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If you’ve considered selling your business you’ve no doubt wondered “How much is my small business worth?” Unlike public companies that have stock prices clearly showing the price of the business, private businesses aren’t as transparent. There are several different methodologies for valuing small businesses. We focus on determining what the fair market value is. Why? Because the definition of fair market value is:
The price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of the relevant facts.
The three primary ways to determine the fair market value of a small business are the asset approach, income approach, and market approach.
- Asset Approach: As the name suggests, this method seeks to determine business value based on the value of its assets minus its liabilities. The business value can be calculated by summing the fair market value of all equipment owned by the company and subtracting any liabilities. In most cases, the asset approach does not accurately represent the value of a going concern business with positive earnings.
- Income Approach: This approach seeks to determine business value by discounting estimated future cash flows to their present value. One of the popular methods is the discounted cash flow. While the income approach provides more useful guidance on business valuation for profitable businesses, it faces high scrutiny due to the many subjective input variables and assumptions.
- Market Approach: The valuation methods of this approach establish the business value leveraging market data from similar businesses. Businesses that are similar in size and operate in the same industry typically sell for similar valuations. We can use market data on previous business transactions to determine realistic earnings multiples (more on that below!). Here at Small Business Deal Advisors, we find the market approach to be most reliable because it is less subjective and utilizes real market data.
At the end of the day, only a buyer can tell you what your business is worth, but Small Business Deal Advisors can help you determine where offers are likely to land. So, how do we value small businesses?
- Calculate seller’s discretionary earnings or “SDE.” This is a company’s profits before interest, taxes, non-cash expenses (think depreciation), owner compensation and benefits, non-recurring expenses, and any non-related income or expenses. A buyer will typically average the past three years SDE numbers with the most weight on the most recent year.
- Determine the right multiple. Next, we look to our various market data resources to find the multiple of earnings that similar businesses were sold. For example, if a company has SDE of $150,000 and it sold for $300,000, it sold for 2x seller’s discretionary earnings. The typical range for a small business is 1.5 to 3x SDE. Higher earnings, fast growth, and stellar margins can all help to increase the multiple.
- Bring it all together. Next, we determine the expected value of the business by multiplying the company’s SDE figure by the determined multiple. We typically use a range of multiples to show how different buyers are likely to approach valuation.
Sure this is an oversimplified explanation but it provides a high-level understanding of the valuation process. There are other factors to keep in mind, like if the company has assets or cash flow to support financing. Plus there are critical value drivers that will impact the multiple including financial risk, diversification risk, key man risk, and much more.