How to Value a Small Business

As a small business owner, you are well aware of your business’s liabilities and cash flow, and you probably have a good idea of its potential future earnings. However, you may still be unsure of how to evaluate how much it is worth on the open market.

There are three main methods of business valuation: asset-based, market-based, and income-based (valuation based on cash flow). No single method is right for every business, and sometimes you may need to consider all of them when trying to get the best estimate of what your business is worth if you put it on the market today.

Asset-Based Valuation

For some businesses, the simplest valuation method, asset-based, may be best. An asset-based valuation uses the company’s net book value to set the price of a business – that is, it subtracts a business’s liabilities from the fair market value of its assets.

This approach will work well if you sell a retail or manufacturing business – where tangible assets, like equipment and inventory, determine value. However, asset-based valuation only shows the value of net tangible assets. It does not take into consideration future growth potential.

There are several ways to value assets:

• Balance sheet value arrives at net book value by subtracting your liabilities from your tangible assets. It is a current assessment rather than one based on income potential.
• Replacement value is the cost to replace all assets your business owns. Although replacement value doesn't account for intangible assets, it does take into consideration the market value of a property that has depreciated for tax purposes but must still be factored into the purchase price of your business. You may need to have a formal appraisal performed to provide an accurate estimate of these assets.
• Intangible asset valuation adjusts the assets in a simple balance sheet calculation by considering things that add value to your business but are typically not listed on a balance sheet, like goodwill and the strength of your customer base. 

At the very least, an asset-based approach to business valuation provides you with a rock-bottom estimate. Using an asset-based approach in combination with other methods is wise unless you can adjust the net book value with proof of intangible assets or are simply looking to liquidate a small retail or manufacturing business without positive cash flow.

Using net book value to value your business has another advantage – it gives the buyer some indication of the downsize risk of making the purchase. Even if they believe that the business has significant growth potential, an investor will at least know how much money they can recoup should the business fail shortly after they take it over.

Market-Based Valuation

In some ways, selling a business is no different from selling any other property. It's only worth what the customer is willing to pay when you are ready to sell. Sales prices can vary based on economics and geopolitics, oversaturation in your market share, government regulations and zoning ordinances, and other factors you have no control over.

Although ostensibly based on the sales price of comparable businesses in your region and industry, at the end of the day, market value is perceived value. As with residential real estate sales, psychological factors may come into play.

That said, the primary way to assess market value is to find meaningful comparables by looking at small businesses that are either currently listed or have recently sold. The more niche and smaller your business, the more difficult this task will be.

Factors to consider are:

• The industry itself. Is this a plumbing company, a goat's milk soap distributor, or a motel franchise?
• The location of the business. Are you in a big city or a rural setting? Is it a seasonal area dependent on tourism?
• Competition in your market share. Are you trying to sell a motel franchise in a university town? Do you sell felted hats and purses online?
• How products and services are delivered to the customer. Is your business e-commerce, a storefront, or a combination of both?
• The size of the business. How many people do you employ? How big is your customer base?

Although you can hire a business broker to locate comparables for you, a good place to research on your own is an online marketplace that allows you to filter current businesses for sale by industry and region. This research will give you a ballpark range even if you eventually decide to hire a broker to assist with the sale.

Another way of conducting a market-based evaluation is to employ precedent transaction analysis. In this method, you price multiples based on the observable transactions of companies that have features similar to yours, often with the help of an online database.

Because precedent transaction analysis relies on publicly available information about past mergers and acquisitions, it is unlikely that you would use this method to find comparables with a small, private business. However, the advantage of this method is that you are not restricted to current businesses for sale when looking for comparables. 

Valuation Based on Cash Flow (Income-Based Valuation)

The last way of assessing the value of your small business is to determine what its earning potential will be for the new owner. Estimating current cash flow and predicting future cash flow are more accurate ways of valuing businesses that do not have a lot of tangible assets. For example, businesses that provide services but have a strong annual income statement would fall into this category.

Income-based business valuation uses present earnings to form future cash flow projections that are then adjusted for changes in your business’s growth rates, the tax code, inflation, and other factors. Because you are projecting future earnings but want to sell the company now, you'll need to discount or “translate” the value expressed in future dollars into today’s dollars. 

There are several different methods of determining valuation based on future cash flow, some of which rely on complicated formulas, like a discounted cash flow analysis.

For illustrative purposes, we will discuss a simpler income-based valuation method, calculating the seller’s discretionary earnings (SDE).

SDE reflects a business's pre-tax earnings per year before deducting the owner's salary, significant one-time expenses, non-operating expenses, and non-cash expenses such as depreciation. In other words, SDE measures your business's profitability absent costs that aren't directly related to cash flow or are so uncommon that they would deflate the sales price artificially.

To calculate the profitability of a small business, you multiply the SDE by a number ranging from 2 to 3.5. The multiplier depends on factors including future growth potential, economic conditions, location, and the nature of the industry itself. The higher the multiplier, the more potential growth exists for your business.

Suppose you run a tutoring company that prepares students for standardized exams like the SAT and ACT, and you run the business online from your home office. You employ people who work as independent contractors; the business derives much of its annual revenue from the difference between the stipend they earn and the amount you charge customers directly for various services.

Your income statement reflects that your business has an annual revenue of $250,000, with operating expenses of $25,000. The operating income is $225,000 ($250,000 - $25,000).

In this hypothetical, there are few non-operating or non-cash expenses, but this year you paid $15,000 to recruit new employees and develop a training manual. You pay yourself a salary of $65,000.

The SDE would be $225,000 + $65,000 + $15,000 = $305,000. Because there is potential for oversaturation in your market share, you might select a conservative multiplier of 2.3.

Thus, you can value the business at $701,500 ($305,000 x 2.3). 

Key Takeaways

The most important takeaway is that business valuation is not an exact science. It depends on market conditions, the seller’s perception of risk, the goodwill you have established over the years, the size of your mailing list, and the region where you operate the business. All of these factors play a role in determining what your business is worth in today’s market. In addition, the buyer’s psychology plays a role that may involve some, all, or none of these factors.

A second important takeaway is that no single business valuation method suits every business. Sometimes, you may need to use more than one business valuation method to determine the most accurate figure. An asset-based valuation method works well if you want to liquidate a retail business. In contrast, it would prove next-to-worthless in determining the sales price of an online company that sells printable tax forms.

Finally, you will need to research beyond your general ledger and tax statements if you choose to do a market-based analysis. Online marketplaces like DealStream allow you to search businesses for sale by region and industry to find meaningful comparables to help you determine what your business is worth.