Most Americans are probably aware of the changing value of their homes, cars, and salaries over the years. To get a complete fiscal picture of your life, you have to be aware of your assets and incomes, as well as how these values adjust over time. For small business owners, your company might actually be the most valuable asset you possess. Therefore, it is critical to calculate the value of your small business to know the overarching picture of its financial health.
Businesses, of course, are dynamic things. You probably hope to earn more profit in the future than you are earning currently, although the timescale of this goal can vary widely depending on your industry. Additionally, businesses have assets far beyond buildings and cars. An interested buyer will look at your intellectual property, talent, and network. Perhaps you have a toehold in an exciting new region or market.
All of these factors complicate the process of calculating the value of your small business. However, by doing this work, you can get a much deeper understanding of what makes your company valuable on both a financial and human level—you built this value, after all.
A word of advice before you get too deep into the process: it is always a good idea to hire a financial professional to help calculate the value of your business, especially if you are serious about selling.
Why Should You Know the Value of Your Company?
The most obvious reason why you would want to know how your small business is worth is because you’re trying to sell it. If you are already talking to buyers, you might know the basis of how they are pricing their offers; still, it helps to consider elements of your company they might be ignoring.
Even if you want to remain in charge of your business, knowing its total value provides a layer of understanding that can help guide your business decisions. If most of your company’s value is locked up in assets, you might want to diversify. If ballooning debts are deflating your business’s overall worth, you might want to refinance loans or harden efforts to monetize.
Lenders will also be interested in your company’s value. In fact, you might need to have a precise tabulation of your company’s value if you want to get a sizable small business loan. Lenders will want to know how an infusion of capital will help your company expand in value. You need to know where you are starting from in order to explain this.
What Makes Your Business Valuable?
You can determine a simplistic “back of the envelope” value of your small business by adding up assets and subtracting debts. This balance sheet approach, though, doesn’t account for how your company earns money over time, but it can provide a starting point.
Another basic approach to valuation involves subtracting your company’s expenses from its revenue, resulting in a net profit or loss across a year or another set timeframe. A buyer might suggest this is the most honest way to value a business, but it doesn’t really capture the whole picture, either.
Famously, some of the biggest tech companies in the world—think Amazon and Uber—didn’t turn a profit for years. Most of Silicon Valley exists because investors saw the monetization potential in technologies or websites that actually lost money month over month. Even if your business isn’t centered on a new social media app or brilliant website, it helps to remember that it is likely worth more than what is printed on your bank statements.
The value of your business might center on your staff, for example. In fact, it might center on your own abilities. Your location and industry could boost your value, as could your network of clients or aptitude at attracting a certain type of customer. While it can be difficult to assign a dollar value to these factors, they should all be considered at length when determining your business’s worth.
Business Documents to Gather
Before approaching a seller or lender, you will want to have detailed business documents to support your valuation. This includes your books, tax statements, receipts, and your business plan. Business plans should look into the future and estimate revenue based on favorable, neutral, and unfavorable future conditions.
Ideally, you have a strict separation between your business and personal spending. Not only is this generally a good practice, but buyers look closely at this issue when it comes to small operations.
Adding Up Your Assets
Even though your capital assets don’t give an accurate picture of your business’s total value, it is important to know. You should know the value of any real estate and vehicles your company owns. If you sold everything your company owns, what would the capital value of your business be?
In the same vein of adding your assets up, subtract your debts.
In the vast majority of cases, though, your business is much more than the sum of its assets. A buyer is interested in the continuation of your business, not merely stripping the assets out for a cash grab.
Seller’s Discretionary Earnings
If you read the mergers and acquisition section of your favorite business news outlet, you are probably familiar with the acronym EBITDA, which means Earnings Before Interest, Taxes, Depreciation, and Amortization. While large corporations typically use EBITDA to calculate their value, small businesses are usually valued according to Seller’s Discretionary Earnings (SDE).
SDE is the earnings that the one-person owner of a business would obtain from their operation on an annual basis. It is calculating by taking the EBITDA of a business and adding in the annual compensation paid to its owner.
This makes sense because, as with most smaller operations, a significant proportion of a company’s total income goes toward paying its owner.
To determine your SDE, begin with your company’s earnings before tax. Add in your salary as well as any business expenses that aren’t necessary for the ongoing operation of your business, like a company car or a trip to a business conference. What is considered discretionary spending is often a topic of dispute between buyers and sellers, so you should have documentation about why certain expenses are discretionary or not.
You will then subtract liabilities, like debts, to calculate your SDE.
While an SDE provides a clear monetary value for your business, an SDE multiple takes your industry and location into consideration as well. An SDE multiple is a number you multiply your SDE by to understand future value.
It is possible for a print-only local newspaper and a flashy online news outlet to have the same SDE in a given year. However, on the open market, these businesses would probably be valued very differently. This is where the multiples come in.
While you can determine SDE multiples with some research into your marketplace, hiring an appraiser will get you the most accurate value, especially when it comes to your specific region.
Know Your Liabilities
If you sell your business, it is common to pay your company’s liabilities out of the money you earn from the sale. Liabilities include all business debts, unpaid loans, and accounts payable. Unearned revenue is considered a liability, too, such as outstanding unpaid invoices with delinquent clients.
Conduct a Discounted Cash Flow Analysis
A discounted cash flow analysis is a complicated formula meant to evaluate how much money your business will earn in future years. It is a method of comparing your future revenue against the risks associated with your business.
If your small business is new and has a high chance of earning lots of revenue in the future but is not yet profitable, this can be a solid way to measure your company’s value.
Determine Capitalization of Earnings
If your earnings and expenses remain stable year to year, capitalization of earnings can be a great and simple way to determine your company’s value. If you find your business follows a forecastable pattern, you can use this predictable model as your value basis. To do this, use your previous experience to determine your business’s cash inflows and return on investment for a set period, typically agreed upon between you and a potential buyer.
Asset-Based Valuations vs. Market-Based Valuations
Centering your company’s value on its assets or on the overall marketplace is a common, but not particularly accurate, method. Still, these valuation calculations are good to know because many buyers use them.
There are situations where a company’s assets are critical to its value, such as a business facing liquidation or certain types of holding companies. To calculate value in this manner, add up assets and subtract liabilities.
A valuation based on the market will look at what comparable businesses in your location have sold for and set a value established on that. This method depends on there being enough information about your industry for a buyer to decide on an appropriate value.