How to value a business: How much is your business worth?
Whether it’s to acquire funding via a small business loan or investors or sell the business, properly valuing your business is an important step that needs to be done right.
The more accurately you can appraise the value of your business, the more funding you’ll be able to generate and the greater chance you’ll have of securing a buyer.
A business valuation is the process of determining how much your business is worth.
There are several specific methods that are typically used to calculate a business’s true worth, but these are the 3 main overarching valuation methods which all specific methods fit under:
3 Methods to Value a Business:
- Income-based: Calculates valued based primarily on income metrics such as revenue and profit. This includes the Discounted Cash Flow method which takes into consideration projected future cash flow value at present compared to risk as well as Capitalization of Earnings, which is a combination of revenue, profit, and cash flow projections.
- Asset-based: Calculates value based on a business’s assets.
- Market-based: Calculates value based on the sale of similar businesses within your same industry.
It’s also important for entrepreneurs in the market to buy or invest in to be aware of how business valuations work, so they know how to properly value a business which they’re considering purchasing or making an investment in.
No matter where you fall in the process, you should invest the necessary time to better understand how business valuations work.
That’s why the purpose of this guide is to break down how business valuations work, methods for doing so, and tips to help make the process smoother for all parties involved.
Table of contents
- Preparing to value your business
- 3 Primary methods for calculating the value of your business
- How to value your business example
- Tips to make the most of your business valuation
First, let’s talk about some important tips for preparing for your valuation:
Preparing to value your business
Before we dive into the major business valuation methods, there are some important steps you should take to prepare for your business valuation.
Appraising the value of your business is a big step no matter what point in the business growth timeline you’re at, so investing a bit of time to prepare beforehand can help make sure things go off without a hitch.
Here are 4 things you should do before valuing your business:
1. Learn about business valuations
Since you’re reading this, you’re probably already at this step.
However, it’s important to mention that because business valuations can be complex and are directly tied to the success and/or ultimate monetary value of your business, you should take some time to learn about business valuations.
Learn about the different valuation methods, what type of business should use which method, why, and all the various details you should take into consideration when valuing the business.
For example, two of the most important terms you should look into are Seller’s Discretionary Earnings (SDE) and Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA).
SDE and EBITDA are both arguably the two most common types of business valuation methods (which fit into one of the major valuation method buckets we’ll talk about later), though they’re similar in nature.
Both are essentially methods for calculating a business’s pure net profits, SDE generally being used for small businesses under $500,000 in value and EBITDA for businesses above that.
2. Research your industry
Business valuation methods take more into account than a business’s performance and well-being, they look at the industry as a whole as well.
For that reason, take some time to research the industry the business is in– if you don’t already do that regularly– to understand its current state and direction.
Financial information for most public companies is easily enough found online and a great way to get an idea of the state of the industry. However, you can also search out potential business sales listings on sites like AngelList for any that might exist within the industry as another great resource.
3. Get your finances in order
This one might sound like an obvious step in retrospect, but it’s often overlooked until it’s too late.
If you’re the business owner, chances are, there are things you can do to measurably improve your company’s financial situation within a matter of a few months to a year.
Take time to review critical reports such as your profit & loss and balance sheet to get an idea of where you can make improvements.
Also, make sure you have certain financial documents in order which will be necessary for the valuation process:
- Profit & loss statement
- Tax filings
- Licenses and other proprietary documents
- Other basic business finance reports
We’ll go more into considering a professional appraiser later, but it’s important to mention at this point that a professional business appraiser will run a full financial audit of your company, so while they will cost you they’ll take care of this step entirely (and with accuracy you can count on).
4. Review your assets
Similar to the previous point, you’ll also want to review your assets.
This is important for all financial calculations, but most notably for asset-based valuation methods.
Start by making a list of all your business assets (which essentially includes anything that adds value to your business), including both:
- Tangible, and
- Intangible assets
Within these two groups exist all kinds of different business assets, including:
Tangible assets:
- Physical assets such as property/real estate, your production machines, and delivery vehicles
- Inventory
- Cash
- Investments
Intangible assets:
- Intellectual property such as patents and trademarks
- Subscriber list
- Brand reputation
Similarly, don’t forget to take stock of all your liabilities, which can include:
- Business loans
- Accounts payable, and
- Expenses
3 Methods for valuing your business
Now that you’ve taken steps to prepare for your business valuation, whether you’ll be doing it yourself or hiring a professional, it’s time to break down the 3 overarching business valuation methods.
Each method below calculates the value of your business differently. Some methods are used more often than others, however, each is useful to know as they all have a place depending on the industry and other factors.
As a final note, if you’re doing the valuation yourself, work to make it as unbiased and accurate as possible. Inflating your numbers will only hurt you in the long run, from giving you an incorrect picture of your business health to turning away potential buyers.
Also, resist the urge to mesh methods together. Each method’s calculation can be run separately, but attempting to mesh them together is bound to result in skewed results.
These are the 3 approaches to business valuation:
1. Income-driven method
The income method for business valuation uses metrics such as profit and revenue (typically, future projections of those metrics), as the basis for valuation.
There are 2 primary methods used within the income approach bucket:
Capitalization of earnings method
This method takes into account factors such as a business’s cash flow to calculate its future profitability. This method is best for established businesses with stable profit.
Discounted cash flow method
This method, which calculates the value of a business based on its future cash flow projection, is ideal for new businesses with high growth potential.
2. Asset-driven method
Asset-driven methods use, as it sounds, a business’s assets to calculate its value. These are especially good for real estate and investment-based businesses.
Again, there are several different methods within this approach as well, including the Adjusted Net Asset method, which adds up a business’s assets and subtracts its liabilities to find its value.
To use an asset-driven method, you need to have an idea of what monetary value you can place on your assets. If you’re not sure, instead of running a guesstimate, do some research to make sure those estimates are as accurate as possible.
3. Market-driven method
The final business valuation method is the market-based approach.
This approach primarily takes into account the purchases of comparable businesses in your industry as a marker of its value.
This can be a useful method if you’re looking for a quick ballpark estimate as if you know of another similar business in your industry that recently sold, chances are your business will sell for a similar value.
This method is especially useful if your industry is experiencing rapid growth (such as tech) as there are likely examples you can reference in your industry.
Make sure to gather data on all comparable businesses and don’t just settle on the data from one. The more data you can provide to a potential seller, the more solid you’ll make your case for pricing your business at what you decide it to be.
How to properly value your business: Example
While there are many different ways to calculate the value of a business, for the sake of the example, we’re going to use the most common method, the SDE method used often for businesses of <$500,000 in value, for our example.
Adrianna owns a local family restaurant originally started by her parents when she was a child called Luiz’s Hot Spot. She’s interested in getting a valuation for the business so she can put the restaurant up for sale.
First, Adrianna starts by gathering the basic financial numbers we touched on above for the business:
- Annual SDE: $95,000
- Annual revenue: $475,000
- Assets:
- Real estate: $175,000
- Equipment and furnishings: $35,000
- Inventory: $100,000
- Liabilities: $50,000
Next, Adrianna will use these numbers to calculate the average value for her business.
Calculating SDE
Using bizbuysell.com’s latest statistics, the restaurant industry as a whole has an average multiplier of 1.98.
To roughly calculate the value of her business, then, Adrianna takes her $95,000 calculated SDE, found with this equation:
Net earnings (before taxes) + Personal earnings + Non-essential expenses for the year (one-time, non-repeating expenses– doesn’t include COGS) – Liabilities = Your SDE
Then runs her SDE through this equation: Business’s SDE x Multiplier, using the multiplier of 1.98 to get her estimated business value:
$95,000 (SDE) x 1.98 (Multiplier) = $188,100 (Business value, rough estimate)
Keep in mind that this calculation, in particular liabilities and intangible assets, includes things we didn’t cover here such as future prospects, local economy projections, and other elements.
What other factors affect the value of Adrianna’s business?
In addition to the abovementioned factors, there are other factors that can affect the true value of Adrianna’s restaurant that aren’t included in this rough SDE estimate.
There are a whole collection of additional elements that must be factored in to get an accurate value for the business, including:
- How eligible is she for financing?
- How loyal are her customers?
- When will key employees retire?
- Supplier relationships may change
Several factors influence the final number, including the fact that Luiz’s is a family-owned restaurant and a change in ownership will be specifically impactful to such a long-held local establishment. In addition, the trend away from individually owned restaurants, local business growth, and community response.
Keep in mind that the above example is only a rough estimation and shouldn’t be used in exactness to run your own valuation.
Rather, use it to get an idea of what a real business valuation might look like to help you prepare for your valuation.
4 Tips to make the most of your business valuation
Preparing for and executing a business valuation is a big event.
You not only want to make sure that you’re properly prepared, but that you do everything you can to make the most of the valuation throughout the process– and give yourself the greatest odds of success at acquiring funds or an eventual purchase.
Here are some additional tips to help you make the most of your business evaluation.
1. Be realistic (and take emotion out of the equation)
One of the most common mistakes of business owners during the valuation process is to overprice their own business due to bias.
As the owner, you know how much effort you’ve invested in growing your business. This enormous effort can skew your perception of the value of your business, making you overvalue your business.
This is all the more reason why one of the accepted evaluation methods is so important, because it takes that emotional aspect out of the equation.
2. Consider giving your marketing and public appearance a facelift
One of the simplest things you can do to improve your chance of selling the business, and at a desirable price, is to give your marketing and overall public appearance a facelift before putting it up for sale.
The way the public views your business inevitably plays a big part in the process of acquiring a buyer as they will see your business first the way everyone else does.
Taking a bit of time to update your marketing campaigns, branding, advertising, even simple things that might be a bit out of date such as your business cards, signage outside your business, and your facility itself will go a long way toward securing a buyer.
3. Get key employees on board
It’s common for key employees to stay in place after selling. After all, it’s easier for the buyer to keep an already well-oiled team in place rather than hire and train their own.
For that reason, it’s important to make sure you can secure those key employees now and get them on board with the eventual sale and transition.
When you decide to reveal this information is up to you, perhaps you decide not to reveal anything until a prospective buyer is in place, but it’s something you’ll want to do sooner than later to reduce surprises. That way, you can communicate who from the team the buyer can count on staying when the transition occurs.
Secure not only letters of intent from those key employees but also any vital vendors as well. The more you can guarantee your potential buyer that these key elements will remain in place, the more you’ll reassure them of the return on purchasing your business.
4. Consider hiring a professional appraiser
At this point, it might be obvious that appraising your business yourself is risky at the very least.
Between the natural bias that business owners experience and tendency to overvalue when it’s their own business and the complexity of business evaluation methods, appraising the value of your business may be in better hands with a professional.
A professional appraiser can be costly, up to several thousand dollars for a full appraisal, but they’ll run a full audit on your financials to make sure that your valuation is accurate.
In addition to this, having a record of a professional valuation will give credibility to your valuation that is indisputable during negotiations.
A personal valuation is definitely faster and saves you money, but not only may that valuation be incorrect, a buyer is more likely to negotiate the price down without evidence of a professional appraisal.
It’s your business– get the most from it
Valuing your business is a big step in any entrepreneur’s career, whether it’s your first or fifth and your business is worth $200,000 or $2 million (or more).
You not only want to make sure you’re properly valuing your business but that you make that valuation and sales process as smooth as possible and put yourself in a position to maximize your return from that sale or to acquire the maximum amount of funding for the business.
Use the above tips to prepare for your valuation, consider which method might be best for you, apply the additional tips for making the most of the process, and consider hiring a professional appraiser.
It’s your business. You worked hard to grow it into what it is today, so don’t skimp on the details. Get the most you possibly can from your time and hard work.
