Small Business Valuation: Everything You Need to Know
Small business valuation is market value, or the amount a business-for-sale price a buyer would pay for it.8 min read
Small Business Valuation
Small business valuation is market value, or the amount a business-for-sale price a buyer would pay for it. Unlike a corporation, a sole proprietorship or small “limited liability company” LLC without shareholders, will not be able to present what is considered a financial report of the company’s capital structure. S-corporation of small businesses provides legal registration of an entity like a corporation, yet with a more limited federal tax reporting process. Transfer of an entity from a LLC or S-corporation to corporation status requires adherence to additional rule criteria for eligibility; increasing the value of a small business.
One reason business valuation is such a complicated issue is the number of valuation methods employed. Rather than using a single valuation method, sellers must elect an approach suited to their business. Method selection should fit industry, size and the circumstances of the sale. An asset-based valuation is a simple method, determining the total value of the entity’s tangible and intangible assets. The challenge with employing the asset-based method, is that estimation may be too narrow; ignoring value of the company's earnings potential. The asset-based valuation method is commonly used for calculating the price of default businesses and liquidations, and not for healthy companies.
The earnings multiplier uses the discounted cash flow or capitalization rate to calculate the worth of a business in the marketplace. This method allows for large variance between multipliers (e.g. 1, 3, 5, 10 or more) based on recently sold comparisons or “comps”, risk and industry standards. Although other factors can be included in calculating value, the earning potential is the most important indicator that a business is healthy. Discretionary Earnings or Net Earnings of the business, before Interest, Taxes, Depreciation and Amortization, plus Owner's Salary and other non-recurring expenses is generally applied to compare the earnings multiplier of a for sale business with recently sold businesses of the same class and approximate value.
Pricing a business based on an estimate of the business's earnings potential, prospective buyers are given the predicted ratio of return on investment (ROI) to future potential earnings. The earnings multiplier is one of several forecasting techniques applied in valuation of a business. The individual aspects of a business are of course important as well, with assets and liabilities part of the pricing structure. Regression analysis of the actual performance of a business, offers another model of valuation, frequencies of median historical annual or quarterly performance. Negotiation of a final selling price, will normally include the buyer’ valuation of the business.
Before listing a business for sale in the marketplace, websites like BizQuest.com and BizBuySell.com provide an overview of prices and multiples of cash flow or revenue listings for recently sold businesses. The SME Toolkit offers an excellent resource for getting started on business valuation methods
The theoretical foundation to the market approach to business valuation is derived from the field of Market Economics. Supply and demand determine the performance of a business on a price continuum. Price scale of a business is obtained by calculating the adjusted net income; the total cash flow produced by an enterprise. Demonstration of historical earnings must be documented to performance. The adjusted net income of a business for sale includes profits, as well as the owner's salary and cash benefits distributed to principals, like company cars, health, life and auto insurance premiums, and personal expenditures described as “business expenditures”. Interest expense is also included in the reporting of adjusted net income, along with deductions, depreciation and amortization expenses.
The earnings multiplier method is used to reflect the price the market will bear. High performing businesses may apply a multiple up to 10 times current profits, whereas a strong business with consistent performance, competitive pressures, and some losses in earnings may only be valued at five times the current profits. A small business with few hard assets, and dependency on management to create the conditions for minimal growth, can expect to value a business based on a multiplier of only two to four times the current profits of those efforts. Businesses valued at one times the current profits are generally small professional service providers, entirely dependent on a single owner. Middle-market companies reporting sufficient growth in revenues, may apply a multiple of EBITDA (earnings before interest, taxes, depreciation, and amortization).
Low risk businesses with high market demand can apply a stronger than average multiple. Well established businesses, particularly heavily marketed franchises in densely populated areas with little direct competition have the option of market pricing above what would normally be expected; up to three times annual adjusted net income. The same business with lower market demand and higher risk, would be valued at a lower multiple, and therefore less valuable price in the marketplace.
If a business can command a price four times or more annual adjusted net profit, top-tier pricing is appropriate. Simply put, the theory of supply and demands exhibits that volume of available businesses to actual buyer investment, quite clearly dictates the terms to pricing in the marketplace. The art of the deal, or terms to sale is the final, yet powerful element to pricing structure. Seller level of adjusted net income influences cash flows required upfront. Liquidity or cash flows of a business greatly impacts the multiplier applied to the pricing equation. Special terms, such as attractive seller financing or delayed interest payments on a buy, are vital to the valuation process at the time of sale.
How to Improve Business Value
If a broker’s estimate yields a lower-than-expected market price for a business, a seller can alter course to increase an estimated valuation prior to marketing for sale. Sellers should begin the valuation process early, planning up to years in advance to ensure that an estimate is in their favor. Substantial changes to an estimate can be done by improving the value of your company.
Profitability and future earnings potential are essential to the successfully marketing of a business for sale. Record of a company’s track record of annual profits, as well as a history of positive cash flow, can be used to enhance the value of a business and its acquisition price on the market. It is important to remember that the earnings multiplier valuation method projects future earnings based on historical industry performance, and the company’s comparative standing. By identifying the strengths of a company’s assets and structural capital relative to the marketplace, a seller can ask the highest possible price.
Documentation of business structure (i.e. articles of incorporation), valuation methodology, and seller financing all impact the actual value of a business. Type of business registration status with a state’s Secretary of State and the federal Internal Revenue Service, will also dictate type of documentation available on a company based on the existence of assets.
Industry statistics indicating the prospects of a high-growth in a sector, can be critical in the estimation of a business value. Staying abreast of “seller’s market” announcements and the actual supply and demand of businesses sales in a sector, will improve an owner’s chance of getting the asking price for a business. Improving a company’s structural capital position will inevitably pay off.
Enlisting a licensed business appraiser or broker value a company is the surest method of attaining the goal of full price sale. Check a broker’s track record for turnover in the industry the business is associated with. A broker experienced at selling businesses in a target segment of the market, can significantly shorten the time to sale process, and promote full priced negotiation with a buyer.
Business Valuation Calculators
Innovation of business valuation calculators has made estimating simple. While not a substitute for expert appraisal, a business valuation calculator is a tool that enables an owner to gauge the current value of a company. The following is a list of web based business valuation applications:
The CalcXML is basic business valuation calculator that offers a wide array of financial tools to create estimates of small business assets and earnings. The results to CalcXML computations are fast and easy; a snapshot of a company’s performance in annual earnings, excess compensation, also levels of risk.
The crowdfunding specialist EquityNet launched in 2005, is a network of thousands of investors working with entrepreneurs in all segments of the market. Recognized to assisting the start-up of businesses around the world, EquityNet is a site for seed capital, reporting fundraising of hundreds of millions in debt, equity, and royalty finance for members. EquityNet offers a business valuation calculator, supported by real market data from more than 3,000 North American companies. The calculator allows for weighted averaging of competitors, to estimate the market position of a business, as well as tools for calculating an organization’s profit margin, cash flow and risk.
Network support specialist, ExitAdviser connects potential buyers with businesses for sale. The ExitAdviser toolkit includes a quick business calculator that provides potential buyers with a value and range of price quotes. Buyers can enter net profit from a target company’s most recent financial year, as well as forecast sales growth estimates. ExitAdviser is a fairly accurate valuation resource, with advanced options to generate details about a company for sale.
BizEx calculator is a ‘Multiple of Earnings’ method instrument, more advanced than other free valuation calculators available online. Use the BizEx calculator to perform in-depth analysis for breakdown of a target company’s discretionary income and historical earnings to generate an estimate of market worth. The BizEx calculator enables a user to create auto valuation ranges for a range of entered variables. The website offers broker consultation on valuation estimates found with the BizEx calculator.
The Bridge Ventures calculator is designed to estimate market value of company based attributes. A good selection for valuation of small businesses with annual revenues under $2 million, the Bridge Ventures Calculator is compatible with Google Chrome. A quick and easy calculator that generates accurate results.
Hadley Capital’s business valuation calculator applies a multiple of EBITDA to determine the Enterprise Value of a middle-market, high growth, small business. The calculator manages input variables break-down for top revenue sources, as well as annual capital expenditures.
Life insurance companies are experts at business appraisal. Actuarial sources such as John Hancock Life Insurance offer first-time buyers a calculator with a dense glossary of variables to understand financial terms to a business transfer and sale agreement. The MassMutual calculator is a simple tool for step-by-step calculation of the valuation process in minutes.
HelpSME is a highly functional resource for small businesses about to be marketed for sale. Use the HelpSME calculator to perform a valuation with the Net Present Value (NPV) method. The calculator also contains a guide summarizing the estimate provided.
National Life financial services companies offer a free online valuation calculator using NPV, that to generate expected future earnings. The calculator has special features to accommodate issues such as poor marketability, and current excess compensation posing challenge to a seller, and future buyer that can be corrected with appraisal and professional guidance.
The sum of all parts is not always understood by a business valuation estimate. Refer to government and professional resources to obtain more information about how to conduct an accurate and insightful business valuation to arrive at the most efficient price for sale or purchase. Government tender bid on businesses for sale is an option to consider when placing a company on the market. The United States Small Business Administration provides Valuation Guidelines for Small Business Investment Companies (SBICs) interested in new ventures. Visit the SBA’s website for information on small business valuation and other details to marketing a business for investment. Business valuation calculators are a convenient resource. Price estimates of business valuation should be backed up by professional appraisal for the best results.
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