By - Jeremiah Grant
Last Updated - July 26th, 2024 8:40 AM
Jul 26
Valuing a small business can seem like a complex puzzle, but it’s a crucial step whether you’re looking to buy, sell, or simply understand the worth of your enterprise. Did you know that small businesses make up 99.9% of all U.S. businesses and employ over 47% of the private-sector workforce? This massive influence highlights the importance of accurate business valuation. With 33.2 million small businesses contributing significantly to job creation and economic innovation, understanding how to value one can give you a critical edge in the market. Let’s dive into the key methods and metrics used to value a small business effectively.
Small businesses have shown remarkable resilience and adaptability, especially during economic fluctuations. For example, in recent years, new business formations in the U.S. have surged, increasing by approximately 2.5% annually from 2019 to 2023.
These businesses play a significant role in job creation, accounting for 64% of new jobs, and employing more than 59.9 million people. The top sectors include retail (16%), food and restaurant services (13%), and health, beauty and fitness (12%), each contributing significantly to economic growth.
Government policies and increased access to funding are also critical growth factors. Programs like the Small Business Administration (SBA) loans have been instrumental in providing financial support. In 2023, the SBA approved over $27.5 billion for 57,300 7(a) loans, a 12% increase from the previous year.
However, over 50% of small businesses fail within the first five years due to challenges such as poor labor quality and lack of capital. Despite these challenges, the industry shows resilience, with 77% of owners confident in overcoming economic hurdles.
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Valuing a small business involves several common methods. These methods look at different parts of a company to estimate its value. It’s key to know these methods well to get an accurate business value. There are thre classifications of the methods used to value a small business –
Market Approach
Income Approach
Asset-Based Approach
Let’s take a look at the most widely used methods and how a business valuation expert like me will carry out the process.
Market Multiple Method
Also known as the comparables approach, this method involves valuing a business based on the valuation multiples of similar companies in the market. It assumes that businesses with similar characteristics, operating within the same industry, and with comparable financial metrics will have similar valuations. Commonly used multiples include Price-to-Earnings (P/E), Enterprise Value-to-Revenue (EV/Revenue), and Enterprise Value-to-EBITDA (EV/EBITDA). By applying these multiples to the target company’s financial metrics, we can estimate its market value.
Things to Consider
Identify Comparable Companies: Select companies operating in the same industry with similar size, growth rates, and financial health.
Choose Relevant Multiples: Decide which financial metrics are most relevant for your valuation (e.g., P/E, EV/EBITDA).
Gather Data: Collect data on the selected multiples from the comparable companies. Use financial databases or industry reports.
Adjust for Differences: Make necessary adjustments for any significant differences between the target company and the comparables.
Calculate the Multiple: Derive the average or median multiple from the comparable companies and apply it to the target company’s corresponding financial metric.
Example
Let’s consider a small tech company based in San Francisco with an annual EBITDA of $5 million. To value this company, we first identify comparable publicly traded tech companies using the Market Multiple Method.
Suppose we find three comparable companies with EV/EBITDA multiples of 10x, 12x, and 11x, respectively.
The average EV/EBITDA multiple is (10 + 12 + 11) / 3 = 11x.
Applying this multiple to our target company’s EBITDA, the estimated enterprise value would be 11 * $5 million = $55 million.
In my experience, while valuing a small retail business in Austin, we used the EV/Revenue multiple. The comparables had an average EV/Revenue multiple of 1.5x.
Given the target company’s annual revenue of $2 million, its estimated enterprise value was 1.5 * $2 million = $3 million.
Challenges
Finding Comparables: Identifying truly comparable companies can be challenging, especially for niche businesses or unique business models.
Market Volatility: Valuation multiples can be volatile, particularly during periods of economic uncertainty or market fluctuations.
Non-Financial Factors: This method focuses on financial metrics and may overlook non-financial factors that can significantly impact a company’s value.
Adjustments: Making appropriate adjustments for differences between the target company and its comparables requires expert judgment and can introduce subjectivity.
Multiple of Earnings Method
The Multiple of Earnings Method is a valuation approach that involves multiplying a company’s earnings by a specific factor (multiple) derived from comparable companies or industry standards. This method is particularly useful for businesses with stable and predictable earnings. Common earnings metrics used include total sales, SDE or EBITDA. The chosen multiple reflects the investor’s perception of the company’s growth prospects, risk, and profitability.
Things to Consider
Select the Earnings Metric: Decide whether to use SDE or EBITDA based on the company’s financial structure and industry norms.
Determine the Multiple: Research and determine an appropriate earnings multiple from comparable companies or industry benchmarks.
Adjust for Unique Factors: Consider any unique aspects of the target company that may require adjustments to the multiple.
Calculate Value: Multiply the selected earnings metric by the determined multiple to estimate the company’s value.
Example
Imagine a manufacturing company in Chicago with an annual EBITDA of $3 million. To value this company using the Multiple of Earnings Method, we look at comparable companies in the manufacturing industry, which have an average EBITDA multiple of 6x. Applying this multiple, the estimated value of the company is 6 * $3 million = $18 million.
According to their income statement, the owner reports annual revenues of about $600,000 and operating expenses of close to $280,000 for an operating income of $250,000. The owner’s salary, as per the general ledger, were $120,000 and the restaurant bought cooking equipment worth $20,000.
The restaurant’s SDE was – $250,000 + $120,000 + $20,000 = $395,000
I took 2.42 as the SDE multiple for calculating the value. For your convenience, industry average SDE multiple for restaurants is between 2.14x and 2.96x.
So, the final value of the restaurant was – $395,000 x 2.42 = $955,900
Challenges
Earnings Volatility: Companies with volatile earnings may not be suitable for this method as it relies on stable and predictable earnings.
Selection of Multiple: Choosing the right multiple requires a deep understanding of the industry and comparable companies.
Subjectivity: Adjustments for unique factors can introduce subjectivity and may vary between analysts.
Market Conditions: Economic conditions and industry trends can significantly impact the perceived appropriate multiple.
The Discounted Cash Flow (DCF) Method is a valuation technique that estimates the value of an investment based on its expected future cash flows, which are then discounted to present value using a discount rate. This method is grounded in the principle that the value of a business is equivalent to the present value of its future cash flows. It accounts for the time value of money, acknowledging that a dollar today is worth more than a dollar in the future because it can be invested to earn returns. DCF is widely used for valuing businesses, projects, and investments.
Things to Consider
Forecast Future Cash Flows: Project the company’s future free cash flows over a specific period.
Determine the Discount Rate: Calculate the weighted average cost of capital (WACC) or the required rate of return to use as the discount rate.
Calculate Present Value: Discount the projected cash flows to their present value using the chosen discount rate.
Calculate Terminal Value: Estimate the value of cash flows beyond the forecast period using methods like the Gordon Growth Model.
Sum the Values: Add the present values of the projected cash flows and the terminal value to obtain the total estimated value of the business.
Example
Let’s consider a small tech startup in Austin, Texas, planning to expand its operations. The company projects the following annual free cash flows over the next five years: $500,000, $700,000, $900,000, $1,200,000, and $1,500,000. The company’s WACC is determined to be 10%.
Calculate the present value of each year’s cash flow:
Year 1: $500,000 / (1 + 0.10)^1 = $454,545
Year 2: $700,000 / (1 + 0.10)^2 = $578,512
Year 3: $900,000 / (1 + 0.10)^3 = $676,183
Year 4: $1,200,000 / (1 + 0.10)^4 = $819,199
Year 5: $1,500,000 / (1 + 0.10)^5 = $931,383
2. Calculate the terminal value using the Gordon Growth Model, assuming a perpetual growth rate of 3%:
Total Value = $454,545 + $578,512 + $676,183 + $819,199 + $931,383 + $13,758,697 = $17,218,519
The estimated value of the startup is approximately $17.2 million.
Challenges
Accuracy of Projections: DCF relies heavily on accurate projections of future cash flows, which can be difficult to estimate, especially for startups or volatile industries.
Choice of Discount Rate: Selecting an appropriate discount rate is crucial, as it significantly impacts the valuation.
Terminal Value Estimation: Estimating the terminal value involves assumptions about long-term growth rates, which can introduce uncertainty.
Complexity: The method can be complex and time-consuming, requiring detailed financial modelling and analysis.
Capitalization of Earnings Method
The Capitalization of Earnings Method is a straightforward valuation technique that determines the value of a business by dividing its expected annual earnings by a capitalization rate. The capitalization rate reflects the investor’s required rate of return and the risk associated with the business. This method is particularly suitable for companies with stable, predictable earnings and is often used for small businesses.
Things to Consider
Determine Annual Earnings: Calculate the company’s normalized annual earnings, adjusting for any non-recurring or unusual items.
Select Capitalization Rate: Choose an appropriate capitalization rate based on the risk profile of the business and industry benchmarks.
Calculate Value: Divide the normalized annual earnings by the capitalization rate to estimate the business value.
Example
Consider a local bakery in Portland, Oregon, with normalized annual earnings of $250,000. Based on industry analysis and the risk profile of the bakery, a capitalization rate of 15% (0.15) is selected.
Calculate the business value:
Business Value = $250,000 / 0.15 = $1,666,667
The estimated value of the bakery is approximately $1.67 million.
Challenges
Earnings Stability: This method is best suited for businesses with stable and predictable earnings. Companies with volatile earnings may not be accurately valued using this method.
Selection of Capitalization Rate: The capitalization rate must accurately reflect the business’s risk and industry conditions. An incorrect rate can lead to overvaluation or undervaluation.
Non-recurring Items: Adjusting for non-recurring or unusual items in earnings is crucial to avoid distorted valuation results.
Limited Use for Growth Companies: This method may not be suitable for high-growth companies, as it does not account for future growth potential.
Adjusted Net Asset Method
The Adjusted Net Asset Method is a valuation technique used to determine the value of a business by adjusting the book values of its assets and liabilities to reflect their current fair market values. This method is particularly useful for asset-heavy companies, holding companies, and businesses that are not generating significant income. It involves restating the values of all tangible and intangible assets, as well as liabilities, to their fair market values and then subtracting the adjusted liabilities from the adjusted assets. The resulting figure is the adjusted net asset value of the business.
Things to Consider
Identify Assets and Liabilities: List all the assets and liabilities on the balance sheet.
Adjust Asset Values: Revalue assets to their current market value. This includes tangible assets like real estate, machinery, and inventory, as well as intangible assets such as patents and trademarks.
Adjust Liability Values: Revalue liabilities to their current market value, considering any off-balance-sheet liabilities like leases or pending litigation.
Calculate Net Asset Value: Subtract the total adjusted liabilities from the total adjusted assets to determine the adjusted net asset value of the business.
Consider Asset Use: Determine whether the business is a going concern (assets used collectively) or a liquidation scenario (assets sold individually).
Example
Let’s consider a family-owned manufacturing business in Cleveland, Ohio, that has been operating for several decades. The company’s balance sheet shows total assets of $5 million and total liabilities of $2 million, giving a book value of $3 million.
However, the real estate market in Cleveland has appreciated, and the company’s factory, originally purchased for $1 million, is now worth $2 million. Additionally, the company holds patents estimated to be worth $500,000.
Adjust the Real Estate Value: Increase the factory’s value from $1 million to $2 million.
Add Intangible Assets: Include the patents valued at $500,000.
Adjusted Assets: Original assets ($5 million) – old factory value ($1 million) + new factory value ($2 million) + patents ($500,000) = $6.5 million.
Adjusted Liabilities: Assume no change in liabilities, remaining at $2 million.
The adjusted net asset value would be:
Adjusted Assets: $6.5 million
Adjusted Liabilities: $2 million
Net Asset Value: $6.5 million – $2 million = $4.5 million
Thus, the revalued business is worth approximately $4.5 million, compared to the original book value of $3 million.
Challenges
Finding Fair Market Values: Accurately determining the fair market value of both assets and liabilities can be challenging and may require professional appraisals.
Subjectivity in Valuation: The process of adjusting values can introduce subjectivity, particularly with intangible assets and contingent liabilities.
Market Conditions: The values of assets, especially real estate, can be significantly affected by market conditions, which can fluctuate.
Not Suitable for All Businesses: This method is less effective for businesses where value is primarily derived from operational earnings rather than asset holdings.
Choosing the best valuation method depends on the company’s specifics, the valuation’s purpose, and the owner’s or expert’s preference. Working with skilled appraisers or valuation experts ensures a thorough and trustworthy business value assessment.
Valuing a small business starts with knowing the basics of business valuation. Key elements like seller’s discretionary earnings (SDE) and the SDE multiple are crucial.
Seller’s Discretionary Earnings (SDE)
Seller’s discretionary earnings (SDE) show the yearly financial value one owner gets from a business. It’s different from EBITDA because it includes the owner’s salary and benefits. This gives a full picture of the business’s profits and cash flow.
SDE Multiple
The SDE multiple is a way to value your business based on industry standards. Each industry has its own multiple, depending on things like market risk, location, size, assets, and ownership risk. A higher SDE multiple means your business is worth more.
Knowing about business valuation metrics like seller’s discretionary earnings and the SDE multiple is key. These help you understand your business’s true value. They give you insights into your company’s financial health and its potential worth.
Organizing Financial Documents
When you’re getting ready to sell a small business, keeping your financial records in order is key. These records are the base for a correct valuation and are vital when you’re passing on the business. As an owner, make sure your financial papers are tidy. This makes the valuation smoother and shows your company’s good health to potential buyers.
Important financial documents include licenses, deeds, profit and loss statements, balance sheets, and a detailed business overview. Buyers will look closely at these to get a clear picture of your company’s operations, growth chances, and earnings model. You might also need to show your own financial statements to prove the info you give.
Profit and loss statements show how well your business did financially over a year.
Balance sheets give a snapshot of your company’s financial health by listing assets, liabilities, and equity.
Cash flow statements track the flow of cash in and out from different activities.
Getting your small business financial records in order might seem tough, but it’s key for a smooth business sale. Think about sorting your documents into income, expenses, taxes, payroll, and legal folders. Also, regularly clean out and back up your financial records to save space, reduce mess, and keep your data safe.
If you’re struggling to get your financial records in shape, consider getting help from a professional bookkeeper, accountant, or financial advisor. They can make your record-keeping more efficient, ensure it’s correct, and offer insights to help with your business valuation and sale prep.
Discover the Real Worth of Your
Small Business Now!
Gain strategic insights for growth, investment opportunities, or potential buy-outs with our specialized small business valuation services.
When valuing a small business, it’s key to look closely at what the company owns and owes. Assets, both physical and not, are the heart of a company’s value. Liabilities, however, can lower the business’s worth. It’s vital to know how these two parts balance out for a correct valuation.
Tangible Assets
Tangible assets are the things a business uses in its day-to-day work. This covers real estate, tools, stock, and other goods you can touch. It’s important to get the value right for these assets because they add to the company’s total worth. The condition, age, and market price of these items can change the business’s valuation a lot.
Intangible Assets
Intangible assets are valuable but you can’t see or touch them. They include things like patents, customer ties, brand name, and good will. These assets might be harder to measure than physical ones, but they can greatly affect a small business’s value. Figuring out their worth needs a deep look at the company’s special strengths and what sets it apart.
Liabilities, like what the business owes, must be looked at closely too. These can include things like bills to pay, loans, and unpaid bills. These debts can lower the business’s total value and must be considered when figuring out its net worth.
By looking closely at both the tangible and intangible assets and the liabilities, you can really understand a small business’s true worth. This is key for both sellers and buyers. It helps guide the negotiation and makes sure the valuation is fair and accurate.
Considering Industry Trends
Understanding the trends in an industry is key when valuing a small business. This knowledge gives buyers and sellers the right context. It helps them make a fair valuation that matches the business’s worth and the market.
The industry analysis examines several important factors. It checks the right SDE multiple, market share, and growth potential. It also examines what comparable businesses are selling for. This helps you better understand the industry and make smart valuation choices.
Doing thorough market research is a must. It helps you grasp the competitive landscape and what makes your industry valuable. This info aids in making smart decisions on pricing, positioning, and growth plans. These are all key to the business’s final value.
It is vital to examine the industry and business’s growth potential. By studying trends, market share, and company performance, you can see future earnings and growth, which helps in determining the business’s true worth.
By focusing on these industry factors, you get a full picture of the business’s value. This prepares it for a successful sale or acquisition. The insights from this analysis are crucial for handling the complex task of valuing a small business.
Conclusion
Knowing how to value a small business is key for making smart choices about selling, buying, or getting loans. The process can be tricky, but using best practices and expert advice can make it fair and informed. This ensures a good look at what a small company is worth in the market.
Whether you’re looking to sell, secure funding, or simply understand your company’s worth, a professional valuation is invaluable. The methods we’ve discussed offer unique insights into your business’s value. Remember, valuation is both an art and a science, requiring expertise and industry knowledge. If you’re ready to unlock your small business’s true value, don’t hesitate to reach out to our team at Arrowfish Consulting.
We’re here to guide you through the process, providing the clarity and confidence you need to make informed decisions about your business’s future. Let’s work together to reveal the full potential of your enterprise.
Jeremiah Grant is the Managing Partner of Arrowfish Consulting. In addition to acting as a primary liaison for many of the firm’s engagements, He primarily focuses on business valuation and economic damages expert witness assignments, in addition to forensic accounting and insurance claims analysis.
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