4 Simple Steps to Valuing Your Small Business

The importance of knowing your small business’s worth

Valuing your business is important for investment and sales purposes. Knowing the worth of your business helps you tell investors, stakeholders, buyers or bankers the exact amount it’s worth and what a reasonable offer would be. 

“If you overestimate the value, you’ll scare your buyers away. If you underestimate it, you’ll leave money on the table,” Mike Blake, CEO of business valuation and strategic advisory service High Score Strategies (HSS), told us. “But more important than the number itself is why the value is what it is. This empowers you to take action to increase the value and to negotiate with greater authority.”

If you cannot provide evidence of your business’s worth, it becomes challenging for investors to determine how much money is reasonable to invest.

Here are a few of the many reasons you might need to value your business:

• The business is for sale.
• You’re trying to find investors.
• You need to acquire adequate business insurance.
• You are planning a merger or acquisition.
• You plan to sell stock in your company.
• You plan to pass the business to a successor or exit entirely.
• A bank loan is required against the business.
• You must understand your business’s growth fully.
• You have legal obligations such as estate planning, a divorce settlement or tax reporting.

It’s not just enough to know your business’s worth when you’re facing one of these business propositions. Finance experts advise you to know it before you need it.

“The mistake I see constantly is many owners that wait for a potential sale before getting a valuation,” said Holly Andrews, managing director of finance broker KIS Finance. “But, truth be told, whether you’re chasing funding, making deals, mapping growth or taking stock of your financial position, a solid valuation hands you both leverage and clarity. These prove invaluable as you expand or navigate key decisions.”

Methods for calculating your business’s valuation

There are several ways to determine the value of your business. The three most common are the multiples method, the discounted cash flow (DCF) method and the asset-based approach. 

1. Multiples method

The multiples method, a market approach, assumes that similar firms sell for similar prices. This method works best for businesses in well-established industries with recent sales data from comparable companies.

Here is a three-step approach to this method: 

1. Find another company in your industry that has recently sold. 
2. Take the sales price and divide it by that company’s total sales, earnings before interest and taxes (EBIT) or earnings before interest, taxes, depreciation and amortization (EBITDA). You will arrive at a number; this is the multiple. 
3. Multiply the multiple by your company’s sales, EBIT or EBITDA to arrive at a valuation.

2. DCF method

The DCF method, an income approach, does not take other companies’ results into account. Instead, it focuses on your company’s projected cash flow. You’ll give your best cash flow forecast for the next three to five years. Then, using a formula, you’ll calculate the present value of those cash flows. 

Present value is a concept that compares money earned in the future to how much the investor would have made in interest if they had kept their money. It uses a discount rate — the likely interest rate the investor could have gotten from saving the money. If your company’s present value is more than the investment amount, it’s a good investment. 

Using three years of projected cash flow, the formula is: 

Cash flow year 1 + Cash flow year 2 + Cash flow year 3

Value = ———————- ———————- ———————
            (1+ discount rate) (1+ discount rate)² (1+ discount rate)³

3. Asset-based approach

The asset-based approach values your company based on its net asset value. It’s best for those with significant physical or intangible assets, such as manufacturing companies or asset-heavy businesses.

Here is a two-step approach to this method:

1. Calculate the total value of your company’s assets, such as equipment, property and intellectual property.
2. Subtract liabilities, such as debts and obligations, from the total asset value.

How to calculate your business’s valuation

We’re focusing on the multiples method because it’s less complicated and more widely used in business valuations. Follow these four steps to obtain a proper valuation of your business.

Step 1: Forget about capital assets when valuing your business.

Unless you’re a qualified chartered accountant or a financial wizard, you may have made the common mistake of associating asset value with business value. These two entities are completely separate.

Here’s the common misconception:

• Suppose your business has an office block worth $500,000, supplies and products worth $100,000, financial backing of $200,000 and a fleet of trucks worth $85,000.
• In total, you’ve got $885,000 in capital assets.
• If you were to sell everything now, that’s the cash value you’d receive from selling, so that is what your business is worth.

While all the above information may be correct, it isn’t what a business valuation means. It’s not what your business is worth; it’s how much cash is tied up in your business. A buyer isn’t interested in how much money they can make if they sell your office block. They are interested in how much money they can earn through the products and services produced there.

Step 2: Work out profitability by being aware of gross income and all outgoing payments.

Your business’s value is measured in profits.

A company valuation is all about the money you make now and in the future. A buyer wants to know how much they can expect to make if they take over your company.

With gross income and outgoing payments, your salary is included. However, we aren’t talking about every cent you earn from the business, just your base operating wage. We’re looking at net profit.

But that isn’t all we need. A business is not valued based on its income for a single year. We also must consider two more crucial aspects for valuing your company:

1. Multiples: Multiples are longevity meters. You don’t expect your company to go out of business in a year if it’s worth selling, so how long is it likely to keep going and earning investors (or new owners) money? In the small business world, multiples range from two to 10. This number depends entirely on the risk factor involved and the business size. Larger corporations with solid foundations and longevity estimated in decades or centuries will likely achieve high multipliers. However, for a typical small and medium-sized business, a multiple between two and 10 is the accepted norm. You multiply your net profits by whichever multiple is reasonable for your company.
2. Profitability adjustments: A company is unlikely to generate the same profit every year. When valuing your business, you must determine the amount of growth or profit loss you can expect over your applied multiple. To do this, you’ll need to examine historical financial data for your company (if you have it), your market’s expected growth and your competitors’ progress.

“If you haven’t been keeping good financial records for historical data, that can take some time to put together and is often a starting point. But, if you have your historical data, then oftentimes you can have a financial model put together for a small business in about a week or two,” said Abir Syed, co-founder of growth-focused consulting service UpCounting. “For very simple businesses that have all the data readily available, the model can be put together in as little as a day or two.”

Step 3: Calculate the value.

This is the step everyone dreads: The actual mathematics required to calculate your small business’s value.

There are four elements involved in calculating your business’s value.

1. Establish your net income.

To establish your net income, take your small business’s gross profit and subtract all expenses. For example, suppose your business brought in $750,000 and had $500,000 in expenses (equipment, travel, supplies and salaries). We’re left with $250,000.

2. Determine your business multiple.

As mentioned before, the riskier or smaller the business is, the lower the multiple you can expect to achieve. To work out your unique multiple, you must accept that there’s some guesswork and subjectivity involved.

Consider these elements when determining your multiple:

• Industry average: Research your industry. What multiples have other businesses like yours sold for?
• Financial health: How healthy is your business’s financial history? A strong financial history can result in a higher multiple.
• Business stability: Is your business stable enough to request a higher multiple?
• Owner departure impact: If you’re selling, how will your departure impact overall operations? What situation will the business be left in after you exit?
• Guaranteed income: Do you have any long-term contracts or guaranteed revenue over the coming years?
• Business relationships: How extensive is your customer base and how strong are your supplier relationships? Strong, long-term relationships add business value.

“The multiple can vary greatly depending on growth, net retention, monetization method, type of products or services, intellectual property protection and other factors,” said Christopher Moore, president of M&A advisory firm Quiet Light. “The bottom line is that acquirers are looking for predictable revenue married with opportunities for growth. The more these can be combined and shielded from risk, the higher the multiple.”

Looking at your variables, you must make a decision based on what you think your multiple should be. Here’s a basic guide:

Back to our example, we’ve got an annual net profit of $250,000. We have $500,000 in expenses, which implies a reasonable amount of staff. Let’s assume that we fall into the second bracket for this example, leaving us with a multiple between two and five. Playing the middle ground, we’ll go with four.

Initial valuation: $250,000 × 4 = $1 million

To refine your business valuation, consider your potential growth based on historical and market growth trends. While finding this information is fairly simple, it will take time and energy to ensure accuracy. You’ll need the following information:

• Your company’s historical growth rate (or your competitors’ if you don’t have any)
• Your market’s growth

Historical growth is the most impactful factor. It’s hard evidence that your business has a track record of growth. Look at your profits and track how they’ve changed. Let’s keep things simple for our example:

• Over the past five years, our example company has increased profitability by around 8 percent to 12 percent.
• We value our business with additional growth of 10 percent per year across the multiple of four selected.

3. Figure out your market.

Your market significantly affects your profitability in future years. For example:

• Established market: If you are in a relatively established and stable market, you’ll probably be better off using historical figures, as there will likely be little movement.
• New market: If you’re in a new market, you’ve got an opportunity to increase your numbers considerably.

4. Determine your potential market growth rate.

Compare your current growth rate against that of your market. Say your market grew by 15 percent last year and your business grew by 14 percent. You now have reasonable evidence suggesting to investors and buyers that they can expect similar growth levels as those predicted by industry experts.

5. Add growth projections.

Returning to our $1 million example — we aren’t in a new market; we’re in the accounting industry. We’ll use historical data to calculate our growth because accountancy isn’t likely to see more growth as a whole than our hypothetical company will.

Add 10 percent per year to the net profits. Remember to multiply incrementally instead of adding 10 percent to your current figure to ensure accurate numbers.

• Year 1: $250,000
• Year 2: $275,000
• Year 3: $302,000
• Year 4: $332,000

That leaves us with a total company valuation of $1,160,250. Now, $1,160,250 is what our company is worth to investors and buyers, right?

Step 4: Factor in your market valuation.

Your valuation is a guide. You’ve created a valuation you can present to investors and buyers, providing them with a reasonable and respectable answer to the question “What is your business worth?” But that doesn’t mean your business is worth the value you’ve put on it.

Ultimately, your business is worth what the market says it’s worth. “Market value is often a very accurate way to estimate value, as it’s a function of the assessment of all other parties and all other information available,” Syed explained.

For example, we’ve valued our example business at $1.1 million. Continuing with our scenario:

• We meet with investors and buyers several times. While we cite our valuation figure of $1.1 million, we can’t secure more than $1 million. The investors agree with the valuation to a point, but they don’t accept the full figure.
• $1 million is now our business value.

If you can’t secure the full valuation amount from a buyer or investor, then it’s not an acceptable value. The market dictates your business’s overall value. If investors don’t think your business is worth $1.1 million, the business isn’t worth $1.1 million.

What to do after determining your business’s market value

What you do with your business valuation will depend on your current situation and your aspirations for your business. 

Use the value to satisfy your current business needs.

If you are determining your value for a specific reason, such as finding investors, planning a merger or selling your business, you can move forward with that process after valuing your business. If your investor or buyer accepts your valuation, you must now negotiate the deal. In addition to the valuation, you must make many other decisions, including the deal’s terms, restrictions and timing.

If you need an investment to survive or can’t wait to sell, you can’t afford to be stubborn with your numbers. You may need to adjust them down. 

Create goals to improve your value.

According to Moore, the most significant thing someone can do once learning their value is to identify some short- and long-term areas for improvement in the business that will lead to growth, eliminate risk or expand offerings so that a greater valuation can be achieved. 

“The valuation process can typically uncover multiple areas of opportunity, such as removing owner dependency, cleaning up financials and documentation or improving terms with manufacturers or employees,” Moore added.

Blake echoed the sentiment that business valuation can de-risk your business by helping you understand whether to focus on revenue or profit.

“Value is dynamic, it doesn’t just happen,” said Blake. “Getting the value you want depends on the owner doing what is necessary to achieve that value.”

Keep value records for future use.

While many business owners wait until it’s necessary to determine their business valuation, there’s no need to wait. You can assess your business’s market value at any time and some finance experts even recommend doing so.

“Don’t scramble to calculate your company’s worth when pressed,” said Andrews. “Opportunities pop up without warning — interested investors, prospective buyers, major company decisions. Keep a current valuation ready. It lets you move decisively with real confidence when stakes run high.”

If you just want to value your business for your own information, keep this information in your records in case you need it for a loan or investment in the future. The next step is making your projections come true or even exceeding them to build more value in your company.

Skye Schooley and Jennifer Dublino contributed to this article. Some source interviews were conducted for a previous version of this article.