At a Glance
Main Takeaway
Valuing a small business is critical for both buyers and sellers when applying for loans, raising funds, or transferring ownership. The valuation process involves calculating a company’s total worth, considering its assets, earnings, industry, and debt or losses.
Understanding how to value a small business can help sellers determine an accurate price, attract the right investors or buyers, or secure a loan. For entrepreneurs looking to buy an existing business, understanding valuations is essential to know if the asking price is fair.
Next Step
Even if you are not planning to sell your business, knowing how to value a small business can shape your company’s roadmap and future exit strategies. Work with an experienced business valuation partner like Windes to benefit from professional value acceleration and exit planning services.
Steps to Determining the Value of a Small Business
As a business owner or prospective buyer, conducting a valuation is a crucial step in assessing a company’s financial health and potential. For sellers, valuation provides an excellent opportunity to understand your business’s value and the factors determining its worth.
However, knowing how to value a small business requires an objective, level-headed assessment of your company’s worth. If the company is a family-owned business or you are emotionally invested in the business, making an objective valuation can be challenging.
For an accurate valuation, a business owner must calculate their business’s value using an objective process. Windes’ valuation services will help you to determine the accurate value of a small business, whether you are the buyer or seller:
Understand the Valuation Process
Before evaluating a business, it’s helpful for buyers and sellers to understand a few key definitions. You will need to understand the following concepts related to the seller’s discretionary earnings to know how to perform an accurate valuation:
Seller Discretionary Earnings (SDE)
Small business owners use SDE to calculate the actual value of their business for a potential new owner. Because it is the foundation of business valuation for small businesses, it is essential to understand what the SDE entails.
SDE includes expenses such as income reported to the IRS, non-cash expenses, and revenue the business generates. However, SDE also incorporates the owner’s salary and benefits into the calculation.
Typically, the business owner provides this number. Knowing how a business owner arrives at the SDE value and what it reflects about the business is crucial to acquiring the company for a fair price.
Calculating a Business’s SDE
To calculate SDE, begin with your pretax, pre-interest earnings from your financial statements. Next, add back any purchases not essential to your business operations, such as vehicles or travel expenses you reported as business expenses. This also includes employee outings such as lunch meetings, charitable donations, one-time purchases, and your salary.
Occasionally there are non-recurring expenses like a legal bill you can add back or non-recurring income such as the sale of a significant asset for a profit. If your business employs family members who receive above-market compensation, their salaries can also be added to stabilize the financial statements.
Buyers may inquire about your discretionary cash flow when you offer them your valuation, so including and valuing each expense or purchase is crucial. Finally, subtract any current debts or future payment liabilities from the net income to arrive at your estimated SDE.
SDE Multiple Values
Your SDE represents the actual monetary value of your business, but to value your business according to industry standards, you will need to use your SDE multiple. The multiples are driven by various financial factors, including:
- Financing formulas
- The buyers need to have a reasonable ROI after paying debt on the acquisition
- The buyers need to receive reasonable compensation for the time and effort running the business
- The type of industry
Every industry has a distinct SDE multiple. Your business’s SDE multiple depends on several factors, such as market volatility, your company’s location, size, assets, and the risk involved in transferring ownership. Typically, the higher your SDE multiple, the more your business is worth.
Organize Your Business’s Finances
Organizing your financial records is crucial for accurate calculations when valuing a small business for a sale, whether you are a seller or a buyer. You will need organized financials to transfer business ownership.
As a seller, you will need to have the following:
- Licenses
- Deeds
- Monthly income and balance sheet statements for the last three years
- Three years of tax returns
- A list of tangible assets
- A list of intangible assets like vendor relationships and client lists
- Summary of accounts receivable and accounts payable
- A brief overview of your business that helps determine more about the quantitative aspects that your company offers to a potential buyer, investor, or lender
You will not need these documents as a buyer, but sellers may want to see your credit report and basic financial profile. Organize your finances by preparing audited financial statements, a balance sheet, an income statement, and a cash flow statement for your target company to review if needed.
Establishing a firm financial foundation will help you maintain realistic expectations about your company’s value (or the company you hope to buy). The more thorough you are in this step of the valuation process, the more confident you will be in your calculations.
Take Stock of Your Assets
As a seller, you can estimate the value of your business by taking stock of your assets. List all the components that make up your business, including cash and investments, assets and liabilities, employees, and intellectual property. This will help you determine the value of your operation, and you can use it later to provide potential buyers with an overview of your company’s worth.
Intangible Assets
To properly value your small business, it’s essential to identify and record the estimated value of your intangible assets, all non-material assets that add value to your business.
These assets can provide a crucial boost to your business valuation. Examples of intangible assets include:
- Intellectual property (IP) refers to trademarks, copyrights, patents, and trade secrets.
- Brand equity is the value of a business’s brand recognition, reputation, and customer loyalty.
- Goodwill is the value of a business’s customer relationships, supplier relationships, and employee morale. When valuing goodwill, a professional consulting firm like Windes ensures an independent valuation process that accurately determines your company’s value.
- Customer lists and databases are assets that refer to information about a business’s customers, such as names, addresses, and purchase histories.
- Licenses and permits are legal authorizations to use, sell, or distribute a product or service.
- Software and technology can include proprietary software and technology used to manage the business and its operations, especially if it is better than the industry average.
- Contracts and agreements with suppliers, customers, and employees with value and legal significance are intangible assets.
- Franchise agreements refer to contractual agreements that give the right to use a business’s name, products, and services in a specific geographic area.
- Research and development is the value of the investment made by a business in developing new products or technologies.
- Non-compete agreements are contracts with key employees or business partners that prevent them from competing with the business.
- The strength of your management team provides insight into the potential for continued business success.
- A distribution network is the ability to get your products to market efficiently.
When considering intangible assets, you should also identify and record your liabilities, which include any debt or outstanding credit on your business’s books. Liabilities detract from the overall value of your business and will factor into your calculations. Include notes payable, accounts payable, business loans, accrued expenses, other debts or payables, and unearned revenue in your calculations.
Tangible Assets
When performing a valuation on a business, you must consider tangible assets, which are physical assets that can be seen and touched. Tangible assets include property, equipment, inventory, vehicles, land, and cash.
You can value these assets based on their current market value, replacement cost, or depreciated value. Evaluating tangible assets provides insight into the company’s financial position, growth potential, and ability to generate cash flow and create shareholder value. It can also help determine the business’s overall value and guide investment decisions.
Common tangible assets for businesses include:
- Real estate, including land and buildings
- Equipment such as machinery, vehicles, tools, and furniture
- Inventory, including raw materials, work-in-progress goods, and finished products
- Cash and cash equivalents, such as cash on hand, bank accounts, and short-term investments
- Accounts receivable, money owed to the business by customers or clients
- Securities such as stocks, bonds, and other investments
- Natural resources owned by the company, like oil, gas, minerals, and timber
- Art and collectibles, like valuable artwork, antiques, and other collectibles that the business owns
Working with a valuation firm like Windes can provide you with the guidance and experience needed to inventory your assets accurately. Our experienced team of CPAs will review your intangible and tangible assets to calculate your business’s total value.
Business Model
It is essential to outline your business model to show potential buyers how you generate revenue, whether it is through a subscription-based service, direct-to-consumer e-commerce, or B2B consulting. While a valuation can provide an estimated value, your business model gives buyers a clear understanding of how they can reach customers and earn revenue if they buy your company.
If you are a buyer interested in acquiring a business, list the target company’s assets and liabilities. This step helps ensure you and the seller agree on the company’s valuation.
Look for businesses with clear and well-structured business plans that demonstrate effective management and consistent processes. A smoothly-run company will make the ownership transition easier and help preserve profits.
Business Plan
As a small business owner, having a solid business plan is essential for projecting future earnings and market growth to showcase to potential buyers how your business will continue to thrive and remain profitable.
Your business plan offers crucial context about your company, such as your mission, location, and the key products or services you provide. Ultimately, a well-crafted business plan is a valuable tool for providing buyers with a comprehensive overview of your business.
To write an updated business plan to attract potential buyers, keep the following tips in mind:
- Conduct thorough research – When updating your business plan, gather updated data and insights regarding your specific market, competition, industry trends, and target audience. This ensures a potential buyer knows the company’s current situation and challenges.
- Define your business goals – Redefine your business goals, including short-term and long-term objectives. This step shows a potential buyer your direction for the business so they can make informed operational decisions.
- Develop a marketing plan – Include an updated marketing plan that details how your company reaches its target audience and promotes products or services. This plan should include current strategies for social media, advertising, public relations, and other marketing channels.
- Outline your financial projections – Your business plan should include financial projections for at least three years, including revenue, expenses, cash flow, and profitability. These projections help potential buyers understand your business’s financial feasibility and plan for risks or challenges.
- Identify your team – Your business plan should include information about your team, including skills, experience, and roles within the company, so a potential buyer can structure management and employees upon transfer.
- Review and revise – Once you have created your business plan, review and revise it regularly to ensure it reflects current market conditions and financial performance for buyers.
Familiarize Yourself With the Industry
Industry expertise is essential for both buyers and sellers when it comes to valuing a business. If you are selling your business, understanding the trends and dynamics of your industry is critical in arriving at a realistic valuation that considers the current market conditions and your business assets.
Before buyers can make a confident offer on a business, they need to be well-informed about the industry in which the target business operates. This means researching similar enterprises, often referred to as comps, to get an idea of how comparable companies are valued and how they are performing in the market.
For example, you evaluate a privately held software development company specializing in mobile application development. You will determine the company’s enterprise value, or the total value of the business, by comparing it to similar companies in the market.
You might do this by researching other software development companies specializing in mobile application development similar in size, revenue, and growth potential to the company you are evaluating. You may also consider companies that have recently been acquired or gone public to provide insight into the market value of similar businesses.
Gather financial data on comparable companies, including revenue, net income, and EBITDA, as part of your research. Consider factors such as market share, customer base, and product offerings.
Using this data, calculate the enterprise value multiples for each comparable company and apply these to the financial metrics of the company you are evaluating to determine its estimated enterprise value. This can provide a useful benchmark for determining the fair market value of the company and can help guide negotiations during the valuation process.
As a seller, analyzing these comps can provide context about the sector and help you assess your market share and growth potential, making your business stand out to potential buyers.
Tips for Successful Evaluation of a Small Business
As a business owner, being familiar with different business valuation approaches helps determine an accurate number. Each method employs differing factors, such as a company’s income, assets, or market data on comparable businesses, to assess its numerical worth.
Income Approach
If you opt for the income approach to value your business, you can use one of the two popular valuation methods that estimate the amount of income the company is expected to generate in the future. These methods include:
- The capitalization of earnings method considers a business’s future profitability by considering its cash flow, the annual rate of return, and expected value. This method assumes that the calculations for a single period will continue in the future. Typically established businesses with stable profitability use this valuation approach.
While most online business valuation calculators use a variation of the income approach, a more comprehensive business valuation tool that includes profit, revenue, assets, and liabilities in the calculation can be used if you have more financial information available.
- The discounted cash flow method determines the present value of a business’s future cash flow. This approach involves adjusting the business’s cash-flow forecast based on the risk of buying the business. This approach is particularly effective for newer companies with significant growth potential that have not yet turned a profit.
Market Approach
The market approach to business valuation is a method of determining the value of a business by comparing it to similar companies in the same industry that have recently sold. This approach is based on the idea that the sale price of similar companies in the market best determines the value of a business.
To use the market approach, gather information on recent sales of businesses similar to yours or your target company, then make adjustments for differences in size, growth prospects, and other factors that may affect the value of the business being valued.
This process allows you to determine a valuation range for the business based on the multiples or ratios of the sale prices of comparable companies.
The market approach is useful for businesses that are part of a well-defined industry and have many comparable companies with recent sales. However, it can be more challenging for unique or niche businesses with few direct comparables in the market.
Asset-Driven Approach
The Adjusted Net Asset Method is a common approach if you want to value your business based solely on its assets. This method calculates the difference between a business’s assets and liabilities, adjusted to fair market values. Asset valuations are also helpful for internal purposes, helping you track spending and capital resources.
To assess your assets, create a list and assign a monetary value to each item. The value is usually between the sale price and the depreciated value for equipment or depreciating assets. For example, you can estimate how much an item would sell for today.
You can make reasonably accurate estimates because you know your equipment and production. Even if you do not adjust the asset’s worth per the current market, you can still obtain a good idea of a business’s tangible value.
This approach is beneficial if your business holds investments or real estate, is unprofitable, or you want to liquidate it. In any of these cases, buyers will be interested in the individual value of your investments or equipment.
Get an Accurate Business Valuation With Windes
As a seller or buyer, understanding the value of a business is crucial for a smooth transaction. Windes is an experienced business valuation firm serving private companies in Southern California and beyond.
Our accurate valuation services can provide critical insights to help you make strategic decisions when selling or buying a business. We can help determine your company’s value, ensuring a successful and profitable transition.
Connect with us today to discuss your valuation needs and discover how our team can help you when selling or acquiring a private company.
