- Knowing the market value of your business can help in areas like taxation, financing and various disputes, such as divorce proceedings.
- Business valuation is especially important when you need to find out a partner's ownership value during changes in ownership and sales of shares.
- There are multiple methods to estimate how much your small business is worth.
- This story is for small business owners looking to begin the business valuation process.
Over time, the worth of your business fluctuates as different factors contribute to its overall worth. While you might not think you need to calculate your business's valuation unless you're ready to sell your business, there are more uses for this number than making it easier to facilitate a sale. The steps, costs and time it will take may depend on the method you use, but having an accurate business valuation on hand can be a big help in certain situations.
What is a business valuation?
In defining a business valuation, it could help to think of it as an appraisal. For instance, when you sell your home or a valuable antique, you want an estimate of how much the item is worth.
Generally, valuations are done by calculating a company's tangible assets (machinery, real estate, etc.) and intangible assets (brand recognition and trademarks) versus the liabilities and debts it currently holds, though different methods may look at different metrics. A company's value is also impacted by how profitable it is on an annual basis.
"Successfully calculating your business valuation means knowing the aspects of your business that are essential and nonessential and being realistic about what contributes to your effectiveness," said David Adler, founder and CEO of The Travel Secret. "Most formulas to calculate your value based on income involve knowing your nonessentials, your earnings and your owner's draw."
Having a general idea of how much your company is worth can help in several situations. With that information in hand, you can more easily settle disputes, whether they come from a legal issue, the IRS or within your company. While an accurate business valuation can help with the future sale of your business, it can also be helpful for entering a partnership, obtaining a loan or changing ownership – especially if you're getting a divorce, gifting the business to someone else, buying someone out or exchanging shares.
"I have found valuations useful in early-stage companies that are seeking funding," said Tom Mercaldo, president of Aquinas Consulting. "Investors need a justification for the valuation a business is seeking, and [business valuation can] offer data points to justify a business's desired valuation."
Key takeaway: Business valuation helps you determine how much your company is worth, which is useful for seeking funding, changing ownership or resolving various disputes.
How helpful are business valuations?
The perceived worth of a business valuation varies from person to person and is highly dependent on why the valuation is being calculated in the first place.
Zach Reece, COO of Colony Roofers and certified public accountant, said a business valuation can act as a road map to a business's future.
"It's important for business owners to understand the value of what they are building, so they can make sure they're spending their time on something that aligns with their long-term financial goals," he said. "Businesses in different industries are valued at different 'multiples,' so it's important to know what the norms are for your industry."
One of the biggest reasons to get a valuation for your business is that it's going on the market to be sold. With an estimate of how much your business is worth, you can more easily determine your preferred asking price on the market. For many experts, a business valuation is the first step in the negotiation process.
"A business valuation is imperative to understand the true value of the business so that owners don't settle for less than fair value or give up more equity than they should," said Dave Bookbinder, senior director at CFGI.
As for how frequently you should conduct a business valuation, it depends on your business. Most experts will tell you that an annual valuation is unnecessary for the vast majority of small businesses, since valuations can be costly and time-consuming.
"Unless a business owner is actively planning on a sale in the next few years and wants to know how to increase the value of the business, or the business has been sold to an employee stock ownership plan (ESOP), most business owners do not need to have their business appraised every year," said Shawn Hyde, executive director of the International Society of Business Appraisers. "However, if the business is your largest investment, it may not be a bad idea to check on its health every so often, and a detailed valuation analysis can do that."
Key takeaway: Though they can help in situations like selling your business or handling disputes, business valuations don't need to be an annual process for most small businesses.
How can you determine business valuation?
Much like the numerous reasons for wanting an accurate company valuation figure, there are several ways to calculate that estimate. How big your business is, how many employees you have, and your expected business growth all play a part.
As a small business, the most important thing you want to keep in mind is your seller's discretionary earnings (SDE). The SDE is the business's income before it pays the owner's salary. The metric of earnings before interest, depreciation and amortization (EBITDA) is generally a focus of larger businesses.
Here are a few methods you can use to determine your business's worth.
1. Asset-based valuation
This valuation method relies on calculating your business's worth based on its assets. One way to do this is to look at your company's balance sheet, take the total book value of each tangible and intangible asset, and subtract any liabilities. Another method is to calculate how much money you would have on hand after selling the company's entire stock of assets and paying off the remaining liabilities.
2. Historical earnings-based valuation
This valuation method looks at your business's gross income to determine its worth. The more consistently your business remains in the green, the higher value it will have. If your business regularly finds it difficult to generate income, its value depreciates.
3. Market value-based valuation
If your company operates in a crowded field of similar businesses, this type of valuation could work for you. The market value calculation compares your business to a similar company that was recently sold in an attempt to find its fair market value. This is only a valuable measurement if you can find a decent number of comparable businesses that have recently changed hands.
4. Relative valuation
This method deals strictly with how much money your company would bring in if it were sold on the market. With this business valuation method, you'd compare every asset controlled by the business to similar assets. The value determined from there gives you an estimated starting price for negotiations.
5. Discounted cash flow valuation
Depending on your business model, this type of valuation could work if profits aren't expected to be consistent. When using the discounted cash flow method, you calculate any future net cash flow and adjust it to present values. By determining this information, you can figure out how much your business assets will be worth in the future.
6. Revenue basis
Revenue basis valuation combines a few of the previous methods mentioned. You will need to know your annual sales revenue. Once you know that amount (or the projected amount), you can research what other companies in your industry earn annually. According to the Hartford, a broker can inform you about what a typical business in your industry may be worth for a certain number of sales, like two times the sales.
7. ROI valuation
ROI stands for return on investment and is a key figure for businesses that want to know whether they are in the red or the black. ROI is calculated by how much you have invested in the business and how much you can benefit from the sale of the company. You will need to know the current market value to make this calculation. Once you have the ROI, you can assign an estimated value to your company if brought to sale.
8. Book value valuation
To calculate the book value, there are two key numbers you need to know: total annual liabilities and total assets. For instance, if your company has assets worth $500,000 and liabilities that total $275,000, the book value is $225,000. Market value is usually more than book value, because the former takes into consideration intangible assets such as growth potential and profitability.
9. Liquidation valuation
Liquidation valuation is a formula that assigns a value to a business if it went liquid at that moment. You need to calculate if all the assets were sold, how much would you get for the company. Liquidation values are usually less than book and market value because it is considered a rapid sale. Since liquidating is quick, you wouldn't fetch the highest price for assets.
10. Comparable analysis value
Comparable analysis involves comparing different companies in the same class as you. Comparable businesses are similar in size and work in the same industry as your company. The same metrics must be collected from all companies in the analysis with at least three businesses reviewed. Cash flow values are looked at for the businesses to determine the approximate worth of the companies.
Key takeaway: There are multiple ways to conduct a business valuation. The right one for you depends on your reason for conducting the valuation and the specifics of your business.
Should you hire a business valuation professional?
As the owner of your business, you'll likely be able to obtain all of the raw data you need to conduct your own business valuation. While this may be feasible, you should rely on your own findings only for your personal knowledge. If you need a valuation for anything more than that, you should hire a professional.
"If you are looking to sell the business, or sell shares within the business, or have more partners, this is when you would need to have a professional come in," said Ethan Taub, CEO of Billry and Creditry. "If you are just doing this for your own personal knowledge, you can do it by yourself and get a good calculation."
As with most small business considerations, you have to weigh the cost versus the benefit. Business valuation services charge either an hourly rate or a flat project fee, though additional expenses will likely be charged separately. Your final bill will depend on how large and comprehensive the project is, with costs ranging from $5,000 to $20,000.
While it may be worthwhile for you to just skip the cost and do it yourself, hiring an appraiser could be worth the cost in certain circumstances, said Michael Hammelburger, CEO of The Bottom Line Group.
"A professional business appraiser will offer accurate auditing skills and a detailed valuation report to make sure that the financials are correct," he said. "This eliminates doubts on whether you've assessed the value correctly or not when doing it by yourself. In addition, when selling your business, you're on the advantage when a buyer tries to negotiate your price for a much lower value, because your business valuation has been conducted by a professional who can verify its true worth."
Key takeaway: Though their services can be expensive, hiring a business appraiser to conduct your valuation will give you the most accurate estimate of how much your business is worth. As with most things in business, you have to weigh the cost against the benefit.