Every business owner wants to know, “how much is my business worth?” Let’s be honest, you built your business, and it is probably a big part of your financial net worth and maybe selling it is key to your retirement planning. Unlike a publicly-traded company that has shares traded on an exchange such as the NASDAQ or NYSE, private companies, especially small businesses under $5M in revenue, need to take a different approach.
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What Is A Business Valuation?
Basically, a business valuation is a process that involves using financial models to establish an economic value for a business. A financial analyst may take three to five years of profit and loss statements and a balance sheet along with assumptions to things like future revenue and expenses to establish a valuation.
Alternatively, using estimates for revenue and profit as well as the owner’s salary can generate an estimated range value. The need for the valuation largely drives the approach and level of complexity (and cost): is this solely for an owner wanting to know where they are today and what they can do to increase the value, or is the valuation being used in active discussions to sell the business?
How To Value A Small Business: Valuation Methods
There are several methods used to determine the value of a business. When it comes to small businesses or “Main Street” businesses, there are three main types of valuations you should know about.
Seller’s Discretionary Earnings (SDE) – probably the most common approach and one an owner may be able to do on their own.
Discounted Cash Flow (DCF) – is more common for businesses that generate more than $2,000,000 in annual revenue and is performed by a financial analyst with experience in this methodology.
Net Asset Valuation (NAV) is used when the value of assets may be worth as much or more than the business itself or if a business owner is seeking to wind down and dissolve a business.
Seller’s Discretionary Earnings (SDE) you can do this if you have accurate financials to start with and your revenue, profit, and salary do not change drastically year to year. Before we get into the calculation, you should understand “add-backs,” which are used in the calculation – if you do not have any add-backs, that’s okay.
A lot of small business owners pay for things like a car lease, club membership, and some benefits through the business. These are expenses that help reduce the tax liability but are not necessary to operate a business. If you total up these discretionary expenses, you have a total for your “add-backs.”
Okay, now we get into the calculation. Take the net profit for the business and add the owner’s salary and your add-backs. The total from adding these numbers is the Discretionary Earnings. We have one more step to take to get the valuation.
A multiple may be applied, perhaps 1.25X or 3X, for example, to account for future growth in SDE. To determine what multiple to use, you will want to use a comparable business. These are what other owners in similar businesses generate. Applying 2x is fine for general purposes. A prospective buyer may want to know more about what multiple you chose and why.
A small business with straightforward revenue and expenses can calculate using SDE. Broader economic factors, such as COVID-19, can have a material impact on a business in a particular year, changing the amount of income or salary an owner can take out of the business. Therefore, it’s important to look at more than two years of records when calculating SDE in case a recent year does not represent an accurate picture of net profit or the owner’s salary.
What if there is more than one business owner?
Whether your business is a partnership or an entity with equal shareholders, an SDE valuation should account for all owners if more than one person is taking an owner’s salary or income. Why? Typically, the net profit and add-backs are for the whole business and not broken out by respective owners.
Discounted Cash Flow (DCF) is a more involved method and requires at least three years of profit and loss (P&L) statements and a current balance sheet. The DCF uses an estimate for future revenue, operating expenses, and one-time expenses. This calculation provides an estimate of future cash flow from the business. The DCF method helps guide future investment decisions as well as determine the value of a business.
While you can apply the DCF method to a smaller business, typically, it’s used when the business revenue is above $1,000,000 or, more often, above $2,000,000. An analyst will review the P&L statements (profit and loss) and balance sheet.
Then the analyst likely will have questions for the owner about the net profit, estimated growth rate, one-time expenses, and risk factors. This can take time, and fees can range from a few thousand dollars to more than $10,000, depending on the type of business, size, and level of complexity.
Whether applying Seller’s Discretionary Earnings or Discounted Cash Flow analysis, it is essential to have good financial data. This means your expenses are coded correctly, revenues booked accurately, and your books are reconciled with bank statements.
Net Asset Valuation
Net Asset Valuation is calculated by subtracting the liabilities (what you owe) from the assets. If the NAV is positive (meaning assets are more than liabilities), it allows an owner to exit the business by selling assets, paying down liabilities, and then filing for dissolution.
If an owner is not interested in or is unable to sell the business, knowing the net asset valuation is important because it outlines the financial solvency of the business should the owner sell or liquidate assets to pay down liabilities.
How To Prepare for a Business Valuation
It all starts with your bookkeeping. As you review your bookkeeping, ask: Are items coded properly with a Chart of Accounts? Is the information accurate and up to date? Is the process for reconciling the books with a bank account? And are all the assets and liabilities recorded on the company balance sheet?
If you are not sure, or you know your books need attention, start there before assessing the value of your business. Getting help from a professional accountant or bookkeeper can be a tremendous help and a wise investment. Starting with insufficient or inaccurate data will result in an incorrect valuation. This could cause a delay in the sale process, or could diminish your credibility with a potential buyer.
Whether you need a valuation to kick off the process of exiting your business or want to know out of curiosity or to build a plan to increase your valuation, learning the basics will help you prepare and understand what is “behind the numbers.”