We’ve talked in the past about the importance of a professional small business valuation. Today we’re going to discuss different methods of small business valuation and which one might be the best for you.
Why Get a Small Business Valuation?
While you might think that the main reason to get a valuation is to get a good idea of a possible sale price, there are actually lots of reasons to get one:
- A desire to better understand the growth of your business. Perhaps the least often cited reason for a small business valuation, but maybe the most important.
- Interest in a merger or acquisition. You will need to know your financial position relative to your target, and you can’t do that without a valuation.
- A desire to attract investors. Investors will want to see some basis for what you’re asking them to invest in.
- Life events. You may be involved in a divorce or may have to buy out another owner.
- Sharing equity with your team. You can’t offer equity to your staff without knowing the financial value of what you are offering them.
- Need a line of credit or loan. A bank will want to know what they are getting themselves into.
- Examining tax-planning strategies. If you want to get ahead of the tax game, this is important.
Get Your Paperwork Ready
Whichever method of small business valuation you use, you’ll need to get a few things in order for the professional who is going to help you.
There are three categories of paperwork you will need:
- Financial paperwork. The person in charge of your small business valuation is going to want to see a minimum of 3 years of business tax returns and financial statements, like balance sheets, income statements, and cash flow statements.
- Miscellaneous paperwork. This covers items like:
- Business Credit Reports
- Tangible assets.
- Vehicle List
- Equipment List (focus on larger asset with at least $500 value)
- Real Property description and appraisal (if owned by the business)
- Intangible assets. This is helpful information for items that don’t easily have a value assigned to them, yet are very valuable. This could include items like:
- Patents and Trademarks
- An email list (number and engagement)
- SEO rankings (rankings across various keywords)
- Online reviews (number and frequency)
- CRM (customer data and leads)
You should have ready access to these items anyway, even if you don’t have a valuation on the horizon. They will certainly be required of you in any business transaction.
Methods of Small Business Valuation
There are actually quite a few ways to do a valuation, but in this article we are going to focus on four of them.
This is the most subjective valuation and is not focused on the particular numbers of a given business but rather what the recent sale prices of similar companies have been. Similar companies would be within the same industry and revenue range. Finding relevant sales data on privately held industry peers can be difficult.
Discounted Cash Flow (DCF) valuation
For those who don’t have good memories of their financing or accounting classes, this might be triggering. It will take a look at projected cash flow and the time value of money to determine a value. Projecting cash flows into the future is easily manipulated and difficult to determine for most small businesses and can be an easy target for debate.
This is pretty straightforward: assets minus liabilities. However there is a division between whether the business will continue on after a sale (going concern) or it will be closed (liquidation). Obviously in the latter case the valuation will be lower as liquidation means assets will very likely be sold below market value.
Seller Discretionary Earnings (SDE) valuation
This is the small business valuation we most often see at Apex. This small business valuation takes your earnings and applies a multiplier that is appropriate for your industry. You start with EBIT (earnings before taxes and interest) and add back:
- Owner compensation (the new owner may choose a different level of compensation)
- Owner benefits (like season tickets or lake house)
- Non-essential, non-recurring, or non-related expenses (an IRS audit, for example, or a new website build).
- Typically, the valuation will include a reasonable replacement salary for a new owner.
Which is the Best Method of Small Business Valuation?
The short answer is: the one that makes the most sense for your business. While we often see the SDE method most frequently used for transactions we handle, if you’re planning to liquidate your business, an asset-based valuation would make a lot of sense.
Professional appraisers don’t tend to lean on just one form of valuation. Part of their process involves blending different methods to come to a smart and thoughtful final number. That is definitely something the majority of business owners do not have the expertise to do, and why we recommend you hire a professional.
Give us a call to get started on the process!