How to Determine the Value of a Small Business

As a business owner, you're probably no stranger to having a long to-do list of responsibilities. Working with a full plate of deadlines and priorities, it's easy to lose sight of the bigger picture. One of the many important tasks that small business owners often overlook is determining their company's value and knowing how to properly do so.

A market valuation of a business provides an estimated market value through the use of data from similar businesses, the earning capacity and cash flow of a business, and the consideration of intangible assets. The value output can be a range of numbers or a single value that reflects a business's worth.

Even if you opt to use an appraiser or a business broker to get a more formal estimate of your net present value, it's important to stay educated about the differences in valuation methods. Sometimes, business appraisers will only use one or two valuation methods to compile the estimate. Reports like this aren't as detailed and pose restrictions on the intended use of the estimate.

While there isn't one perfect way to figure out the value of a business, there are formulas and tactics you can use to help simplify the process. This article will show you the primary calculations you need to know to determine a business's value for yourself.

Why You Should Know How to Value a Small Business

It's pretty common for small business owners and new owners alike to neglect to calculate their business valuation. However, as time-consuming as it might be, knowing the value of your small business is very important, whether you're selling your business to know what it's worth or buying a business to know what you should reasonably pay. In fact, knowing your business valuation is so beneficial that many experts recommend calculating it on a semi-regular basis.

With an objective and comprehensive business valuation, you'll be equipped with knowledge of how others view your business, an understanding of the size and scope of your assets, and information about important factors that can help drive your business. In understanding your business's strengths and weaknesses, you can fine-tune your financial and succession planning to increase your marketability. This will also help you determine a strategic direction to increase your business's value — one that puts you in an empowered position to focus more on long-term sustainability as opposed to immediate profitability from daily operations.

Furthermore, attempting to negotiate the market value of a business without understanding the business's actual value will put you in a dangerous financial position to lose money. Luckily, this potential loss can be easily mitigated. You can save both money and time by dedicating a few hours to quoting appropriate price ranges for your business valuation.

How to Determine the Value of a Small Business

The process of determining the value of a business is no simple task. There are many business valuation methods for doing market evaluations and some work better than others.

The first step in business evaluations is to figure out your current market value. In doing so, objectivity is key. It's important to use business valuation techniques that objectively measure present and future performance. Even if the results aren't so pretty and you don't like the initial valuation, heeding this input is vital for the health and growth of your business.

Below, you'll find an easy guide to help you learn how to properly calculate the value of a business. Each option is different in terms of factors considered and each will help you calculate a single value or a range of values for your business evaluation.

Calculate Seller's Discretionary Earnings (SDE)

Seller's discretionary earnings (SDE), also referred to as "discretionary cash flow" or "owner's discretionary income," is a cash flow-based measure of business performance. SDE calculations are commonly used when valuing small businesses.

This business valuation method calculates the value of a business through the consideration of several variables so that potential buyers have an understanding of the expected return on investment (ROI). This includes pre-tax and pre-interest profits before non-cash expenses, one-time investments, non-related business expenses, net income, and other adjusted expenses.

This business valuation method helps business owners maximize their business evaluation before starting negotiations with potential buyers and increasing future cash flow. It also helps sellers make the right choice about what expenses and incomes to include so that both parties can come to a reasonable valuation of the business.

It's important to note that SDE calculations can vary significantly for the same business. Disagreements between buyers and sellers over what incomes and expenses to include in the calculation are very common. For example, some one-time expenses declared by a seller might be considered recurring expenses in the future by a potential buyer, such as license fees or website maintenance and updates.

The outcome of this valuation method is entirely dependent on who's crunching the numbers. Therefore, both parties need to agree on appropriate value calculations for all income, expense, and replacement cost factors.

Here's how to calculate discretionary income. Simply plug in your numbers into the formula found below:

Determine the SDE Multiplier

Knowing your SDE multiplier, or "SDE multiple," is important for understanding the range that your business would typically sell for. This number is what you use to get the fair market value (FMV) of your company.

There are two types of multiplier: the industry standard and the specific business multiplier. Each is a separate number that provides different values based on various factors. The industry-standard multiplier gives you a general value based on the average of similar businesses in the same industry. On the other hand, the specific business multiplier gives you a more detailed estimate based on the variable factors of each business.

Factors considered include everything from geographic trends to company size, tangible and intangible assets, independence from the owner (also known as owner risk), and many other variables. The largest factors that influence the SDE multiplier are typically going to be industry outlook and owner risk.

To calculate the estimated SDE multiplier of your business, a good place to start is by looking at multiples for similar businesses that consider business revenue and cash flow. To personalize your business estimate of the multiple, you'll need to collect essential data, including financial statements from the last three years, business tax filing and returns, all licenses, deeds, patents, and other proprietary documents, and a balance sheet for your business.

With this number in mind, you can appropriately determine an estimate that takes into account the long-term value of your business.

Calculate Business Assets and Liabilities

Some values, like your business's assets and liabilities, aren't included in the SDE multiplier.

Assets consist of both tangible items, like real estate property and accounts receivable, and intangible items, which are non-physical goods like intellectual property, trademarks, and patents. All tangible assets should be included in a separate valuation if they are being purchased, whereas intangible assets are included in the SDE multiplier if your business assets are sold.

Liabilities are your business debts and other financial obligations that must be paid in the future. Your liabilities impact the value of your business depending on whether they will transfer during the sale or will be settled by you before the final sale price is determined. Having an understanding of the current debt, payment schedule, and past due balances of your business will help keep you and any potential buyers informed about future expenses that might be incurred.

Calculate the Business's Final Estimated Value

The final calculation you'll need to consider is your final estimated value of the business. This differs from previous calculations in that it ties all the categories together to generate the most accurate value of your business. Take a look at the formula below to get started:

The SDE multiplier that you decide to use will determine how the final estimate will be swayed.

Remember, the multiplier can change drastically depending on your geographic location, your industry risk (also known as market risk) potential, and many other book value factors.

Here's the bottom line: If your industry is doing well in the economy, your SDE multiplier will be higher, as will the final estimated value of your business. Similarly, if there is significant population growth, your specific multiplier will likewise increase, as will your calculated final value.

Now that you have a better understanding of what your business is worth, you're ready to get started on taking proactive steps to increase your earnings before interest or prepare to sell to vetted buyers with the highest selling price possible.

Easily Manage Your Small Business Finances With Skynova

If you are a small business owner and want to maximize your company's value, you'll need the right business templates and software products to improve your business valuation. Skynova's accounting software can help you track and manage all of your business income and expenses with ease to help you get the most out of your business projections.

Notice to the Reader

The content within this article is meant to be used as general guidelines and may not apply to your specific situation. Always consult with a professional accountant for specific advice regarding different bookkeeping practices.