For some small business owners, the long-term plan is to build their company up and sell it when the value is at its highest. But according to market research from IBIS World, only two percent of businesses in the U.S. value themselves annually. Banking on a final payday when you're ready to sell is no safe strategy unless you know for sure what your company is worth.
"Nearly 40 percent of active businesses [in the U.S.] will sell in the next 10 years," said Mike Carter, CEO of BizEquity. "The haunting statistic is that 78 percent of the business owners who sell think they're going to fund 80 to 100 percent of their retirement needs from the sale of the business. But if only two percent really know what they're worth that's a huge problem, not just for the owners but also for the economy."
The reason so many business owners don't know their company's worth is they don't add their expenses back into the total value, Carter said. He recommended utilizing the "Seller's Discretionary Earnings" methodology in order to obtain a truly accurate picture of a privately held company's value. [5 Ways to Prepare Your Business Before You Sell It]
Seller's Discretionary Earnings (SDE) is a measure of a business's net profits with certain expenses added back. These expenses are generally ones that benefit the business owner, such as the owner's salary, insurance premiums, and larger one-time expenditures. Knowing your SDE and total revenue is crucial to gaining an accurate valuation of your company.
In addition to being aware of your SDE and revenue, Carter recommended following these steps to determine your business's value:
Research your industry. Utilize free search tools to find the North American Industry Classification System (NAICS) and Standard Industrial Classification (SIC) codes for your specific business. This will help you compare your value to other businesses in your sector.
Think about your growth rate. Long-term growth rate can factor into your business's value, and could account for why your company is actually worth more than what the market says.
- Don't only use the buyer's valuation. When you're ready to sell, a buyer may make an offer based on his or her valuation of your business. Before completing the sale, be sure to get another third-party value assessment to ensure you're not underselling your company.
If you're planning on funding your retirement with the sale of your business, it's important to begin evaluating your company's worth now. Putting it off until shortly before you're ready to call it quits is a recipe for disaster, Carter said.
"If you wait until right before you retire [to value your business] it's like planning for retirement the month before you actually retire," Carter said. "You wouldn't do that, I wouldn't do that, and yet millions of business owners are doing that every day."
Additional reporting by Adam C. Uzialko. Some source interviews were conducted for a previous version of this article.