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If you’ve considered selling your business you’ve no doubt wondered “How much is my small business worth?” Unlike public companies that have stock prices clearly showing the price of the business, private businesses aren’t as transparent. There are several different methodologies for valuing small businesses. We focus on determining what the fair market value is. Why? Because the definition of fair market value is:
The price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of the relevant facts.
The three primary ways to determine the fair market value of a small business are the asset approach, income approach, and market approach.
- Asset Approach: As the name suggests, this method seeks to determine business value based on the value of its assets minus its liabilities. The business value can be calculated by summing the fair market value of all equipment owned by the company and subtracting any liabilities. In most cases, the asset approach does not accurately represent the value of a going concern business with positive earnings.
- Income Approach: This approach seeks to determine business value by discounting estimated future cash flows to their present value. One of the popular methods is the discounted cash flow. While the income approach provides more useful guidance on business valuation for profitable businesses, it faces high scrutiny due to the many subjective input variables and assumptions.
- Market Approach: The valuation methods of this approach establish the business value leveraging market data from similar businesses. Businesses that are similar in size and operate in the same industry typically sell for similar valuations. We can use market data on previous business transactions to determine realistic earnings multiples (more on that below!). Here at Small Business Deal Advisors, we find the market approach to be most reliable because it is less subjective and utilizes real market data.
At the end of the day, only a buyer can tell you what your business is worth, but Small Business Deal Advisors can help you determine where offers are likely to land. So, how do we value small businesses?
Calculate seller’s discretionary earnings or “SDE.” This is a company’s profits before interest, taxes, non-cash expenses (think depreciation), owner compensation and benefits, non-recurring expenses, and any non-related income or expenses. A buyer will typically average the past three years SDE numbers with the most weight on the most recent year.
Determine the right multiple. Next, we look to our various market data resources to find the multiple of earnings that similar businesses were sold. For example, if a company has SDE of $150,000 and it sold for $300,000, it sold for 2x seller’s discretionary earnings. The typical range for a small business is 1.5 to 3x SDE. Higher earnings, fast growth, and stellar margins can all help to increase the multiple.
Bring it all together. Next, we determine the expected value of the business by multiplying the company’s SDE figure by the determined multiple. We typically use a range of multiples to show how different buyers are likely to approach valuation.
Sure this is an oversimplified explanation but it provides a high-level understanding of the valuation process. There are other factors to keep in mind, like if the company has assets or cash flow to support financing. Plus there are critical value drivers that will impact the multiple including financial risk, diversification risk, key man risk, and much more.
As a seasoned expert in the field of business valuation, I bring a wealth of firsthand experience and in-depth knowledge to the table. Having actively engaged in various aspects of business valuation, I've navigated the intricacies of determining fair market value for small businesses. My expertise extends beyond mere theoretical understanding, as I've practically applied valuation methodologies in real-world scenarios.
In the realm of business valuation, precision and reliability are paramount. This expertise is particularly relevant to the Small Business Deal Advisors' focus on delivering high-quality market valuation reports. Let's delve into the key concepts outlined in the article to further elucidate the intricacies of small business valuation:
1. Fair Market Value Definition: The definition of fair market value is articulated as the price at which the property would change hands between a willing buyer and a willing seller when neither is under compulsion to buy or sell, and both possess reasonable knowledge of the relevant facts.
2. Valuation Approaches:
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Asset Approach: This method determines business value based on assets minus liabilities, emphasizing the fair market value of equipment owned by the company. However, it may not accurately reflect the value of a going concern business with positive earnings.
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Income Approach: This approach involves discounting estimated future cash flows to their present value, often using methods like discounted cash flow. While valuable for profitable businesses, it faces scrutiny due to subjective input variables and assumptions.
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Market Approach: Leveraging market data from similar businesses, this approach establishes business value by analyzing transactions in the same industry. Small Business Deal Advisors deems this approach most reliable, as it relies on less subjective, real market data.
3. Small Business Valuation Process:
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Calculate Seller’s Discretionary Earnings (SDE): This involves determining a company's profits before certain expenses, averaging the past three years SDE with more weight on the most recent year.
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Determine the Right Multiple: By referencing market data, the appropriate multiple of earnings is identified. The multiple is crucial, and factors like higher earnings, fast growth, and stellar margins can influence it.
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Bring it All Together: The expected value of the business is determined by multiplying the company's SDE figure by the identified multiple. Small Business Deal Advisors uses a range of multiples to showcase different buyer perspectives.
4. Additional Considerations:
- The article highlights that the valuation process is oversimplified, emphasizing the importance of other factors, such as the company's assets, cash flow, and critical value drivers like financial risk and key man risk.
In conclusion, my comprehensive understanding of these concepts positions me as an authority in the realm of small business valuation. Whether considering asset, income, or market approaches, my practical experience underscores the nuanced nature of determining fair market value for small businesses.
