How do you estimate the economic worth of your business? You might have been in business for 20 years without ever having to do it. Or maybe you've only been up and running for six weeks. At some point, you'll likely find a need to place a cash value on your company. Yet, it's unlikely you are a financial expert, so how do you figure out what your business is worth?
Why do you need to know what your small business is worth?
There are numerous reasons why you might need to value your business, including:
- The business is up for sale
- You are trying to attract investors
- You plan on selling stock in your company
- A bank loan is required against the business
- You need to fully understand your business's growth
The most common of the above reasons are for investment and sales purposes. Having a value placed on your business means you can say to an investor, stakeholder, buyer, or banker that it is worth X amount and, therefore, if you want Y percentage of it, you'll have to fork out Z.
For investors and buyers, a business valuation is very important. Evidence of value is vital to gaining the attention and interest from those with the financial capital you seek. If you can't demonstrate to an investor how much your business is worth, how can they know how much money is reasonable to invest?
The valuation of your business must be done properly. Improper valuation of your business can lead to financial issues in the future, upset or unimpressed investors or buyers, and damage to your reputation as a business owner.
What method of business valuation is best?
There are several ways to determine the value of your business.
"The two most common methods are the multiples method – or comp method – which is the simplest, and the other is what's called the discounted cash flow method (DCF), which is more complicated," said Brian Cairns, CEO at ProStrategix Consulting at "I recommend at least attempting both. The first method requires you to apply the multiple of revenue of EBITDA [earnings before interest, taxes, depreciation and amortization] at which companies like yours were sold and multiplying it to your latest EBITDA or revenue. The DCF requires you to forecast your earnings into the future (normally five years) and calculate a net present value," Cairns explained.
In this article, we will focus on the multiples method. Follow these five steps to obtain a proper valuation of your business.
Step 1: Forget about capital assets when valuing your business.
Unless you're a qualified chartered accountant or a financial wizard, you may have made the common mistake of associating asset value with business value. In fact, these two entities are completely separate.
Here's the common misconception:
- Suppose your business has an office block worth $500,000, supplies and products worth $100,000, financial backing of $200,000 and a fleet of trucks worth $85,000.
- In total, you've got $885,000 in capital assets.
- If you were to sell everything now, that is the cash value you'd receive from selling, so that is what your business is worth.
While all of the above information may be correct, it isn't what is meant by business valuation. It's not what your business is worth ‒ it's how much cash is tied up in your business. A buyer isn't interested in how much money they can make if they sell your office block. They are interested in how much money they can earn through the products and services produced there.
Step 2: Work out profitability by being aware of gross income and all outgoing payments.
If the value of your business isn't measured in capital assets, then what is it measured in? Profits.
A valuation of your company is all about the money you are making and the money you are likely to make in the future. A buyer wants to know how much they can expect to make if they take over your company.
With gross income and outgoing payments, your own salary is included in that. However, we aren't talking about every cent you earn from the business, just your base operating wage. Net profit is what we are aiming for.
But that isn't all we need. A business is not valued based on its income for a single year. We also need to consider two more important aspects for valuing your company:
- Multiples: Multiples are longevity meters. You don't expect your company to go out of business in a year if it is worth selling, so how long is it likely to keep going and earning investors (or new owners) money? In the small business world, multiples range from two to 10. This number depends entirely on the risk factor involved and the size of the business.
Larger corporations, with solid foundations and longevity estimated in the decades/centuries, are likely to achieve high multipliers, but for your common variety, small and medium enterprise, a multiple between two and 10 is the accepted norm. You multiply your net profits by whichever multiple is reasonable for your company.
- Profitability adjustments: A company is unlikely to generate the exact same profit year after year. When valuing your business, you must determine the amount of growth or profit loss you can expect over your applied multiple. To do this, you'll need to examine historical financial data for your company (if you have it), your market's expected growth and your competitors' progress.
"If you haven't been keeping good financial records for historical data, that can take some time to put together and is often a starting point. But, if you have your historical data, then oftentimes you can have a financial model put together for a small business in about a week or two," said Abir Syed, a marketing consultant at UpCounting. "For very simple businesses that have all the data readily available, the model can be put together in as little as a day or two."
Step 3: Calculate the value.
This is the step that everyone dreads: the actual mathematics required to calculate the value of your small business.
"It shouldn't take long if you do proper bookkeeping, but if you're in the middle of liquidating capital assets because you're getting ready to execute an exit strategy that involves selling your business, it may take you months just to get ready to do the math," said Jack Choros, finance writer at Sophisticated Investor.
First, establish your net income.
To do this, take your small business's gross profit and subtract all expenses. For example, suppose your business brought in $750,000, with $500,000 in expenses (equipment, travel, supplies and salaries), and we are left with $250,000.
Second, look at multiples.
As mentioned before, the riskier or smaller the business, the lower the multiple you can expect to achieve. To work out your unique multiple, you need to accept that there is some guesswork and subjectivity involved. Unfortunately, there is no set way of finding a designated multiple. Instead, there are a few basic rules of thumb to follow:
- Research your industry. What multiples have other businesses like yours sold for?
- How healthy is your business's financial history?
- Is it stable enough to request a higher multiple?
- What situation will the business be left in once you depart (if you are selling)?
- Do you have any contracted income guaranteed over the coming years?
- How expansive is your customer base, and how strong are your supplier relationships?
Looking at your variables, you must make a decision based on what you think your multiple should be. Here's a basic guide:
- A business run by a single worker will be unlikely to sell for a multiple above three.
- Businesses with revenue below $500,000 often max out at five.
- Only larger companies earning more than $500,000 in net profits can expect to reach a double-digit multiple.
Back to our example, we've got an annual net profit of $250,000. We have $500,000 in expenses, which implies a reasonable amount of staff. Let's assume, then, that we fall into the second bracket for this example, leaving us with a multiple between two and five. Playing the middle ground, we'll go with four, taking us to a current value of $1 million.
Now, bump up the value of the business based on potential growth. It sounds intimidating, however, finding this information is fairly simple, but will take time and energy to ensure accuracy. You'll need the following information:
- Your own historic growth (or your competitors', if you don't have any)
- Your market's growth
Historic growth is the most impactful factor ‒ it is hard evidence that your business has a track record of growth. Look at your profits and track how they've changed. Let's keep things simple for our example:
- Over the past five years, our example company has increased profitability by around 8% to 12%
- We value our business with additional growth of 10% per year over across the x4 multiple selected.
Third, figure out your market.
Your market significantly affects your profitability in future years to come. For example:
- If you are in a relatively established and stable market, you'll probably be better off using historic figures, as there is likely to be little movement.
- If you're in a new market, you've got an opportunity to increase your numbers considerably.
Fourth, determine your potential market growth rate.
Compare your current growth rate against the market you are in. Say your market grew by 15% last year, and your business grew by 14%. You now have reasonable evidence that suggests to investors and buyers that they can expect to see similar levels of growth as those predicted by industry experts.
While you can evaluate market growth yourself, and its potential impact on your company, now is a good time to ask financial experts for assistance, or other business owners in your network for a second opinion.
Finally, add growth projections.
Going back to our $1 million example – we aren't in a new market; we're in the accounting industry. We're going to use historic data to calculate our growth, because accountancy isn't likely to see more growth as a whole than our hypothetical company will.
Add 10% per year to the net profits. Remember to multiply incrementally instead of adding 10% to your current figure, to ensure accurate numbers.
- Year 1: $250,000
- Year 2: $275,000
- Year 3: $302,000
- Year 4: $332,000
That leaves us with a total company valuation of $1,160,250. Now, $1,160,250 is what our company is worth to investors and buyers, right?
Step 4: Factor in your market valuation.
Your valuation is a guide. You've created a valuation you can present to investors and buyers, providing them with a reasonable and respectable answer to the questions of "What is your business worth?" But that doesn't mean your business is actually worth the value you've put on it.
In the end, your business is worth what the market says it's worth. "Market value is often a very accurate way to estimate value, as it's a function of the assessment of all other parties and all other information available," Syed explained.
For example, we've valued our example business at $1.1 million. Continuing with our scenario:
- We meet with investors/buyers several times. While we cite our valuation figure of $1.1 million, we cannot secure more than $1 million. The investors agree with the valuation to a point, but they do not accept the full figure.
- $1 million is now our business value.
If you cannot secure the full valuation amount from the buyer(s), then it is not an acceptable value. The market dictates your business's overall value. If investors don't think your business is worth $1.1 million, then the business isn't worth $1.1 million.
Even though you've done all the proper calculations, your business's value ultimately lies with the people investing in or buying your business to determine what they think it's worth.
Step 5: Accept the will of the market.
You may need to compromise on your figures if the market doesn't support them. If you need investment to survive or you can't wait to sell, then you cannot afford to be stubborn with your numbers.
"A business is only worth what the market demands. If your industry has fallen on hard times, due to the coronavirus, for example, you may value your business at a much higher valuation than the market would," said Choros. "Things like timing and the greater need for your business within the marketplace still matter, even if your brand might be worth a lot more money, or your accounting records may show that you are worth more. Business is always about leverage. You don't often get what you deserve, you get what you negotiate."
Additional reporting by Jennifer Post.