Understanding various methods of how to value a small business
March 13, 2023 ⋅ 14 min read
When I asked my parents what they were going to do with their business when they retired, they had no idea. I asked them if they had ever considered selling the business (they had not) and naturally, their first question was “Well, how much is the business worth?” Baton was born to help answer this question for small business owners. We’ve come to find that the methods used to value a business tend to be fairly opaque to small business owners. Understanding the underlying principles can be helpful to build a shared language with brokers and buyers owners may encounter down the line.
There are many reasons to pursue a valuation aside from planning to sell the business. For example, you may be buying out a partner's shares, planning for retirement, evaluating other business opportunities, or looking to chart your business’s growth path. Read on to learn about the most common techniques used to determine the value of a small business, and how to determine which method is right for you.
Understand Different Approaches to a Successful Small Business Evaluation
While there are a lot of different methods of valuing a small business, the best one for you and your business may depend on the stability of the company's finances or the purpose of the valuation. It’s important to consider:
How much income the company is expected to generate for its owners;
What the company owns (its assets); or
How much the market is likely to pay for the business based on comparable sales.
Market-based Valuation Methods
Market-based valuation methods rely on evaluating the sales prices of businesses with similar revenue, EBITDA, and cash flow. Recent sales, as well as active listings, are considered. While finding comparables is often difficult, it can be accomplished with the assistance of an experienced broker or appraiser, or by working with Baton to access its extensive small business dataset. The benefit of market-based valuations is that you're not relying on assumptions about future cash flow. Instead, you're offering real data to justify your business’s worth. The downside is that your company may have value that isn’t necessarily captured in your financial statements like a competitive moat or intellectual property.
Adjusted Net Asset Method
The adjusted net asset method changes the stated values of the company's assets and liabilities in order to better represent current estimated fair market values. The allowed changes include all tangible and intangible assets, as well as off-balance sheet assets, such as operating leases, leaseback agreements, and accounts receivable. This method is often utilized in liquidation scenarios by companies that regularly generate losses and where a value based on a company's net income or cash flow levels would be valued lower than the adjusted net asset method.
Unfortunately, however, this valuation method is often inadequate at showing any goodwill and intangible value held by the company. It’s important to note that valuations featuring off-balance sheet assets are often considered misaligned with generally accepted accounting principles.
Discounted Cash Flow Method
This method provides a valuation based on expected future cash flows. This method is typically used to calculate a business' value when the business owner is planning to sell it, or to better inform decisions about budgeting and operating expenditures made by owners or managers. The method is most useful when the company has a steady cash flow or it is expected to significantly grow or decline in upcoming years.
The discounted cash flow is determined by first finding the cash flow over multiple quarters, months, or years. Cash flow refers to net cash payments received by the company. Next, you need to determine the business's weighted average cost of capital which can get a bit technical. At a high level, the weighted average cost of capital is the cost of capital for a firm. You can then arrive at the discounted cash flow by taking the sum of cash flow in each defined period, divided by one, plus the discount rate. A discount rate is typically the interest rate charged by banks for short-term loans.
Seller's Discretionary Earnings Method
The seller's discretionary earnings (SDE) method is used exclusively by small businesses and is often the choice method when buying or selling a small business, as it can help a buyer to understand how much income they can reasonably expect to earn from the business. This method involves determining the business's earnings before interest, taxes, depreciation, or amortization. This information, known as net profit, is found in your company's financial statements.
From this net profit, you "add back" the owner's compensation and benefits, interest, taxes, depreciation, as well as non-essential and non-recurring business expenses such as travel, one-time consultations, one-time technology upgrades, or the use of the owner's personal vehicle for business purposes or charitable contributions.
After finding the seller discretionary earnings, you apply a multiple to get the valuation. The multiple can be based on a variety of factors between business size, industry, and characteristics. These multiples are sourced from market comparables (comps) and you can typically expect them to be anywhere from 0x-5x.
Capitalization of Cash Flow Method
This method is simpler than many of the other methods for determining the value of your small business, requiring you to divide the cash flow of a specific period by a capitalization rate. The capitalization rate is the business' expected rate of return that a buyer could expect to earn with the exclusion of their salary. This method is generally used for valuing businesses that have been around a while and have a stable, consistent cash flow. That said, it is not as flexible as the discounted cash flow method, which allows for more variation in growth rate, debt repayment, and other types of costs that are not always static.
What Is the Quickest Way to Value a Business?
The quick method used by many professionals in the space is the multiple of earnings method. This method involves determining your discretionary earnings likely to occur in the near future and using a multiplier between 0-5. To determine the multiplier used, consider that most small businesses sell for about 2-3 times the discretionary earnings, with the amount over the discretionary earnings being the value of tangible assets needed to operate the business, such as inventory, fixtures, or equipment.
Baton uses a combination of the methods we’ve discussed to provide an unbiased, accurate valuation that considers the unique details of your business. Getting started takes just 10 minutes.
Factors that Influence the Multiplier/Base Value
There are a number of factors that are taken into consideration when determining the value of a small business — here are some of the main considerations.
When someone determines the list price they want to place on the home they're selling, they often look at similar homes in the area and what those homes have sold for to arrive at a fair price. While the concept is similar when determining the value of a small business, it can often be harder to find the details of a small business sale or to understand whether the two businesses are really similar enough to have close to the same value. Just a few of the many questions to consider when studying comparables include:
Is the business within the same industry as yours?
How many employees does the comparable have?
What is the size of the company's customer base when compared to yours?
Does the business have similar competitive moats?
Tangible assets refer to the physical assets owned by the business. These commonly include:
Real estate and lease terms
Securities, such as stocks, bonds, or cash
Tangible assets are generally described in one of two ways. They're either a current asset, such as cash, inventory, or marketable securities that are anticipated to be used in a year or less, or they're a fixed asset – such as machinery, buildings, and office furniture that is needed to operate the business.
Not all of the assets of a business are physical. Intangible assets refer to long-term assets that exist but cannot be touched or seen. Examples of this type of asset include:
Goodwill, which includes customer loyalty or brand reputation.
Proprietary technology, such as specially developed products or software that the business has copyrighted or patented.
Positive online search rankings.
Positive online reviews.
Goodwill is only calculated as an intangible asset when there has been a recently completed merger or acquisition. When a buyer pays above and beyond the net value of the business, the additional amount over the identifiable assets is considered a "goodwill" payment for the value of loyal customers and an established brand.
If two businesses possess roughly the same amount of earnings and assets, but one business derives its earnings from a customer base of 200, while another business generates all of its revenue off of three customers, which one is typically valued higher? As it turns out, the one with more customers. Customer concentration is the measure of total revenue that comes from your biggest clients. For example, a business that relies on two customers for 30% of its annual sales would be said to have a high customer concentration, which can be a poor signal when it’s time to sell. Customer concentration is viewed as a negative signal because the potential impact of losing a single customer can be financially devastating for the company, whereas a more diverse customer base serves not only to lessen the impact of a lost contract but can also result in greater opportunities for growth.
How Many Times Profit Is a Small Business Worth?
While most small businesses sell between 0-5 times seller discretionary earnings, there is no hard and fast rule to determine value. Ultimately, a small business, like any asset, is worth what someone is going to pay for it. A good valuation will help you understand what fair market value is for the business.
As you can see, there are a variety of factors that may impact a valuation. Baton uses a holistic approach to determine the fair market value of the business by understanding what makes your business unique, leveraging multiple valuation methods, and building a personalized roadmap with the support you need to improve your business’s valuation.
Tips for Improving Your Small Business Valuation
Keep in mind that whatever valuation you receive for your business can be improved with proper planning. There are many things you can do to increase the value and prepare for a potential sale. Here are just a few tips:
1. Consider the market
Understand how market volatility can impact the value of your business. Troubles with the economy may have negative impacts on your business, including customers unable to pay what they owe, investors slowing down on executing deals as the cost of capital changes, and difficulty finding new talent as quality employees are more likely to stay at a job they are unhappy with than move forward to a new opportunity. Even economic booms can result in market volatility that could make it hard to accurately pin down a business's value.
2. Don't wait until the last minute
If you are planning to sell your business but have yet to create a business exit plan, consider doing this first. It’s never too early to start thinking about how you would like to exit the business and how you might fund your retirement. Baton is here to help you answer critical questions like, “How much money will I have to retire with if I sell my small business?”
3. Understand the current value of your business
You’ll want to consider using the methods above and working with a company like Baton to help you understand how much the business may be worth.
4. Improve your cash flow
In spite of the often difficult financial climate in recent years, there are many ways a business owner can improve their cash flow. For example; keeping a watchful eye on customer credit in order to determine when it is time to pursue collections; keeping a consistent watch on inventory to determine which products are in high demand; using high-interest savings accounts that will provide a higher yield than a traditional account; and, of course, finding ways to generate more cash-producing revenue for the business.
5. Diversify your customer base
As we discussed earlier, significant customer concentration can reduce the value of your business as buyers or investors often regard it as a risk. If you're only serving a handful of customers and one of them decides to take their business elsewhere, it is going to have far more of a negative impact than if you have a wider customer base.
6. Improve customer service
Build brand loyalty and maintain a diverse customer base.
How Baton Can Help
Baton is the ideal starting point in learning what your business is worth. We work with a network of small business and finance experts, in order to provide business owners with valuations and recommendations.
Additionally, we have a network of vetted partners (including brokers) to help grow or sell your business. We give transparent information of various partners, ultimately giving power back to the small business owners.
Working with a business broker may not be right for everyone but they may be able to supercharge your efforts by doing things like locating buyers who are interested in a business like yours that may help drive up the price. A good broker will also help you negotiate fair and standard terms for your business.
Examples of How to Value a Small Business
Knowing your business's value can be used to:
Track the growth of your business over time.
Satisfy income requirements when applying for financing.
Set a fair price for employee shares.
Below are some examples of how to value a small business. It’s important to note that these examples give a representation of just one type of valuation method each. When determining the value of your business in real life, it’s best practice to use more than one method of valuation to determine the most accurate value of your business. At Baton, we can walk you through which valuation methods are right for your business and how to make sense of those outcomes.
There are two retail automotive parts stores located on the same block. One of the stores just sold for $3 million a month ago, and an automotive service store that also sells a limited amount of merchandise two towns over is listed for $3.8 million – and has been on the market for six months. The owner of the second retail automotive store is now planning to sell and wishes to determine the value of their store. They think they should be worth nearly the same as the other businesses, but upon analyzing the detailed information about each of the comparable businesses, the owner determines that the automotive service business is not truly comparable because it not only places a larger focus on its service offerings but is also likely overpriced. The owner of the second retail store places their business on the market with a list price of $3 million, as that is what the owner is likely to sell the business for based on comparable businesses in the market.
A dentist wants to value their practice. They have a net profit of $200,000 a year. By using the seller's discretionary earnings method, the dentist is able to "add back" certain expenses to the value of the business, such as:
The $90,000 a year salary they collect.
$25,000 worth of equipment that had to be replaced this year.
$20,000 from the company's share of the owner's payroll taxes.
$1,500 that the owner spends each year to provide mobile phones for their family members who are not employees of the business.
With $136,500 in SDE (the total of the expenses above), we figure in a multiple of 2.0-2.5. This brings the total value of the business to $200,000-270,000, plus the $200,000 profit, for a total of $400,000-470,000.
The owner of a software company is planning to sell the business and is valuing the business using the capitalization of cash flow method. The owner expects $100,000 in free cash flow to the firm (FCFF), which is cash available after paying operating costs. They invested their FCFF, leading to a 5% growth rate. The weighted average cost of capital is how much the company must make in order to begin making a profit, at 15%. The formula for valuing the business is FCFF/( WACC-g) for a total enterprise value of $1,000,000.
Determining the value of your business is helpful for a number of reasons beyond preparing to sell. You may want to attract investors who can provide money that the business needs to grow or simply to better inform business decisions. Baton makes it simple to get an estimated business valuation fueled by actual data. Whether you’re looking to grow your business or preparing to sell, we’re here to support you. Find out what your business is worth and get access to our vetted partner network by getting started today.