If you’ve decided to sell your small business, then you’ve come to the right place.
Having exited two small businesses I know there’s so much to consider when selling a company that you’ve worked so hard to build.
I'm going to introduce you to six tried and tested small business valuation methods that will enable you to market your business at the price that it is objectively worth.
But first, let’s look at what we mean by a business valuation method and why choosing the right one is important.
What is a Business Valuation Method?
A business valuation method is simply a way of determining the economic worth of a company. As we introduce throughout this article, there are different ways in which you can value your company, but each method works towards the same fundamental objective.
When you’re valuing your business, the method you employ considers a wide range of factors, including assets, liabilities, inventory, property, customer base, and reputation. It’s common for business valuation methods to consider growth prospects, share price, and projected revenue, too.
Ultimately, utilizing a business valuation method takes the guesswork out of marketing your small business for sale. After all, it’s tempting to look at the current market, see what other companies in your area are selling for, and pitch yours at the same price.
But doing so isn’t necessarily a smart move, as it doesn’t take into account the nuances of your business and is likely to leave you out of pocket.
Why and How Should You Value a Small Business?
There are several reasons why you should value your small business. Most obviously, a valuation is necessary if you’re planning to put your business on the market. You need to ensure you get the asking price your business deserves, so utilizing a proven valuation method is a crucial step to take.
But you may also need to value your business if you’re applying for a business loan, seeking external investment for your company, or perhaps to offer your employees equity. All these reasons aside, you might just want to value your business so you fully appreciate the scale of your operation so that you can plan your financials for the future.
No matter your reason for valuing your business, it’s important not to solely compare your business to similar entities on the market. Instead, you should follow a proven process that provides you with a clear insight into the objective value of your business that considers a broad range of factors.
Below, we share a list of six small business valuation methods that will help you get the right price when you come to sell your company.
Six Small Business Valuation Methods
1 – Net Asset Method
Providing you have been diligent at keeping records of your business transactions, the net asset valuation method should be relatively straightforward. Using your company’s balance sheet as a guide, calculate its starting value by adding up its assets and subtracting its liabilities.
Typically, you can approach an asset-based valuation of your business in two ways:
This means you’re planning to sell the business to a prospective buyer who will essentially continue with its operations. You will need to present the equity of your business (assets minus liabilities) to sell it as a going concern.
This asset-based approach to valuation considers that your business will cease operating once sold. You will need to calculate the cash value of assets that remain within your business, which will almost certainly be lower than you could reasonably expect if you were selling as a going concern.
In most cases, you’re likely to be selling your business as a going concern, but it’s important to distinguish between the two.
2 – Market Value Method
While it’s not the best approach to valuing your business, the market value method is one of the most popular. Simply, a market value valuation method is calculated by reviewing the current market and valuing your company by comparing it to similar entities that have been sold in recent times.
To ensure a market value method is fair, you need to consider the following factors:
- Geographic location
- Structure, size, and performance of other businesses sold (including their reputation)
- External market influences that have affected the economy
- Industry or niche
To give an example, if you’re selling a coffee shop, it’s not enough to look at the market value of similar outlets that have sold nationwide in recent times and hope to get a similar price. You need to dig a little deeper into the current landscape and ascertain some of the factors behind the sale price.
If you’re following a market value method, you might consider hiring an appraiser who will be able to provide you with a broad and accurate representation of similar businesses that have been sold in recent times.
3 – Capitalization of Cash Flow (CCF) Method
Capitalizing your business cash flow is a relatively easy income-based method of ascertaining its worth. To calculate, you need to divide your business cash flow from a set period by what is known as your company’s capitalization rate. The capitalization rate (often referred to as cap rate) is the business’s expected rate of return, which is likely to be somewhere between 20-30% for a small business.
When you’re calculating your CCF, you should take your figures from a stable period during which your business sustainably generated revenue. Potential buyers and investors want to see a business that is on top of its cash flow, as cash flow issues tend to represent financial difficulties.
As such, valuing your business by CCF will potentially attract buyers looking for a stable investment.
4 – Discounted Cash Flow Method
Another income-based business valuation method is discounted cash flow (DCF). This approach looks at future projections of your cash flow and the time value of money in order to ascertain your company’s current value.
Employing a DCF valuation of your business is a smart move if you can realistically predict that your business is going to grow (or shrink) in the years to come. Conversely, the CCF is much more appropriate for marketing companies with established periods of sustained cash flow.
Although the time value of money concept is a little difficult to get your head around at first, it’s based on the premise that money is worth more now than it is in the future. You can use a cash flow calculator to work out your DCF valuation on your behalf, as it’s a difficult calculation.
Regardless, you need to begin with your current cash flow statement, as well as projected cash flows if you’ve already put them together. Various other complex metrics are required for a DCF to be accurate, including data on the weighted average cost of capital.
The bottom line here is that it’s a good idea to work with an accountant to help you estimate your company’s worth via DCF, as there’s a lot to consider if your sums are to be accurate.
5 – Book Value Method
If DCF is one of the more complex small business valuation methods, the book value method is one of the most straightforward. As the name suggests, you review your books (or balance sheet) and discern the worth of your business at any given moment by calculating its equity.
You simply add the value of your assets and subtract your liabilities, and you find out your company’s book worth. This is valuable for small businesses that aren’t showing a great deal of profit but are asset-rich. It’s also a valuable approach if you’re looking to keep things simple!
6 – Seller’s Discretionary Earnings Method
A valuation approach that is suitable only for small businesses, the seller’s discretionary earnings method (SDE), will help the buyer work out how much they can expect to earn from the business each year.
The most important sum for this method is to understand how much cash it takes to run your business each year. To work this out, begin with your company’s earnings before interest and tax, then add owner’s compensation, benefits, and other non-essential business expenses.
You need to consider a broad range of costs, including but not limited to:
- Health and employer insurance policies
- Travel and accommodation
- Consulting fees
- Accountancy & legal fees
- Business vehicle fees
To make sure your sum is truly representative of the value of your business, be careful not to leave yourself short. In some instances, however, you will find that the buyer challenges the numbers that you’ve used to determine the one-time value of your business.
While this isn’t normally a deal-breaker, you might have to be prepared to justify your calculations and should be willing to negotiate. Although it can take time to put together, the SDE approach gives you a fairly holistic overview of the costs associated with your small business and is an ideal method for many small business owners looking to sell.
How to Prepare for the Valuation & Sale of Your Small Business
Now that we’ve introduced six ways that you can value your small business, it’s important to consider how to prepare for the valuation. Ultimately, your goal is to make your company look as attractive as possible to potential buyers, so you need to get your financial house in order.
Give yourself several months to prepare for your valuation, so you can be certain of your sums when you take your business to the market. Here are some ways that you can prepare for one of the business valuation methods introduced above:
Prepare Your Financial Documents
It’s nigh on impossible to accurately value your business without access to accurate and up-to-date financial documents. Whether you take care of the financials yourself, have an in-house accounting team, or outsource your finances, you need to get your documents in order. As a minimum, you will need access to:
- 3-5 years of business tax returns and bank statements.
- Financial statements including cash flow, balance sheet, and income statement.
- Actual and projected sales reports.
- Industry and market forecasts.
Even for the most straightforward valuation methods (like the book value approach), you need to be abreast of your company’s financial health, so begin by getting your documents in order.
Organize Other Essential Documents
No matter the industry you work in, to sell your business, you will need to show prospective buyers your paper trail. Collate a file that contains the following:
- Insurance policies and contracts.
- Permits & licenses.
- Business credit reports & credit scores.
- Employee information.
- Detailed overview of CRM.
List All Other Assets
While your company’s core assets (cash, property, equipment, etc.) will be listed within your financial reports, you need to prepare a detailed list containing all the other intangible assets of your business. This can include:
- Copyrights & patents.
- Email list & customer database.
- Online store, SEO ranking, and engaged social media profiles.
- Online reviews on Google & TripAdvisor (if relevant).
Although these assets won’t appear on your balance sheet, they can boost the earning potential of your business, and therefore should be included in its valuation.
Consider Hiring People to Help You
While you probably want to keep your costs as low as possible when selling your business, hiring qualified people to help you can help you put together an accurate valuation. As briefly touched upon, an appraiser can help you gain a realistic insight into your company’s worth in the current market and could be a savvy investment.
It’s also a good idea to include your accountant in the process (whether internal or external), as they will help you get together all of the relevant financial information and can advise on how best to proceed with the sale.
Selling your small business isn’t as simple as performing a quick Google search to find out what your competitors have sold for in recent times. To ensure you get a fair price for your small business, you need to follow one of the detailed business valuation methods introduced above.
They will help you look at your company’s finances objectively and ensure you don’t sell yourself short. No matter which approach you employ, give yourself sufficient time to get your paperwork in order and to perform your calculations before hiring the right people to help you market your business successfully.