the weighted average cost of capital (WACC) as a discount rate in the formula.

If you’re only looking at one year, the formula is: DCF = Yearly Cash Flow / (1 + Discount Rate)

The same formula can be added to itself as many years as you’d like, substituting the appropriate anticipated yearly cash flow in the first portion as you go.

Market-Based Valuation Method

There’s no official formula for the market-based valuation method. You’ll simply look at the purchase price of similar businesses in your area. If there haven’t been recent purchases or no businesses of the same size and industry have recently sold, you can sometimes look outside your geographic area too.

Seller’s Discretionary Earnings Method

The seller’s discretionary earnings (SDE) method is exclusively used in small business valuation. It might be your best bet if you’re a business owner presenting your company to potential buyers because it can help them better understand what they might earn. It’s similar to earnings before interest, taxes, depreciation, and amortization (EBITDA) in that it looks at the profit of a business.

To calculate business value using the SDE method, you’ll start with the business’s earnings before interest and taxes (EBIT). Then, you’ll add back in all expenses that relate to the current owner including salary, health insurance, and other benefits. You’ll also add back any expenses that aren’t related to the business as well as non-essential and non-recurring expenses. For example, if you’ve been claiming educational or trip expenses against the business, you would add those back in. As a final step, you’ll also subtract liabilities from your net income. This includes any debts you’re currently paying or will have to pay.

Sometimes prospective buyers will argue sellers are adding things back in that shouldn’t be in an effort to bring the estimation back down. For example, let’s say you sponsored a little league team this year and paid for their jerseys. Since it’s a one-time expense, you add it back in. The buyer might contend it’s part of an ongoing marketing campaign and that they’ll need to sponsor again next year. Any items such as this that come up for debate will need to be resolved before the valuation is set.

It’s also worth noting that professional appraisers will use multiples when working with the SDE method. Multiples vary based on the business, industry, and other factors and make it easier to see what a business is really worth. For example, it’s conceivable that a company that makes parts to repair VCRs could have the same value as a company that produces smartphone parts if you’re looking at a one-year snapshot. However, the company making VCR parts has a limited audience that’s only getting smaller while the smartphone parts company has room to grow.

Know When to Get Help and When to Pivot

If calculating a small business valuation is too complicated or a lot hinges on getting it right, it may be better to bring in a business broker or specialist in valuations. On the flip side, you may find that having a formal valuation performed is a bit more trouble than it’s worth or won’t help you if your goal is to secure funding. In this case, you may prefer invoice factoring. With factoring, you get instant payment on your B2B receivables that you can then apply to your business in the way that makes the most sense to you. To learn more or get started, request a free rate quote from Charter Capital.

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