There are several reasons why you should calculate the true value of your business. You may be considering selling it; you may be searching for the partnership of investors; the decision to expand a project could be on the horizon; insurance options may need to be addressed, etc. The problem is, it’s your business, so you’re more likely to see the endless potential of its earning power, the behind-the-scenes blood, sweat, and tears that have been invested into it, and the piles of cash that you have sacrificed to get it off the ground. However, these factors tend to color an entrepreneur’s point-of-view causing him or her to overestimate its real world value. Doing so could hurt your chances of getting investors on board or it may possibly create inaccurate financial projections.
Here are a few options as to how to determine the true value of your business:
Option 1 – Asset Valuations
Step 1: Value the business’ assets. What does the company outright own? Add up the value of real estate, equipment, cash in the bank, accounts receivable, and so on. For example, if your business owns $100,000 in land, possesses $15,000 in equipment and office supplies, has $5,000 in accounts receivable and $10,000 in cash on hand, then your total assets would equal $130,000.
You could also think of this as the liquidation value which determines the worth of the company’s assets if it you forced to sell everything in a short period of time (usually within a year).
Step 2: What are your expenses? Consider your mortgage, outstanding loans, accounts payable, wages payable and credit card balances.
Step 3: Deduct your expenses from your asset value. This gives you an idea of the tangible assessment of your company if you were to close shop, pay off your debts and sell your assets. This is the amount of cash that you would be left with.
Step 4: Also consider the “Income Multiple.” The net income of a business is definitely a consideration to arrive at a selling price or determining a company’s value. For instance, add or deduct the profit or loss from the most recent company income statement to the amount calculated when you deducted your expenses from your assets. If the business made a profit for that time period, add the revenue to the amount determined in Step 3. If the business lost money, then you should subtract that amount. This further gives you a more accurate idea of your company’s current standings since any business is hardly static.
Option 2 – Owner Benefit Formula
Richard Parker, author of How To Buy A Good Business At A Great Price, recommends this formula:
Pre-Tax Profit + Owner’s Salary + Additional Owner Perks + Interest + Depreciation less Allocation for Capital Expenditures
“History has shown that this methodology, while not bulletproof, is the most effective way to establish the valuation basis of a small business. Then, a multiple, based upon a variety of factors, is applied to this number and a valuation is established,” comments Parker.
So what is the multiple? It’s usually one to three times the figure that is calculated from this formula. “The best mechanism I have found is that a one-time multiple is for those businesses where the seller is ‘the business.’ In other words: ‘as out the door goes the seller, so too can go the customers.’ Consulting businesses, professional practices, and one-man businesses come to mind,” explains Parker. “Businesses that have a strong track record, repeat clients, historical pattern of growth, more than 3 years in business, perhaps some proprietary item, or an exclusive territory, a growing industry, etc., will sell in the 3-times ratio. The others fall somewhere in-between.”
Option 3 – Discounted Cash-Flow Analysis
While not the most popular, this is what Warren Buffet swears by and with his track record, I figured it was worth mentioning.
According to Stever Robbins on Entrepreneur.com, “Warren Buffett uses what’s called a discounted cash-flow analysis. He looks at how much cash the business generates each year, projects it into the future and then calculates the worth of that cash flow stream ‘discounted’ using the long-term Treasury bill interest rate. There’s no room to explain the theory or calculation here, but you can do it in Excel using the NPV ‘net present value’ function.
“For example, if the shop earns $10,000/year and T-bills are returning 3 percent interest, the business is equivalent to $333,333 worth of T-bills ($10,000/3 percent=$333,333, so $333,333 invested in T-Bills would return the same $10,000 income). So if you had $333,333, you could earn your $10,000/year by investing in T-bills with a lot less effort than running the shop. This technique puts an upper limit on your valuation. After all, why would you spend more than $333,333 on a store when you could earn more by spending the same money in T-bills? Of course, using this quick-and-dirty technique assumes that the teashop will have the same earnings year after year, and assumes that only monetary return matters.”
However, even with these steps and formulas in place, it can be tricky to determine an accurate value for your business. Contact your accountant to review your results and most definitely connect with an UpCounsel business attorney before entering any contracts that rely on your business value calculation.