The Ultimate Guide to Assessing the Value of Your Small Business
Ezra Cabrera | November 2, 2021
Key Takeaways
- Your tangible and intangible assets are the primary factors that will influence your business’ value.
- There are four ways you can calculate the value of your small business: income-based approach, asset-based approach, market-based approach, and the seller’s discretionary earning method.
- You have two choices on how to conduct a business valuation: either you do it yourself or you hire a professional appraiser. Having a credible appraiser value your business gives you hard evidence of how much your business is truly worth.
Business valuation is the process of estimating your company’s economic worth. There are many reasons why entrepreneurs need to assess this value, whether they plan to sell their company, buy another company, add new shareholders or apply for a bank loan. No outside investor, buyer or lender will commit to putting money into your business before knowing its market value.
This article will help you understand the factors that affect your business’ value and the different methods for calculating it.
What Are the Factors that Influence Your Business’ Value?
Let’s say you’re looking to sell your business. Potential buyers will consider several aspects when calculating the value of your company. Here’s a list of the primary factors that will influence your business’ value:
Tangible Assets
Tangible assets pertain to physical items that you can sell and convert into cash, like furniture, fixtures, real estate, equipment, company vehicles and inventory. The more assets your company has, the higher its market value.
When calculating the value of physical assets, always be sure to consider depreciation. For example, a piece of equipment that’s nearing the end of its life will not be worth as much to buyers as a brand-new piece of equipment. New owners may see depreciated assets as a liability that could lower the value of your business.
Intangible Assets
Intangible assets are not material in nature, but still have a heavy influence on your business’s value. Some examples include (but are not limited to): reputation, brand, trademarks, copyright, patents, recipes and, if applicable, independence from the previous owner.
These types of assets help to gauge whether a business is going to transition to a new owner successfully or not. Does the company have a strong built-in customer base that will remain loyal to the brand? There probably isn’t much value in buying a company with a bad reputation.
Franchises tend to have a high value because of their intangible assets – franchise rights, non-compete agreements, established brand, patents and goodwill, etc. – which is why many potential buyers prefer buying them versus independent companies.
Seller Financing
Seller financing is a loan that the current business owner can give to a prospective buyer to cover a portion of their company’s total purchase price – usually around 30% to 60%. Offering this to potential buyers can increase the value of a business as it essentially sweetens the deal.
Seller financing benefits both the buyer and the seller. For buyers, it provides access to funding for the purchase of the business for sale and usually results in a quicker transaction. For sellers, it adds purchasing incentive which can attract more buyers and drive up the sale price.
Loyal Customers
Strong client relationships are often formed through constant personal interactions. More often than not, local customers do business with a certain establishment because they have a good relationship with the owner. Keep in mind that if your customers leave, it decreases the value of your business; if they stay, the value increases.
In order to assess the value of your business in this aspect, you can ask your customers if they would still patronize your small business even if it were under new ownership. You can lower the risk of customer turnover by remaining on the transitional capacity for a few months after the sale of your business. This means that you remain an integral part of the company even after you’ve sold it. However, be sure to discuss this with the new owner before making any decisions.
Skilled Employees
Investors, buyers and lenders all want to know that you have a team of engaged employees that help you operate your business successfully. Having a reliable and highly qualified team can help improve productivity and efficiency, provide exceptional customer service and boost your bottom line – all of which significantly influences the value of your business.
Relationships with Suppliers
If you’ve had a positive relationship with your suppliers, you’ve likely received great deals and discounts. But what would happen if you leave the company? Will your suppliers offer the same perks towards the new owner? If so, that would add value to your company. If those deals were to dry up or if your suppliers were to back out once you sell, it would decrease your company’s market value. New owners don’t want to put in the extra time and effort to find new suppliers. If you’re planning to sell your company, take the time to ask your suppliers if they’d stick around.
The Four Valuation Techniques
- Income-based approach
- Asset-based approach
- Market-based approach
- Seller’s discretionary earnings method
Now that you have a better understanding of what effects your company’s value, let’s move on to how you determine what that value actually is. There are four techniques that small businesses can use to estimate their market value:
Income-Based Approach
The income-based approach calculates your company’s value based on its future income. This method uses a company’s financial history to project future profits. There are two main types of income-based methods you can choose from:
- Capitalization of cash flow method
- Discounted cash flow method
Capitalization of Cash Flow Method (CCF)
Best for: Mature companies with steady revenue streams and future growth potential.
The CCF method is the process of valuing a business based on current earnings and future profitability performance. When using the CCF method, you divide the business’ historical cash flow stream by the capitalization rate. The capitalization rate is the rate of return potential buyers expect to earn (excluding their salary) if they buy the business. This usually about 20% to 25% for small businesses.
Discounted Cash Flow Method
Best for: Mature companies with steady cash flow, and new businesses that are not yet profitable but have a lot of growth potential.
The DCF method is also based on future cash flows. It estimates the money an investor makes from an investment while considering the time value of money. The time value of money assumes that the money you have now will bw worth more in the future because of its potential earning capacity. For instance, if you invest $100 today and earn interest, you’ll receive more than a hundred dollars in the next five years or so.
When calculating your company’s value using the DCF method, you’ll need details from your projected cash flow and current cash flow statements. You’ll also need to determine the weighted average cost of capital (WACC) or the discount rate and decide on the cash flow periods you want to include in the valuation.
Asset-Based Approach
Best for: Companies that hold valuable assets they want to liquidate, as well as businesses that need to sell ASAP.
The asset-based approach calculates the value of your business based on the difference between its assets and its liabilities. Your assets add value to your business while liabilities (what you owe to creditors) add debt. To find the value of your business using the asset-based approach, all you need to do is to subtract the liabilities from the assets.
For instance, if you have $500,000’s worth of assets and $150,000 in liabilities, then the value of your business is $350,000 ($500,000 – $150,000 = $350,000).
This difference in liabilities vs. assets can also be known as the book value. If you’re selling your company, the book value should be the lowest possible purchase price you’d accept.
The asset-based method is relatively straightforward if your balance sheet is up to date. However, this approach does not consider your company’s current and future earning potential and having your assets appraised can be expensive.
Market-Based Approach
Best for: This method works for any type of business as long as you can find reliable information on comparable businesses.
In a market-based valuation method, you determine your business’s value based on the sale prices of similar or competing companies in the market that have already been sold. This approach assumes the fair market value for your company under normal economic conditions.
It’s often difficult to find reliable and comparable data as this kind of data is typically private. This is why it’s best to work with an appraiser who has had experience in
Seller’s Discretionary Earnings Method
Best for: small businesses (with gross annual sales under $1 million) typically owned by the manager
The SDE approach reflects a business’ financial benefit to its owner by calculating the owner’s cash flow (salary, all benefits, travel expenses, etc.) as it pertains to a company’s total net worth.
For a prospective buyer looking to purchase a small business and fill its ownership role, the SDE is a great indicator to accurately predict his or her ROI as the new owner. For a current owner looking to sell, it allows you to focus on growing your business before you do.
How to Calculate Your SDE
Here’s how you can calculate your SDE in three easy steps:
Step 1: Check your tax returns. Most business owners use the last three years’ worth of tax returns, but this depend on the number of years you’d like to calculate.
Step 2: Add the numbers. You can usually find the following expenses on the first page of your tax returns. Here’s the equation you need to use:
Ordinary business income (pre-tax) = interest expenses + depreciation expense + amortization expense + owner compensation and benefits
You can find the amortization expense in the itemized expense statement section in your tax return.
Step 3: Adjust for one-time and non-recurring expenses. After calculating the SDE, review the expenses incurred during the period you calculated the SDE for. Check any non-recurring expenses like charitable donations, travel and entertainment expenses, etc. and add them back.
What You Need to Do to Prepare for a Business Valuation
No matter which method you choose, the success of your valuation lies in your preparedness. Here are a few tips to remember to prepare for a business valuation:
Organize Your Financial Documents
The value of your business is heavily based on your business’ finances. Even if you end up using the market-based method, you still need your company’s financial information to find appropriate comps.
Depending how long you’ve been in business, you should have the past three to five years’ worth of financial statements and tax returns prepared. This includes your balance sheets, cash flow statements and income statement. Review your documents to make sure that the information is accurate.
Appraisers may need additional financial paperwork like industry forecasts and sales reports, especially for DCF and market-based methods.
Keep Other Important Documents Handy
If you’re planning to sell your business or apply for a loan, appraisers may also ask for your business permits, licenses, deeds, and other necessary certifications, as well as your contracts with creditors, suppliers, insurers, and customers. You may also need to submit business credit reports to share with potential buyers, creditors, and your appraiser.
2 Choices on How to Conduct Business Valuation
There are two ways on how to conduct business valuation:
- You can value the business by yourself with the help of your lawyers and accountants; or
- You can hire a professional appraiser.
Calculate Business Value on Your Own
Conducting your own business valuation saves you time and money. Professional appraisers have varying price ranges for appraisals, but a rough estimate would be around $5,000 or more for small businesses worth $500,000 or less.
Valuing your business by yourself is faster compared to having it done by professionals. A professional appraisal usually takes two weeks to a month, while doing it on your own will only take a few days’ time.
Hiring an Experienced Appraiser
While hiring an appraiser can be costly, there are several reasons why they’re worth the investment. A professional appraiser will audit your company’s financials to ensure that you’ll get a more accurate appraisal.
Having a credible appraiser value your business gives you hard evidence of how much your business is truly worth. Even though your business is only worth whatever potential buyers are willing to pay for it, it’ll be harder for them to negotiate your sales price if you provide an appraisal from a professional.
When looking for a reliable appraiser, check to see if they have the following credentials:
- ASA (Accredited Senior Appraiser) – rendered more than 10,000 hours of work, had their appraisals reviewed by colleagues and passed several examinations.
- CBA (Certified Business Appraiser) – passed a peer-review process.
- ABV (Accredited in Business Valuation) – granted to Certified Public Accountants who completed 75 hours of coursework and passed a business valuation exam.
- CBI (Certified Business Appraiser) – knowledgeable about business purchases and sales.
Before you hire an appraiser, be sure to verify their credentials. Remember that appraising your business doesn’t come cheap and only a trained appraiser can come up with a realistic value to your business.
The Bottom Line
When it comes to business valuation, buyers and investors have their own say when it comes to your company’s value. Improving the value of your business doesn’t happen overnight; it takes time and thorough planning.
While you can conduct your company’s valuation by yourself, it helps to consult an experienced appraiser for a professional company valuation. A reputable appraiser can offer valuable insights on how to maximize your sale.
Knowing how to estimate the value of your business is an important skill every small business owner should possess. Even if you’re not planning to sell your business or apply for a loan, regularly performing a business valuation lets you keep track of your company’s growth through the years as well as uncover growth opportunities for your business.
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