5 Simple Steps to Valuing Your Small Business
Many business owners pour their blood, sweat, and tears into building value in their companies, yet few have a firm understanding of the actual value of their enterprise. One of the explanations is that – let’s face it – valuations are notoriously tricky. They’re usually jam-packed in metrics, variables, and hard-to-measure factors and riddled with intricate finance theory and intimidating jargon that only exacerbates the confusion. Small business owners often do not even want– or need – to make the whole thing that complicated. Most just need a general idea of how valuations work and a quick way to determine their company’s fair market value using some “back-of-the-envelope math.” So, skipping all that, TamBay Business Brokers reveals five simple steps to valuing your small business.
Step one, understand your valuation
It’s like we’ve said: unless you’re a financial wizard, naturally talented with numbers, or a business person, putting a price on a small business isn’t the easiest thing in the world. For this reason, you might want to familiarize yourself with some key concepts.
To get a rough idea of how valuations work, you must first familiarize yourself with a couple of key concepts.
Seller’s discretionary earnings
First, let’s tackle what SDE, or seller’s discretionary earnings, is. You can think of it as pre-tax net income. Basically, the bottom-line profit will show on your profit and loss statements, plus any personal, discretionary, and one-time expenses, depreciation and interest, and owner’s compensation. Of course, these must be documented and justified.
So, let’s say you have a net profit of $100,000, a salary of $50,000 per year, and add-back expenses of $50,000. So, $100,000 + $50,000 + $50,000 equals SDE of $200,000 for the previous year.
Finally, subtract any liabilities—debts, unpaid bills, etc., and the final number is your SDE. But, more on liabilities later. A note on the side: you can always set a goal SDE for the next year and work on increasing your business’s value before you sell.
SDE multiples
However, SDE does not speak to your business’s long-term, fair market value. That’s when an SDE multiple comes in. It considers all the essential data such as:
- your business’s size and location,
- tangible and intangible assets,
- what industry you are in,
- market volatility,
- risks,
- how much of the value comes from your personal brand or skills,
Of course, the higher the multiple, the better. But you may need a professional – a mergers and acquisition specialist or a business broker with CBI designation – to help you determine your multiple and tailor it according to your company’s specific characteristics and circumstances.
Step two, gather relevant data
When selling your business, you must organize your financial and business records. This is a crucial step not only for reaching accurate calculations but also for transferring business ownership. You will need:
- Licenses, deeds, proprietary documents;
- Tax filings and returns (do not forget to add these back to your earnings when calculating your SDE);
- P&L statements (for the last three years);
- An overview of your personal or business finances.
You must have your paperwork in order.
On the other hand, if you’re buying a business, make sure to review your credit report and basic financial profile. Establishing a solid financial foundation is imperative for maintaining realistic expectations about the business you are selling – or hoping to buy. So, make sure to be as thorough as possible. Later, you’ll be more confident in your calculations when valuing your small business.
Step three, take stock of your assets
Review your assets and liabilities
A small business valuation calculator also includes your business’s production, property, and resources. Sellers will need to review assets and liabilities and make a detailed report. Business assets include anything of value that your company owns, creates, or benefits from. They can range from your production line, raw materials, and delivery truck to office equipment and intellectual property. These mainly fall into one of the two categories, which are weighted differently when calculating your small business’s value.
- Tangible assets include real estate or property, inventory or stock, cash on hand, and all the computers, monitors, and other office equipment you’d be packing into moving boxes if you were relocating your business. So, all the physical resources and holdings of a company. When packing office equipment, create a detailed list and take inventory of your assets. Tangible assets require that you exercise care since they can be physically damaged and thus reduce the value of your business.
- Intangible assets are all non-material assets – such as patents, trademarks, copyrights, brand and reputation, customer loyalty, and subscriber base – that add value to your business.
To properly value your small business, you should also know its liabilities. These include any debts, credits, or other obligations that detract from a given business’s overall value. That is why they’re later deducted from the SDE in the valuation process. Examples include:
- Accounts payable
- Interest payable
- Bills payable
- Accrued expenses
- Business loans
- Other debts or payables
Outline your business plan and model
The next step in determining your small business’s value is to outline your business plan and business model. As a seller, your prospective buyer will want to know how your business generates revenue – and that it will continue to.
A solid business plan provides a crucial context for a business. It captures critical goods or services you offer, your mission, and your strategy. Also, it makes it easier for business owners to make accurate projections for earnings and market growth. Basically, it goes into detail to show the potential of your business. On the other hand, your business model is a gateway to show how your organization functions and how your company generates profits. Moreover, it is the structure companies use to build value, manage challenges, and achieve success.
Step four, perform due diligence
Making yourself familiar with your industry is imperative for both sellers and buyers. First, buying a business is not a decision one should make lightly. You must know what you’re getting into, especially if you’d have to pack up and move to a different city or country. That’s why miamimoversforless.com always emphasizes the importance of doing your research before buying a property and relocating. You should know the ins and outs of the company you’re buying and become well-versed in that business’s industry.
Always make sure to do your industry research.
On the sell side, an in-depth understanding of the industry trends plays a big part in reaching an informed valuation (one that reflects both the assets of your business and the current market). For instance, your SDE multiple – and the valuation method – hinges on several factors, including the industry’s strength. Therefore, try to learn as much as possible about other businesses in the same niche that are similar in size, business model, and revenue. Doing so will help you orient within the marketplace, obtain some context about the sector, and assess your market share, future outlook, and growth potential. You can ultimately demonstrate to prospective buyers what makes your business unique.
Step five, choose your approach
The fifth step in valuing your small business is determining the valuation method that creates the most value for you. The three most common are the asset, market, and income methods. Let’s briefly mention how each of them works.
- Asset method. If you decide to take the asset-driven approach, you would simply take the difference between a business’s assets and its liabilities, which are adapted to their fair market values.
- Market method. Just like the name suggests, the basic premise of this approach is to look at what comparable companies within the same industry have successfully sold for.
- Income method. This method determines a business’s future economic benefit. Two methods fall under this category. The first is the so-called discounted cash flow method, and the second is the capitalization of earnings method.
The final words from TamBay Business Brokers
So, why not try plugging your earnings numbers into different method formulas and make a comparison? Inspect what doesn’t seem right, and don’t be shy to call in a professional for extra help. After all, doing the math is free. Still, the best tip we can give you is to talk to a business valuation expert who can help you reach your ultimate valuation. They have the necessary experience, training, and education. Plus, they will guide you through all the steps to valuing your small business – from preparing documentation to choosing the best valuation method for your circumstances.
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