Determining the economic worth of your business is crucial for various reasons. Regardless of whether you’re a seasoned entrepreneur or just starting out, there will come a time when you’ll need to place a monetary value on your company. For those who lack financial expertise or access to an experienced finance team, the task of business valuation may seem daunting and complex.
In this article, we’ll delve into the reasons why business valuation is important and provide a straightforward, four-step method you can use to estimate your business’s economic worth.
Why do you need to know what your small business is worth?
There are many reasons you might need to value your business, including the following:
- The business is up for sale.
- You’re trying to find investors.
- You plan to sell stock in your company.
- A bank loan is required against the business.
- You must fully understand your business’s growth.
Valuing your business is important for investment and sales purposes. Knowing the worth of your business helps you tell investors, stakeholders, buyers or bankers the exact amount it’s worth. This information is necessary because if you want to sell a percentage of your business, you need to know how much it’s worth precisely.
The importance of a business valuation cannot be overemphasized when presenting to investors and buyers. It is crucial to demonstrate the value of your business to gain their attention and interest. If you cannot provide evidence of your business’s worth, it becomes challenging for investors to determine how much money is reasonable to invest.
Did You Know?
Angel investors and venture capitalists are two types of investors startups and small businesses may encounter..
Methods for calculating your business’s valuation
There are several ways to determine the value of your business. The two most common are the multiples method and the discounted cash flow (DCF) method.
1. Multiples method
The multiples method assumes that similar firms sell for similar prices. With this method, you would need another company in your industry that has recently sold. Take the sales price and divide it by that company’s total sales, EBIT (earnings before interest and taxes), or EBITDA (earnings before interest, taxes, depreciation and amortization). You will arrive at a number; this is the multiple. Next, multiply the multiple by your company’s sales, EBIT or EBITDA to arrive at a valuation.
2. DCF method
The DCF method does not take other companies’ results into account. Instead, it focuses on your company’s projected cash flow. You’ll give your best cash flow forecast for the next three to five years. Then, using a formula, you’ll calculate the present value of those cash flows.
Present value is a concept that compares money earned in the future to how much the investor would have made in interest if they had kept their money. It uses a discount rate – the likely interest rate the investor could have gotten from saving the money. If your company’s present value is more than the investment amount, it’s a good investment.
Using three years of projected cash flow, the formula is:
Value = Cash flow year 1 + Cash flow year 2 + Cash flow year 3
(1+ discount rate) (1+ discount rate)2 (1+ discount rate)3
To prepare a cash flow statement, run a cash-flow report in your accounting software, or calculate it manually using your balance sheet and income statement.
How to calculate your business’s valuation
We’re focusing on the multiples method because it’s less complicated and more widely used in business valuations. Follow these four steps to obtain a proper valuation of your business:
Step 1: Forget about capital assets when valuing your business.
Unless you’re a qualified chartered accountant or a financial wizard, you may have made the common mistake of associating asset value with business value. In fact, these two entities are completely separate.
Here’s the common misconception:
- Suppose your business has an office block worth $500,000, supplies and products worth $100,000, financial backing of $200,000, and a fleet of trucks worth $85,000.
- In total, you’ve got $885,000 in capital assets.
- If you were to sell everything now, that’s the cash value you’d receive from selling, so that is what your business is worth.
While all the above information may be correct, it isn’t what a business valuation means. It’s not what your business is worth; it’s how much cash is tied up in your business. A buyer isn’t interested in how much money they can make if they sell your office block. They are interested in how much money they can earn through the products and services produced there.
Step 2: Work out profitability by being aware of gross income and all outgoing payments.
Your business’s value is measured in profits.
A company valuation is all about the money you make now and in the future. A buyer wants to know how much they can expect to make if they take over your company.
With gross income and outgoing payments, your salary is included. However, we aren’t talking about every cent you earn from the business, just your base operating wage. We’re looking at net profit.
But that isn’t all we need. A business is not valued based on its income for a single year. We also must consider two more crucial aspects for valuing your company:
- Multiples: Multiples are longevity meters. You don’t expect your company to go out of business in a year if it’s worth selling, so how long is it likely to keep going and earning investors (or new owners) money? In the small business world, multiples range from two to 10. This number depends entirely on the risk factor involved and the business size. Larger corporations with solid foundations and longevity estimated in decades or centuries will likely achieve high multipliers. However, for a typical SMB, a multiple between two and 10 is the accepted norm. You multiply your net profits by whichever multiple is reasonable for your company.
- Profitability adjustments: A company is unlikely to generate the exact same profit every year. When valuing your business, you must determine the amount of growth or profit loss you can expect over your applied multiple. To do this, you’ll need to examine historical financial data for your company (if you have it), your market’s expected growth and your competitors’ progress.
“If you haven’t been keeping good financial records for historical data, that can take some time to put together and is often a starting point. But, if you have your historical data, then oftentimes you can have a financial model put together for a small business in about a week or two,” said Abir Syed, co-founder of UpCounting. “For very simple businesses that have all the data readily available, the model can be put together in as little as a day or two.”
Tip
To achieve growth and profitability, businesses can increase their market share, introduce new products and services, merge with or acquire other companies, or open a new location.
Step 3: Calculate the value.
This is the step everyone dreads: the actual mathematics required to calculate your small business’s value.
“It shouldn’t take long if you do proper bookkeeping, but if you’re in the middle of liquidating capital assets because you’re getting ready to execute an exit strategy that involves selling your business, it may take you months just to get ready to do the math,” said finance writer Jack Choros.
There are four elements involved in calculating your business’s value:
1. Establish your net income.
To establish your net income, take your small business’s gross profit and subtract all expenses. For example, suppose your business brought in $750,000 and had $500,000 in expenses (equipment, travel, supplies and salaries). We’re left with $250,000.
2. Look at multiples.
As mentioned before, the riskier or smaller the business, the lower the multiple you can expect to achieve. To work out your unique multiple, you must accept that there’s some guesswork and subjectivity involved. Unfortunately, there is no set way of finding a designated multiple. Instead, there are a few basic rules of thumb to follow:
- Research your industry. What multiples have other businesses like yours sold for?
- How healthy is your business’s financial history?
- Is it stable enough to request a higher multiple?
- What situation will the business be left in once you depart (if you are selling)?
- Do you have any contracted income guaranteed over the coming years?
- How extensive is your customer base, and how strong are your supplier relationships?
Looking at your variables, you must make a decision based on what you think your multiple should be. Here’s a basic guide:
- A business run by a single worker will be unlikely to sell for a multiple above three.
- Businesses with revenue below $500,000 often max out at five.
- Only larger companies earning more than $500,000 in net profits can expect to reach a double-digit multiple.
Back to our example: We’ve got an annual net profit of $250,000. We have $500,000 in expenses, which implies a reasonable amount of staff. Let’s assume that we fall into the second bracket for this example, leaving us with a multiple between two and five. Playing the middle ground, we’ll go with four, taking us to a current value of $1 million.
Now, bump up the value of the business based on potential growth. While finding this information is fairly simple, it will take time and energy to ensure accuracy. You’ll need the following information:
- Your own historical growth (or your competitors’ if you don’t have any)
- Your market’s growth
Historical growth is the most impactful factor. It’s hard evidence that your business has a track record of growth. Look at your profits and track how they’ve changed. Let’s keep things simple for our example:
- Over the past five years, our example company has increased profitability by around 8 percent to 12 percent.
- We value our business with additional growth of 10 percent per year across the multiple of four selected.
3. Figure out your market.
Your market significantly affects your profitability in future years. For example:
- If you are in a relatively established and stable market, you’ll probably be better off using historical figures, as there will likely be little movement.
- If you’re in a new market, you’ve got an opportunity to increase your numbers considerably.
4. Determine your potential market growth rate.
Compare your current growth rate against that of your market. Say your market grew by 15 percent last year and your business grew by 14 percent. You now have reasonable evidence suggesting to investors and buyers that they can expect similar growth levels as those predicted by industry experts.
Tip: While you can evaluate market growth and its potential impact on your company yourself, consider asking financial accounting experts for assistance or seeking a second opinion from other business owners in your network.
5. Add growth projections.
Returning to our $1 million example – we aren’t in a new market; we’re in the accounting industry. We’ll use historical data to calculate our growth because accountancy isn’t likely to see more growth as a whole than our hypothetical company will.
Add 10 percent per year to the net profits. Remember to multiply incrementally instead of adding 10 percent to your current figure to ensure accurate numbers.
- Year 1: $250,000
- Year 2: $275,000
- Year 3: $302,000
- Year 4: $332,000
That leaves us with a total company valuation of $1,160,250. Now, $1,160,250 is what our company is worth to investors and buyers, right?
Step 4: Factor in your market valuation.
Your valuation is a guide. You’ve created a valuation you can present to investors and buyers, providing them with a reasonable and respectable answer to the question “What is your business worth?” But that doesn’t mean your business is actually worth the value you’ve put on it.
Ultimately, your business is worth what the market says it’s worth. “Market value is often a very accurate way to estimate value, as it’s a function of the assessment of all other parties and all other information available,” Syed explained.
For example, we’ve valued our example business at $1.1 million. Continuing with our scenario:
- We meet with investors and buyers several times. While we cite our valuation figure of $1.1 million, we can’t secure more than $1 million. The investors agree with the valuation to a point, but they don’t accept the full figure.
- $1 million is now our business value.
If you can’t secure the full valuation amount from a buyer or investor, then it’s not an acceptable value. The market dictates your business’s overall value. If investors don’t think your business is worth $1.1 million, the business isn’t worth $1.1 million.
Bottom line: Even though you’ve done all the proper calculations to assure a good investment deal, your business’s value ultimately lies with investors or potential buyers.
A valuation can be just the beginning
After valuing your business, you may be ready to sell your business or take on investors. If your investor or buyer accepts your valuation, you must now negotiate the deal. In addition to the valuation, you must make many other decisions, including the deal’s terms, restrictions and timing.
If you need an investment to survive or can’t wait to sell, you can’t afford to be stubborn with your numbers. You may need to adjust them down.
“A business is only worth what the market demands. If your industry has fallen on hard times … you may value your business at a much higher valuation than the market would,” said Choros. “Things like timing and the greater need for your business within the marketplace still matter, even if your brand might be worth a lot more money, or your accounting records may show that you are worth more. Business is always about leverage. You don’t often get what you deserve; you get what you negotiate.”
If you just want to value your business for your own information, keep this information in your records in case you need it for a loan or investment in the future. The next step is making your projections come true or even exceeding them to build more value in your company.
Jennifer Dublino contributed to the reporting and writing in this article. Some source interviews were conducted for a previous version of this article.
