How to Calculate the Value of Your Small Business

Small business owners devote their lives to building up a business. But you might not realize exactly how valuable that life’s work is. Like a house or car, every business has a value, and business valuation is the process of determining that value. It isn’t just a fun, theoretical exercise. Knowing your business’s value is important for smart planning, looking for investment, or if you’re thinking about selling.

Here, we explore how to calculate the value of a business using a few common valuation models.

Practical Reasons for to Calculate the Value of a Business

Why would you want to put a price tag on your business? There are several practical scenarios in which knowing your business’s worth can be helpful:

• Selling the business: If you’re planning to exit your business, a professional valuation helps you determine a fair asking price.
• Seeking capital: When you need capital to grow, investors and lenders will want to know your business’s value. A strong valuation can attract investors or help you secure better loan terms.
• Succession planning: When transferring ownership to family members or employees, a valuation helps establish a fair price for the transfer.
• Partner buyouts: You need a valuation to establish a fair price to buy out a partner.
• Estate planning: In personal legal matters like divorce settlements or estate planning, your business might need to be valued as part of your assets.

Common Business Valuation Methods

Valuing a business isn’t a one-size-fits-all process. Different methods are used depending on the type of business, its assets, and its earning potential.

Asset-Based Valuation

Asset-based valuation values your business based on the fair market value of its assets (like equipment, inventory, and property) minus its liabilities (debts). It’s essentially what your business would be worth if you sold off all its assets and paid off all its debts.

This approach is on the simple side, and can be good for asset-heavy businesses like manufacturing companies, real estate firms, or other businesses holding tangible goods, like wholesalers. It’s also the most common valuation method used when companies are facing liquidation.

Asset-based valuation is a relatively simple method to understand and calculate, but it doesn’t reflect the intangible value of your business. It misses the mark on factors like brand reputation, customer relationships, or future earning potential, which can unjustifiably lower an overall valuation.

Example:

Imagine we’re valuing a company called “Melrose Manufacturing” with the asset-based valuation model. Melrose Manufacturing has the following assets:

• Machinery and equipment: $300,000 fair market value
• Inventory: $50,000 FMV
• Accounts receivable: $20,000
• Cash in bank: $10,000
• Total assets: $380,000

The company has the following liabilities:

• Accounts payable: $15,000
• Small business loans: $75,000
• Total liabilities: $90,000

Income-Based Valuation

Income-based valuation focuses on your business’s ability to generate future income. It’s a more sophisticated method that aims to capture what a business may be worth to its new owner going forward.

There are a couple of different valuation methods that leverage income: Discounted Cash Flow (DCF) and capitalization of earnings, or cap rate.

DCF is a sophisticated method in which you project your business’s future cash flows over several years and then “discount” them back to a present-day value. It analyzes the time value of money, meaning a dollar today is worth more than a dollar tomorrow.

DCF can provide a very detailed picture of value, but it relies heavily on assumptions about future performance, growth rates, and discount rates, which can make it subject to bias and prone to inaccuracies depending on who is doing the valuation.

Example:

For this example, digital marketing agency Maple Street Marketing is performing a DCF analysis for the next five years. Their projected annual free cash flow (FCF) is as follows:

• Year 1: $100,000
• Year 2: $120,000
• Year 3: $140,000
• Year 4: $160,000
• Year 5: $180,000

Their discount rate, or cost of capital, is 10%, which reflects the risk and desired return. Now, each year’s projected FCF is divided by (1 + discount rate) raised to the power of the year number. We get the following breakdown:

• Year 1 PV: $100,000 / (1.10)^1 = $90,909
• Year 2 PV: $120,000 / (1.10)^2 = $99,174
• Year 3 PV: $140,000 / (1.10)^3 = $105,185
• Year 4 PV: $160,000 / (1.10)^4 = $109,240
• Year 5 PV: $180,000 / (1.10)^5 = $111,760

In many instances, you would also calculate a terminal value, which reflects the value beyond the fifth year. For simplicity’s sake here, we’re going to stop after five years. Now, simply add up these numbers to get a DCF for $516,268 valuation.

The capitalization of earnings, or cap rate, method takes your business’s average normalized earnings and divides them by a “capitalization rate.” The cap rate reflects the desired rate of return for an investor and the risk associated with the business.

The cap rate method is usually simpler than DCF and is suitable for businesses with a stable and predictable earnings history. The biggest challenge is accurately determining an appropriate cap rate.

Example:

Let’s look at a stable local coffee shop, Cornerstone Cafe. Their normalized annual earnings, or profit before the owner’s salary and one-time expenses, is $100,000. To reflect the risk and return expected for a small, stable business in the coffee industry, we’ll use a 20% cap rate.

The calculation is simply normalized annual earnings divided by capitalization rate, so:

$100,000 / 0.20 = $500,000 valuation.

Market-Based Valuation

Finally, market-based valuation values your business by comparing it to similar businesses that have recently been sold or valued. Just like the real estate industry often uses comparable sales to value a home, market-based valuation uses other business sales to assess your business’s value.

This approach relies on applying industry-specific “multiples” to your business’s financial figures. For example, a business in your industry might typically sell for twice its annual revenue (revenue multiple) or four times its Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA multiple).

Market-based valuation that uses multiples can make it easy to understand and estimate your business’s value. The greatest challenge is finding truly comparable businesses, especially for private small businesses where sales data isn’t always public.

Revenue Multiple Example:

Let’s say “Jerry’s IT Solutions” is looking to sell. Their annual revenue is $750,000 and the industry revenue multiple from comparable sales data is 1.5x.

The valuation would simply be annual revenue times industry multiple, so:

$750,000 x 1.5 = $1,125,000.

EBITDA Multiple Example:

Now, “Billy’s Landscaping” wants to understand its business value using the EBITDA multiple. The business’s EBITDA is $150,000, and a common EBITDA multiple for profitable service businesses is 3.5x.

The valuation would be EBITDA x industry multiple, so:

$150,000 x 3.5 = $525,000.

Key Factors Influencing Your Business’s Value

These examples are intentionally simplified to help you understand the basics of how to calculate the value of a business. Valuation often goes beyond the numbers, however. While calculations like these are a good starting point, there are many things that could make one business more attractive to a buyer than another, including:

• Industry trends and market conditions: The growth of your industry and your competitive landscape may make a big difference.
• Leadership team: The strength and experience of your leaders and key employees is vital since many acquirers want business to continue running smoothly after acquisition.
• Customer base: A diverse, loyal customer base with recurring revenue streams can increase value. Dependency on a few large customers can diminish value.
• Brand reputation and intellectual property: Your brand’s goodwill, trademarks, patents, unique processes, or proprietary technology can add significant intangible value.
• Dependency on owner: A business that is highly dependent on the owner’s personal relationships or skills is generally less valuable because it’s less transferable.

These qualitative factors should be measured into your calculations to get a more accurate understanding of business value.

Tips for Small Business Owners When Valuing Their Business

Calculating your business’ value can be complex and confusing, but you can take steps to prepare yourself to ensure you get an accurate assessment. These may include:

• Maintaining accurate financial records: Clean, organized, and up-to-date books is absolutely essential to getting a credible valuation.
• Understanding industry benchmarks: Research typical multiples, growth rates, and profitability trends for businesses in your specific industry to get a realistic context for your business’s performance.
• Focus on recurring revenue: Businesses that generate recurring revenue through subscriptions or service contracts can be more appealing.
• Build a strong, transferable team: Work on building a capable, self-sufficient team that doesn’t need your oversight to thrive.
• Document processes and systems: Clearly documenting your operational processes, systems, and client onboarding makes the business easier to understand, manage, and ultimately, more attractive to buyers.

Finally, professional help can allow you to get more accurate and credible results. A qualified business appraiser or valuation expert can help you apply the right methods and consider all relevant factors to get a fair value.