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What Small Business Owners Need to Know About Business Valuation

4 Mins read

Placing a dollar value on your business is a complex and sometimes a touchy subject – especially if you’ve spent years building it to become profitable. Valuation is not a subjective assessment or a personal opinion. It is based on solid facts and figures based on economic and industry realities.

The latest report by Massachusetts Mutual Life Insurance Company (MassMutual) showed that some business owners only want to know their business’ value once they are ready to sell rather than to protect the business and the wealth it generates. 

The study also revealed that one out of four owners surveyed did the valuation by themselves. Two things can happen out of this; either they can over or undervalue the business by a significant amount which can result in challenges when you try to sell or transfer to an heir or management team.

When should small business owners get a business valuation?

If you haven’t done an assessment of your business’ worth over the last twelve months, then it’s time to roll up your sleeves and start the work. Knowing what the business is worth today will set your expectations so you are mentally prepared for what buyers may be willing to pay. More importantly, knowing the valuation allows you to examine your business metrics and create a plan that will enhance the value. It may take months or even years to reach your desired valuation. 

How to calculate business valuation for a small business

There are a variety of methods to value a business and not all are applicable to what are known as “main street” businesses which are those with less than $5 million in annual revenue and fewer than 10 employees. By the way, “main street” businesses account for nearly 96% of small businesses in the U.S.

Three common approaches to business valuation are:

  • Net Asset Valuation (NAV): As the name suggests, this method looks into your business’ total net asset value minus the total liabilities. The NAV is also helpful if you plan (or need) to enter into an Asset Purchase Agreement whereby a buyer acquires a number of assets from the business without taking on any of the businesses liabilities. 
  • Discounted Cash Flow (DCF): This method is based on the business’ ability to produce earnings in the future and this approach is more suited for businesses that have at least $5 million in revenue and have been in business for at least five years. 
  • Seller’s Discretionary Earnings (SDE): This is the most common approach for a majority of small businesses. This calculator takes the net profit + owner’s salary + add backs to get to the SDE number. What are add backs?

They are expenses a business owner chooses to pay from the business, for example:

  • The amount of the owner’s salary
  • Family members on the payroll 
  • Leisure activities, such as business golf outings 
  • Charitable donations 
  • The purchase or lease of a vehicle used for business and personal use

To get the valuation, a multiple is applied to the SDE – an example of this may look like:

2021 net profit = $365,000

2021 owner salary = $55,000

2021 add backs = $10,000

SDE = $430,000

Multiple = 2.3

Valuation = $989,000 which is $430,000 x 2.3 

The valuation process can give you an insight into the strengths and weaknesses of your business. It may also reveal areas of the company that contribute to its lower value, such as weak financials or under-performing assets.

How to obtain a small business valuation

Licensed professionals or third-party experts handle Discounted Cash Flow (DCF) and this requires providing profit and loss statements, a balance sheet, three years of revenue projections and answering questions related to your business expenses. You may also visit the American Society of Appraisers (ASA), so you can speak with a registered person that can help you determine your business’ worth. 

However, if you are just curious to get a basic idea of your business’ value, a simple way to give you a rough estimate is through Seller Discretionary Earnings (SDE). SDE starts with your net profit. Then adjust by determining what items should be added to (called add-backs) or deducted from your net profit. Sites such as ExitGuide provide a free estimated valuation as well as other tools related to exiting a business. 

Benefits of getting a business valuation before you plan to sell your business

  • A business valuation gives you information about your business’ strengths and weaknesses.

If a fair sale value is your primary goal, obtaining an accurate business valuation is a significant first step. It also provides you with a better knowledge of your business assets’ worth. Despite its benefits, it may be intimidating to get an appraisal every year, as it exposes not just your business’ thriving areas but also its weak spots. But knowing these can put you in a better position to make strategic decisions and measured approaches that will ultimately enhance your business’ worth.

  • A business valuation can help you form SMART goals.

Once you’ve done this process, you can study the results and set SMART goals around them. Setting quantifiable goals will be much easier for you to focus on areas that will drive your company the most growth.

  • A business valuation is essential in a negotiation.

Selling a business requires an accurate business valuation. Although it doesn’t guarantee a sale, it provides you with facts and figures so you can defend its price. 

It will be much easier to enter into a negotiation once your claims of the business’ potentials and growth are backed-up with pieces of evidence. This includes historical information (profit and loss statements) and revenue forecasts. 

  • A business valuation provides you with an opportunity to track its growth.

Determining the growth of your business includes routine checks of your balance sheet. You want to ensure that liabilities do not outweigh assets. Monitoring the business’ cash flow provides you an overview of how much goes to paying essentials such as inventory or staff’s salary. 

Both these processes are weaved into a business valuation. This provides information about what factors can enhance your business’ worth or factors that weaken it. 

  • A business valuation improves your decision-making from a financial standpoint.

Estimating revenue and profit is undeniably a risky move. Aside from that, you won’t get a realistic figure that represents your business. A professional business valuation provides you with an accurate and actual number of your business’ financial health.

In business, concrete numbers are 100% better than rough estimates. You can use that information to make strategic and informed business decisions.

Final thoughts!

The bottom line is that investing in a valuation is a way to ensure that you are getting a thorough and objective assessment of your business’ worth. In some cases, multiple business valuation methods are necessary. Once you already have an accurate business valuation, you can set measures to increase its value over the following years.

Eric Grafstrom is founder and CEO of ExitGuide.

Business Valuations stock image Rasdi Abdul Rahman/Shutterstock

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