- A business valuation is the process of determining a business's economic value.
- Calculating a business's value isn't an exact science; several formulas and strategies are commonly used.
- When you're determining your business's value, it's critical to figure out what a potential buyer or investor wants to know.
- This article is for small business owners who want to calculate their business's value for informational purposes or to prepare for selling it.
When you run a small business, you wear many different hats. From bookkeeping to marketing to developing your product or service offerings, entrepreneurs and small business owners are busy. While it's not always easy to find time to complete additional tasks, small business owners should take the time to determine their business's value regularly.
With small businesses being sold at historic rates, it's essential that your business is ready for a potential sale. Even if you don't want to sell your business, knowing its worth is a good idea.
But determining your business's worth is easier said than done. If you're unsure how to find your business's worth, speak with a business expert to get an accurate valuation. We spoke with experts who shared a few tips on how businesses can find their value.
What is a business valuation?
A business valuation is the process of determining a business's economic value. Analysts will use factors like company leadership, the current market value of a company's assets, and future earnings to determine valuation.
It's a good idea to perform a business valuation regularly since it can help you identify ways to improve your company. But a business valuation can also be used in exit strategy planning, when you're preparing to sell a business or if you're looking for funding.
What's the benefit of knowing your business's value?
A business's value is incredibly important information if an owner is thinking about selling it. Trying to successfully negotiate a deal without a prior understanding of what your business is worth puts you in a position to lose money.
Many small business owners neglect to calculate their business's value, but you can easily remedy this omission. If you're putting countless hours into a business, speak to a business appraiser or business advisor; they can help you determine what your business is worth.
"Many business owners expect the income they make from the future sale of their business to fund their retirement," said Justin Goodbread, owner and CEO of Financially Simple. "Yet, most do not have a formal valuation done on their company until they are ready to sell it. Many are then shocked to learn that they haven't created enough value within their business to reach their retirement goals."
A business valuation can help you plan your future as you prepare for retirement.
"If you wait to assess your business's value until you want to retire or have to retire, you have no time to increase the value of your company," Goodbread explained. "You will only get what you can get, whereas if you know your business's value ahead of time, you can work with professional advisors to increase the value of your capital – your cash flow, your tangible assets and your intangible assets – which will then increase the value of your business."
What are the different methods of determining valuation?
There are three main strategies most investors use to determine valuation: comparable, precedent transactions and discounted cash flow analysis.
- Comparable analysis: This valuation method measures a business's current value by looking at the metrics of other businesses in its industry. Comparable analysis is a relative form of valuation and looks at company size, share price, market capitalization and earnings before interest, taxes, depreciation and amortization (EBITDA).
- Precedent transactions analysis: Precedent transactions analysis is also a relative valuation form. It compares the business to other companies in its industry that were recently sold. However, the values can easily become outdated as time passes.
- Discounted cash flow analysis: Unlike the other two valuation methods, discounted cash flow (DCF) analysis is an intrinsic valuation form. DCF analysis measures a business's value based on its expected future cash flow.
What factors should I be aware of when placing a value on my business?
In addition to using specific formulas to calculate your business value, it's important to be well versed in a few key business areas.
- Tangible assets: Tangible assets include machinery, property and inventory. It's easy to calculate the value of tangible assets.
- Intangible assets: Intangible assets include brand recognition, trademarks and patents. These assets can add tremendous value to a business, and you should have some idea of the monetary value of your intangible assets.
- Liabilities: Business liabilities, including any debts your business owes, factor into its valuation.
- Financial metrics: Is your business profitable? If so, what's your annual profit? How much revenue does your business bring in? Know your financial statements inside and out, as potential investors or buyers will want to know about your financials.
Understanding your business assets is an added benefit of going through a business valuation. By looking at tangible and intangible assets, you learn what makes your business valuable and just how valuable those assets are.
Even if you don't sell your business, knowing your business's worth can provide additional insights into future business decisions. For example, do you have a lot of money tied up in inventory? This insight may change the way you handle inventory procedures moving forward.
How to calculate your business's value
Your business's value depends on various factors, including its size, your team, your expected growth and a plethora of other elements.
A few formulas are used regularly to calculate a business's value. Exact formulas vary by company, and business valuation is far from a precise science.
"Unfortunately, if we have 10 different people in a room trying to determine a price for our business, we will more than likely receive 11 different answers," said David Creech, former owner of the business brokerage and consulting firm DVAR Business Group.
Let's look at some of the most commonly used formulas for determining value.
1. SDE and EBITDA
Before diving into the formulas, it's crucial to define seller's discretionary earnings (SDE) and EBITDA.
SDE refers to a business's net income prior to deducting the owner's salary. Other discretionary, non-operating expenses are added back in for the calculation. Calculating EBITDA is clear-cut, as the name describes what goes into the calculation.
Generally, SDE is used to calculate the value of small businesses, while EBITDA is used for larger businesses. Some sources use gross annual sales of $1 million as the benchmark for the difference between a small business and larger business, but there's no set rule for when you should use SDE or EBITDA.
"I like to use the SDE model when I price small businesses," Creech said. "I inspect the profit and loss statements, determine owner benefits and addbacks, then add to the net income. I then use this sum and multiply by the industry's specific multiple. This gives me a ballpark figure to begin negotiations with potential buyers."
Industry-specific multiples apply to both the SDE method of calculating a business's value and the EBITDA method. These multiples vary by industry and are based on industry trends and history.
To find an accurate multiple for your industry, search online and use the advice of a site like Valuation Academy. You can also speak with a qualified business appraiser, which may lead to a more thorough examination of which multiple makes sense for your business.
2. EBITDA multiples
According to Jeff Rasmussen, founder of Fairway Business Advisors, the EBITDA multiples method is one of three standard formulas for calculating business value. "There are three primary methods of calculating the value of a business: multiple of sales, multiple of adjusted EBITDA, and discounted cash flow of adjusted EBITDA."
Multiples are decided by various factors, including the industry, business size and business growth. A business's multiple changes over time. To calculate an enterprise multiple, or EV multiple, you perform the following calculation:
EV ÷ EBITDA = Enterprise multiple
EV is calculated by adding market capitalization, debt, minority interest and preferred shares. You then subtract cash. The subsequent enterprise multiple provides information to potential investors or buyers, as low ratios may mean a business is undervalued. This calculation is used primarily for big businesses and shouldn't draw much attention from smaller organizations. [Related: The Basics of Accounting Ratios and Formulas]
3. Comps method
Comparing your business to others in your industry is another way to get an accurate idea of its worth.
"For small businesses, I would recommend using the comps method," said Brian Cairns, founder of ProStrategix Consulting. "Try to find a business similar to yours that has been sold or received funding. Apply that multiple to your sales. Sometimes business brokers can be helpful in this, and sometimes average multiples are published. If you can't find comps, I would suggest you consult a professional."
However, be careful about relying too much on formulas, as they don't always tell the whole story.
"A flaw in the use of formulas can be demonstrated as follows," said Seth Webber, principal and head of BerryDunn's Valuation Services Group. "Company A had an average EBITDA of $1 million for the last five years. Company A owns a taxi company in a city that has aggressively pushed back against the use of Uber. However, the political climate has shifted, and Uber is about to enter their city.
"Company B also has an average EBITDA of $1 million for the last five years. Company B is a pharmaceutical development company. They just got their most recent drug approved by the FDA and expect to quadruple their EBITDA going forward. Both companies have the same amount of EBITDA. Are they worth the same amount? Certainly not."
How do investors evaluate my business?
When determining your business's value – and which factors play into its worth – figure out what a potential buyer or investor wants to know.
"There are straight mathematical ways to determine the value of a business, but those are dependent on the quality of the data used in the calculation," said Michael Ott, CEO of Rantizo. "Oftentimes, it ends up with an agreement between a lead investor and the business based on a number of factors that are acceptable to both sides."
If you're looking to attract investors or buyers, you need to appeal to how they value businesses. If they use the SDE and multiple methods, use that to determine your business's worth. If they use another method, that may be the method used to agree on a purchase price and valuation.
"I have owned and sold my own businesses, along with assisting others [to] do the same," Creech said. "I have found one truth that is always consistent: All that matters is what you are willing to sell for and what I am willing to pay."
If you're calculating your business's value just for informational purposes, try using a few different methods to get an idea of how different investors and buyers may value your organization.
"Valuations are more of an art than a science, especially for early-stage private companies," Ott said. "If there are revenues, and they are representative, a proper multiple for the industry can be used to get a fairly accurate number. If there aren't revenues or they don't reflect the direction of the business, more interpretation is needed. There are a dozen ways to value a business, and a successful strategy can be to try three or four and use a hybrid."
How can I value my business at different stages in its growth?
It's easier to estimate the value of a business that's been around for 30 years than it is to value a startup. A newer company is dealing with startup costs and has fewer years of financial statements, and it's hard to know how large the brand may become.
A 30-year-old business, on the other hand, has years of financials and an established brand that can be easier to value. This makes calculating the value of your business at different stages of its growth cycle difficult.
With challenges like this, you can utilize a few different methods and project numbers to get general estimates of your business's worth.
The best solution is to speak with an investment banker or someone experienced at calculating business worth, suggested Stephen Opler, partner at Barnes & Thornburg. He explained that business owners may struggle in negotiations with potential buyers if they aren't aware of their business's value. If someone offers to buy your business out of the blue, it's good to know if that offer is consistent with market value.
"As I say to people, there's nothing more boring than a one-horse race," Opler said.
Speaking with a professional business appraiser makes it easier to check your business's worth during different growth stages, preparing you for a potential sale of your business.
While speaking with an expert can be costly, the strategic insights you glean may be worth the price.
"If you spend $1 million on an investment banker, it seems like a lot of money, right?" Opler said. "But if they increase the purchase price by $1.5 million, do you really care?"
How often should I calculate my business's value?
Calculating business value for informational purposes can be done in a few ways. You can use a few formulas and create estimates for your value, or you can speak to a business appraiser.
For informational purposes, and assuming you aren't expecting to sell your business in the immediate future, it's not necessary to bring in a business appraiser. Bringing in a business appraiser would make for a more accurate valuation, but the added detail might not be worth the cost.
"Until you are ready to sell or do a buyback from your partners, knowing the value of your business is simply a feel-good exercise, but one that can serve as a reference point moving forward," said James Cassel, chairman and co-founder of investment banking firm Cassel Salpeter & Co.
If you don't have plans to sell soon, and you just want an idea of what your business is worth, an annual valuation is appropriate. Others may suggest an annual valuation done by your own calculations and speaking with an appraiser every couple of years. It depends largely on your business needs and when you expect to be in the market to sell your business.
Knowing your business's worth
It's a good idea to know your business's worth, and there are a few different ways to come up with valuations. Whichever method you use, update your calculation annually, and speak to a professional business appraiser for the most accurate valuation possible.
Jamie Johnson contributed to the writing and reporting in this article. Source interviews were conducted for a previous version of this article.