Whether you’re trying to sell your company, buy one, or are going for a new round of funding, there are times when you need to know how to value a business. You can determine that valuation by calculating the total value of a company’s worth. There are a few different methods for doing this, but they all take into account physical and intangible assets, earnings, the industry, and any debt or losses. Know that business valuations are estimates—the process is perhaps as much an art form as a science.
The most crucial element in a solid small-business valuation is accurate reporting of numbers and an understanding of your market and your industry. It’s critical to have all paperwork, such as financial records, bank statements, and deeds, in order to get the most accurate valuation possible. The better organized your books, the more value you can show to a potential buyer.
You can conduct a small-business valuation by yourself or by using an online calculator, or you can hire a professional business analyst or broker. Before you begin to run the numbers, use the small business valuation tips below to get prepared.
Tips to keep in mind
1. Calculate the business owner’s discretionary earnings
Discretionary earnings refer to the pretax income of a business before items such as non-cash expenses, the owner’s salary, and one-time expenses—basically, the things entrepreneurs can deduct from their taxable income. Looking solely at a tax return can underestimate the total revenue that a company actually takes in. Looking at the seller’s discretionary income—or SDE—can reveal a more robust picture of a company’s profits and potential profits.
2. Know your SDE multiplier
While your SDE represents a monetary value for your business, the SDE multiplier compares your company with others in your industry. Generally, businesses sell for between one and four times their SDE. Industries are assigned a standard multiple, but the number for your business may be above or below that depending on the size of your company, your location, your assets, and a number of other variables. If your company’s success is highly dependent on you (or another individual) being involved, a buyer’s risk for success is higher, and your multiplier will go down. On the other hand, if you’re in an industry showing tremendous growth potential, your multiplier will go up and your small business will be worth more.
3. Understand your industry and your place in it
As much as possible, learn about other companies in your industry that are similar in size to yours. Being able to compare yourself with other organizations, and being clear on where you sit within the marketplace, is essential to having clarity about your value within a sector.
4. Determine your assets and liabilities
If you’re thinking about selling your small business or buying one, it’s critical to get your financial paperwork, from deeds to licenses and other documentation, in order. But you’ll also need to clearly and accurately assess your assets, liabilities, and revenue streams.
Assets fall into two categories—tangible and intangible. While both are critical for determining the valuation of your small business, your intangible assets will have a greater bearing on your SDE multiplier. Adding together all of your assets, minus your liabilities, is the first balance you’ll create in determining worth.
• Tangible assets include all material items that your company owns—equipment, inventory, machinery, vehicles, real estate, and so on.
• Intangible assets are all of those things that are not material goods but that add value to a business. These might include reputation, trademarks, copyrights, patents, methods, or recipes. Generally, a solid list of intangible assets is considered a better indicator of a bumped-up SDE multiplier because they indicate that your company can transition successfully to new ownership. However, intangible assets may occasionally be seen as liabilities if they are not transferable. Say, for example, that an interior design firm’s reputation is highly dependent on its founder. If that person leaves, will the clients follow? If it is suspected that the firm cannot survive a transition to new ownership, the value of the business will go down.
• Liabilities are debt and other outstanding obligations that the business must pay off. Often a business seller is asked to take responsibility for business liabilities and pay for them with proceeds from the sale. Other times, agreements dissolve when an agreement cannot be made. Liabilities that can factor into a small-business valuation include accounts payable, loans, accrued expenses, and more.
5. Look forward, not just back
Be clear about how your business generates revenue and will continue to do so going forward. You want to show potential buyers that your business will continue to grow and generate income in the future. Add value by updating your business plan and clearly outlining your business model; both will help buyers understand how your business operates and how exactly they can keep it going. You can also add value by beefing up marketing and promotions, locking in contracts that are up for renewal, and getting letters of intent from critical employees.
6. Pay more taxes
While most entrepreneurs spend tax season furiously figuring out what they can write off, there is actual value in reporting higher profits to the IRS. When you pay more taxes, it’s easier for potential buyers to see from your tax returns what your company is making. It’s a straightforward way of proving your small business’s worth. Some business analysts argue that for every dollar of profit you write off, you could be losing two to three times that in your business valuation.
7. Consider getting professional help
Anyone can do a back-of-the-envelope calculation or use an online calculator to get an estimate of the value of their small business, and you don’t have to hire someone to do a valuation for you, which can be pricey. But working with a professional business appraiser or broker can yield a handful of benefits. These professionals will conduct a thorough audit of your company and deliver a business valuation that is tailored to your region and industry. Additionally, it will be harder for a buyer to negotiate against a professional assessment.
How to determine a small-business valuation
There’s no official or legal definition for determining the value of a business, and, to an extent, it’s a subjective calculation. But there are three general types of assessments, and four specific methods, for calculating a business’s value. Each employs income, assets, or market comparisons to come up with a valuation. Keep in mind that consistency is paramount to accuracy: Don’t combine formulas, but do try them all and choose the equation that’s best for your small business. Here are your options.
• Income approach
The income approach has two methods. Either will result in showing the future income a small business can expect to generate.
Discounted cash-flow method determines today’s value of a business’s future cash flow, adjusted for risk associated with purchasing the business. Young companies with excellent growth potential are good candidates for this method.
Capitalization of earnings method assesses the current value of a business by looking at projected future profits and expected rate of return. This method is a typical choice for established businesses with stable cash flow.
• Asset-based valuation
An asset-based valuation calculates the value of a business by combining all tangible and intangible assets, minus liabilities.
The difference yields the book value of the company. If you’re looking to sell quickly or liquidate, this may be a good choice, but it may not yield the highest valuation.
• Market-based valuation
A market-based valuation uses a comparison-based approached.
This approach uses the sales of other companies similar to yours to determine a fair market value based on other purchases and sales. In other words, the existing market establishes the valuation. A market approach can be used by any type of small business.
No matter which approach you use, realize that your small business’s value will change over time. It’s useful to conduct a small-business valuation periodically, whether you are aiming to sell your business or not. A business valuation can help you understand how your risk, record keeping, assets, and liabilities are affecting both your bottom line and your long-term goals.
Originally Appeared on Architectural Digest