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Business Valuation Methods for When You're Ready To Sell

If you're considering selling your business, it's important to understand different business valuation methods to get the best price possible. Keep yourself from holding the short end of the stick on a business valuation. Use this article to help you come up with a number to offer or accept from potential buyers.

How Do You Value a Small Business?

Before selling, you'll need to know how much your business is worth. This allows you to have an idea of where to set the asking price. With the rise of internet databases and more readily available information on similar businesses, valuing a business involves more accuracy and less guesswork. But it isn't an exact science, and there is room for divergent valuations.

There are several different methods of valuating a business, each of which takes a different perspective when looking at the business's value. There is no "right" valuation method. But if you calculate poorly or decide to use your own methodology, you could have several "wrong" prices.

Can a Small Business Perform Its Own Valuation?

Many small businesses want to avoid paying an accountant, CPA, or business broker to value their company. Instead, they take on their own valuation process. You can determine the value of a small business on your own, so long as you have kept proper bookkeeping. Remember to "show your math" and have the documents you've used on hand in case someone else wants to "check your math."

There are multiple approaches to business valuation. You can use any of the following to determine the value of the business. One may be more beneficial to you to set your business worth.

Market-Based Approach

This approach looks at similar businesses sold in the last year. You base your sale price on the average of other companies. This approach can be risky as it relies on different selling prices. It may not capture the actual value of your business.

For example, the other companies have sold at low prices because their owners failed to value the business properly. This results in a domino effect on businesses in the area, and now, every small business's valuation is low.

Asset-Based Approach

This approach looks at the individual assets of the business. This method looks at the price of the business on the fair market value of the assets. The drawback of this method is that it needs to account more adequately for intangible assets such as a business's goodwill, intellectual property like copyrights, or forecasts of future revenue.

Income-Based Approach

This approach is the most commonly used. It focuses on the amount of money a business generates for its owner. Income statements are useful in this method. Showing the last year's net income and the average net income of the past three years will help you come up with a fair price. This method looks at the cash that flows into the business and accounts for things such as debt owed.

Discounted Cash Flow Method

This approach uses the present value for future cash flows. The discounted cash flow formula uses a cash flow forecast for the next few years. Then, you take that discounted number back to the equivalent value if you received it today. You put the future amount into what you'd receive in today's dollars.

DCF = CF1 + CF2 + … + CFn / (1+r)1 (1+r)2 (1+r)n

r = interest rate

n = cash flow for the final year

CF = cash flow period

It does not subtract initial costs that include capital expenditures. Only use this method when your future cash flows are predictable, and make sure you use a discount rate for risk. This method does have its downsides since you cannot predict future economy, geopolitical events that affect the market, and new competitors in your industry who could lower your value.

Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) Method

Medium to large businesses use this method. Your business valuation takes into account your current financial statement but gives weight to expenses like taxes and depreciation. The formula is Net Income + Interest Expense + Depreciation Expense + Amortization Expense + Taxes = Value of a Small Business.

Return on Investment Approach

The ROI approach focuses on a formula that evaluates how quickly a buyer would receive a return on their investment. This approach's formula is an investment's net profit (or loss) divided by its initial cost.

ROI= Current Value of Investment−Cost of Investment / Cost of Investment

Book Value Approach

This approach relies on a small business's balance sheet statement. The valuation subtracts the total liabilities of a company from its total assets.

Seller's Discretionary Earnings Method (SDE)

SDE is the most common definition of earnings for small businesses. As you've likely figured out by now, most approaches look at the earnings, or income, of a business. SDE is the most common method used in looking at earnings. Discretionary earnings are your pretax earnings, salary, depreciation, and other expenses.

This earnings method looks at the pretax net income of the business. This means it takes into account the owner's salary, interest, depreciation, amortization, and any non-recurring expenses like a lawsuit judgment.

An income-based approach has several subsets that appraisers use to evaluate a business.

There are two steps in the Multiple Discretionary Earnings method.

  1. Calculate the business's discretionary earnings for the next several years. You can take your most recent earnings and estimate what's likely to happen going forward. Or you can average your last several years and use that figure.
  2. Multiply your figure by anywhere from 0 to 3. An average for most small businesses would be between 1.5 (higher for businesses that perform above average). This multiplied figure accounts for the tangible business assets that the business will use going forward. For example, if you calculate your discretionary earnings to be $50,000 and the business performs above average, you might multiply the figure by two to reach a value of $100,000.

This approach is the most straightforward and easiest to reproduce method.

Other Factors

While the above methods factor in tangible assets and revenue forecasts, don't forget about intangible issues such as customer goodwill. Goodwill is the customer loyalty and good reputation of the business. Assuming you have a high level of goodwill, you should be comfortable asking for the high end of your price range.

There are other factors individualized to business owners. If you need cash badly and simply want to sell, you'll probably have to be content with a lower price and quick sale. On the other hand, if selling to someone who shares your vision and affinity for the business is important, you may have to wait for the right buyer. Depending on the market and economic climate, you may be able to sell for higher or be forced to sell at lower than fair market value.

Get Outside Help

Small business valuation is a complicated process. While you can certainly use the information above for a rough estimate, you should consult with outside sources in order to accurately gauge the value of your business. Use your accountant, a business broker, and a business and commercial law attorney.

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