Business valuation can seem complicated. A couple of relatively simple methods will get you on the right track for what you need.
Are you considering selling your small business? Are you looking for financing for your small business? Are you creating a will or your succession plan? If you answered yes to any of those questions then you need to know the value of your business first.
There are many ways to create a valuation and each method may give you a different answer. This is actually a good thing because you may end up with a range of values. Depending on your purpose, this can provide you with a lot of guidance. For example, if you are planning on selling, then having a range might give you your starting asking price but also guide you to the lowest amount you would be willing to accept to complete the deal. There isn’t going to be a 100% accurate answer; at the end of the process, your business is only worth what someone else will pay for it. Here are two common ways to objectively value a small- or medium-sized business.
The first method is calculating a multiple of earnings. Essentially this method requires you to take the normalized net income of your business and apply a multiple to get to the value. First, to normalize your net income you have to add back all of the deductions you have made to lower your taxable income that were not part of the operation of the business, or are expenses that a new owner would reasonably not expect to incur. Some examples may be your personal salary, or expenses for a vehicle, your cell phone or extra meetings held at nice restaurants. Look closely at the potential list of items you want to remove. The more you can legitimately add back, the greater the increase will be to the value of your business. Don’t forget though, what you add back must be reasonable because you will be expected to defend the adjustments to a potential buyer. Once you have normalized your net income, try to determine what multiple of that number would be typical in your industry. There will be a range here as well with no definitive answer. Try checking with a business broker, looking online or at others within your industry. Many industries, especially those that are service related, may fall in the 2.5 to 3.5 times net earnings range. For example, if your normalized net income comes out to $80,000, these multiples would show a valuation range of $200,000 to $280,000. A flaw in this method is that an underperforming business may be significantly undervalued by a net income that doesn’t truly reflect the opportunity of the business. That is the potential gap.
The second method is calculating a multiple of sales. This method is quite simple: determine the sales multiple that would be typical within your industry and apply that to your gross sales. Use the same suggestions above to try to determine the multiple. Let’s assume the typical range for your industry is 0.75x to 1.25x sales. To continue the example, if your sales are $300,000, then you would get an expected valuation of between $225,000 and $375,000.
You can now see that the two different methods give two very different answers. It is noteworthy that if there is no overlap between the values you get using these two different methods, and in fact there is a significant gap between the two ranges, it could indicate an issue with the overall health and performance of the business. For example, it could reveal that your net income is relatively low compared to what the valuation would expect. This gap could influence the buyer’s decision. A flaw in the multiple-of-sales valuation method is that ultimately a buyer wants to know what his or her return on investment will be – what can they expect to make with this business relative to what they have to spend to get it. That’s why the income-multiple method is more valuable on its own, but the two methods together are even more useful.
When you combine the two ranges together, you arrive at an estimated range of between $225,000 and $280,000. After you’ve establish an estimated range, your next steps will be determined by the purpose of your valuation. If your intent is to sell the business, you will need to justify the gap between what you think the business is worth (top of the range) and what you might expect someone else to value it at if they were to offer to buy it (bottom of the range). Consider some of the following aspects that will improve your multiple:
- Growing market share
- Sales increasing over time
- In a growth industry
- Ease of entry
- Availability of opportunity
- Tenure of staff
- Training and support for new ownership
Any of these factors will improve the valuation. You can use these points as leverage to help justify a higher selling price.
Valuing a business can be a very subjective process. I have only outlined a couple of methods and ideas to give you a framework. If you are thinking of buying or selling, it’s important to look at the business as an investment – what will be the return on the investment? What is the opportunity cost compared to another investment? From there you can add or subtract any other emotional or qualitative judgement. Always be prepared to negotiate and defend your principles.
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Business Matters Consulting provides consulting and coaching to small and medium sized businesses and their owners to help them achieve their fullest potential. For more information please visit businessmattersconsulting.com.