As a small business owner, you likely want to find out how much your business is worth at any given point. Finding out its value may satisfy your curiosity or guide you toward making the right choice in critical business decisions.
However, unlike real estate, finding the value of a small business is rarely straightforward. In this article, we cover how to valuate a small business, looking at some of the most practical methods you can deploy.
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What Is Small Business Valuation?
Small business valuation measures the economic worth of the company. Several approaches to small business valuation exist. Each method objectively assesses the business by analyzing the liquid assets, property, and anything else of economic value that the business owns. The valuation will also consider savings, loans, earnings, insurance plans, intangible assets, and more.
The valuation approach will often come down to the size of your business, the industry in which you operate, and other such factors.
Why Is a Small Business Valuation Necessary?
A small business valuation is necessary if you’re:
- Looking to acquire another company or complete a merger
- Thinking of selling your business
- Seeking funding from new investors and partners
- Undergoing divorce proceedings
- Re-evaluating a tax situation
- Looking to establish new ownership percentages
The reason for scheduling a valuation often influences the approach to the valuation process.
Eight Simple Steps to Small Business Valuation
Below are some key ways to valuate a small business:
1. Using Capitalization of Cash Flow (CCF)
The CCF approach is a simple income-related approach to valuating a small business that generates significant income. The method involves dividing the cash flow during a calendar period by the business’s capitalization rate.
When using this method, you must choose a period representing the business’s typical (and sustainable) cash flow. You should make adjustments to eliminate one-off expenses or large one-off income events that may significantly alter the results.
Your business’s capitalization rate is the projected rate of return a prospective buyer might earn if they were to acquire your business. It’s typically between 20 and 25% for most small businesses.
2. Using a Small Business Value Calculator
Business value calculators online provide you with an estimate of your business value by looking at metrics like profit and sales targets over a specific period. However, the results are too simplistic to depend on.
For example, the calculators typically won’t consider industry-related peculiarities, the economic outlook, the influence of the employee and management team, and other such details. You can only use this valuation method if you don’t have any official business valuation needs.
3. Using Future Maintainable Earnings
The value of your business hinges a great deal on its future profitability. The future maintainable earnings valuation method is a good business valuation method if you expect profits to remain stable over time. To valuate your business using this method, you have to evaluate the three-year data for:
- Gross profits
From the figures generated, you can come closer to predicting future cash flow and profits and giving your business an assumed value.
4. Using Discounted Cash Flow
This approach is another income-related approach to valuating a small business. This method uses the time value of money and the business’s expected cash flow to work out the current value. It’s an effective method if you’re expecting significant changes to business growth in the near future.
Calculating discounted cash flow is fairly complex. You need to know how to interpret your business cash flow statement and also how to read the expected cash flows. Additionally, you must know and understand the discount rate and the weighted average cost of capital (WACC).
5. Using Seller’s Discretionary Earnings
This approach is one of the best valuation steps if you’re looking at valuating a small brand —especially if you’re considering selling the enterprise. The SDE approach makes it easy for prospective buyers to see the projected earnings they can realistically expect per year.
The first step to calculating SDE is figuring out how much money you need to run your small enterprise. You can calculate this by evaluating EBITDA and EBIT.
You can find both calculations in your financial statements. The next step is to add details such as owner’s compensation, group health insurance, and other benefits.
You should also calculate other non-recurring, non-essential business expenses, like the cost of travel, consulting fees, the cost of running a business or personal vehicle, and more.
The expenses returned during the calculation of SDE often result in disagreements amongst stakeholders in the valuation process.
While you may count a consultancy payment as a one-off, a party interested in the valuation may regard it as a yearly expense necessary to keep the business profitable.
So, if you’re using this method to arrive at a valuation before selling your business, it’s best to liaise with the potential buyers to arrive at an understanding on what expenses to return.
6. Using Rules of Thumb
Many platforms have published “rules of thumb” approaches to small business valuations. However, they all have different methodologies.
At the base level, they all multiply sales, earnings, or revenues by designated multiples to come up with a value. Thus, for a business that generates $100,000 a year, these methods might put its value at $400,000.
Some multiply earnings by five or six times, while others multiply the EBITDA by three to five times. Ultimately, it’s difficult to know the right one for your business.
Even when you find “rules of thumb” relevant to your industry, the data may come from jurisdictions outside your province or outside of Canada. So, the numbers achieved by using this valuation method are no different from what you’ll get from plugging your business numbers into a random online valuation calculator.
7. Using a Market-Based Valuation
In market-based valuation, you can calculate the current value of your business by looking at the value of similar companies in your industry.
However, using the market-based valuation approach is difficult for small businesses for several reasons.
First, small businesses vary greatly, unlike the real estate market, where properties within the same postcode are often similar.
No two businesses are truly similar. Therefore, it’s hard to draw parallels with businesses valuated in your industry.
On the off-chance that you find businesses similar to yours, you may not find the valuation data you’re looking for.
Small businesses in Canada are typically sole proprietorships. They are not under obligation to disclose valuation data, even in the event of a sale. Therefore, market-based valuation is not the first-choice valuation method for small businesses.
8. Using a Chartered Business Valuator
A chartered business valuator (CBV) saves you the hassle of relying on black-box business valuation calculators or engaging in complex calculations beyond your scope. A CBV will look at your business and determine the best way to arrive at a value.
These professionals complete dozens of valuations yearly. Therefore, they are most likely to arrive at the true value of your business. However, as with all other professionals, you should carefully weigh your options before you choose a CBV.
First, you must choose a valuator who has significant experience working in your industry. They will understand the industry’s peculiarities and will most likely have a finger on the industry pulse.
Secondly, you should choose a CBV with experience working with small businesses exactly in your bracket. Most of the methods of valuation can work for businesses of all sizes. However, it’s in your best interest to work with a professional that understands the unique challenges facing small businesses like yours.
Finally, you need to choose a CBV with whom all parties involved will agree to work. For example, a prospective buyer will favor working with a well-known CBV over an obscure practitioner.
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