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Overview of small business valuations
A lot of small business owners start planning their exit with questions about business valuations. In addition to “what’s my business worth?” many owners are not sure how to get a business valuation that meets their needs.
A business valuation can come from a simple online calculator to hiring a professional financial expert to perform a fair market valuation. Which approach is best for your particular situation? We answer three of the most popular questions owners ask when researching small business valuations.
How to calculate the value of a small business?
There are a variety of ways to calculate the value of a private business. The size of the business, location and industry are important as well as the financial health of the company. The most common approach for what are commonly referred to as Main Street business is Seller’s Discretionary Earnings.
A Main Street business applies to businesses that generate less than $5M in revenue and typically have less than 10 employees. Oftentimes, these businesses generate less than $2M in revenue, these are known as micro-businesses. According to the non-profit Prosperity Now, over 92% of small businesses in the U.S are classified as micro businesses.
Given that small businesses make up approximately 45% of the GDP, these owners are truly the backbone of our economy.
Small business valuation methods
Seller’s Discretionary Earnings (SDE) is frequently used for micro-businesses to provide an estimate of the potential cash flow an owner can generate from the business. The discretionary piece is important because many owners choose to optimize for cash flow and to reduce their tax liability by paying for discretionary expenses such as a car lease or other items from their business account. Consulting with a tax accountant is a good idea if you have questions as to what is an acceptable discretionary expense.
Learn more about Seller’s Discretionary Earnings.
Discounted Cash Flow (DCF) is more common for a business that is generating $5M or more in revenue per year. It is uncommon to use this approach to obtain a valuation for a micro-business, you should have a solid reason for using this approach for a micro-business.
Investopedia describes this approach as an analysis that “attempts to determine the value of an investment today, based on projections of how much money that investment will generate in the future.” In this case, the investment may be a partial or outright purchase of the business.
Net Asset Valuation (NAV) is often used when someone is interested in buying some or all of the assets but not the business entity itself. This type of transaction separates the assets from the liabilities and the proceeds from the sale of the assets may be used to pay down remaining liabilities prior to dissolving the business. The calculation is pretty straightforward, total assets minus liabilities which will come from the balance sheet.
Information needed to obtain a small business valuation
The most important thing to understand is that accurate information leads to a more accurate valuation. In other words, if your books are not up to date or contain errors, your valuation will not be an accurate reflection of the value of your business. Step one, review your profit and loss statements and balance sheet and if necessary, hire a professional accountant to clean things up.
When you’re confident the information is accurate and up to date, you will need the following to obtain a valuation.
Profit and loss statements for three years which are used to measure the cash flow generated by the business. You will want to note what expenses are discretionary and have an accurate representation of your income (salary).
Balance sheet is used to obtain the amount of liabilities and assets and determine if the difference is a positive or negative number. A negative number will decrease the valuation and may mean that the business is potentially insolvent. If this is the case, creating a plan to reduce liabilities is important if you want to try to sell the business.
Revenue projections for next twelve months are helpful and will lead to a more accurate valuation. This is not what you “hope” the business will do; rather it is an estimate based on previous years and investments in areas such as marketing, adding employees or other investments that can help grow your business or reduce operating expenses.
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What does a small business valuation cost?
The cost depends on the type of valuation methodology, the accuracy and detail of the financial records and the requirements of the buyer or their lender. First of all, if your financial records are not accurate or out of date, someone needs to make corrections and updates and this could take a few hours to several days or sometimes weeks.
A good bookkeeper will typically charge anywhere from $30 to $85 an hour and an accountant can cost anywhere from $50 an hour or more. If you need to revise tax returns, hiring a CPA is essential and most will charge $75 per hour or more. If your books are accurate and up to date, you are ready to obtain a valuation!
Generating an estimated valuation can be done online at no cost using information provided by the owner. Automated valuations such as the one provided by ExitGuide are often used as a starting point or baseline.
Automating a valuation by uploading financial statements is a challenge and unlikely to provide an accurate valuation due to a variety of issues ranging from the lack of consistent formatting and terminology used in financial statements and potentially misleading certain fields.
Hiring a professional may be necessary when the seller and buyer are seeking a neutral third party to perform the valuation and provide some form of certification. This may be necessary when a buyer is seeking an SBA loan or investors to help finance the transaction. This approach will cost a few thousand dollars depending on the information provided and the level of detail required to satisfy both sides.
Do I need a valuation to sell my small business?
The short answer is yes, you will need something if you plan to sell the business or the assets. A buyer will need some form of proof for the amount they paid for the business or the assets and that should be recorded in the company’s financial records.
Also, if the buyer is seeking investment or a loan to purchase the business, the lenders will require a valuation. Even if you plan on using seller financing, you need a valuation to outline the details in the loan agreement (also known as a note).
As a small business owner, you may use a simple online estimate to engage a buyer and then seek a professional to review the estimated valuation or perform their own valuation. As we’ve mentioned earlier, starting with accurate financial records is key.
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Owners that visit ExitGuide want to know what their business is worth but having an estimated valuation requires accurate information about profit, loss, assets and liabilities. Even if you have no plans to exit in the near future, knowing the value of your business is important as it will help you build a plan to increase the value of the business to meet your ideal exit price.