When you decide to exit your business, the first question any business owner asks is, “how much is my business worth?” It makes sense, you have worked hard to build your business and want to know the value you have created. There are different methods used to value a business as well as different resources and tools available to get a business valuation.
A valuation uses real financial data from your business, if your financial records are up to date and accurate, you are ready to get a valuation. If the financial records are not current or you believe there are some errors including misclassified items or missing data, it may be time to focus on getting things in order before you get a valuation.
This guide will help you understand the basics of a small business valuation, the methods used to calculate the value of a business, explain the key terms you need to know when reviewing a valuation and how to prepare for a valuation. If you are planning to sell a small business, knowing how much your business is worth is the first step.
What is A Business Valuation?
A business valuation is a process that involves using financial models to establish an economic value for a business. Typically a financial analyst will use an established methodology to create a financial model and then apply assumptions to things like future revenue and expenses to establish a current value of what a business is worth today. Comparables or “comps” may be used as well. These are valuations performed on similar businesses and may also include what a business was sold for in the past.
A business valuation should use actual financials from a business including 3 - 5 years of profit and loss statements and a current balance sheet. Using estimates or self-reported financials are acceptable for providing an estimated range for potential value however, a potential buyer or other entity needing a valuation (for a loan for example) will require a valuation based on actual financials. If you use Quickbooks or other accounting software, generating these reports is easy.
How To Value A Small Business: Valuation Methods
There are a number of methods used to determine the value of a business and when it comes to small businesses or “Main Street” businesses, the Seller’s Discretionary Earnings (SDE) and Discounted Cash Flow (DCF) are commonly used. A Net Asset Valuation (NAV) is used when the value of assets may be worth as much or more than the business itself or if a business owner is seeking to wind down and dissolve a business.
Seller’s Discretionary Earnings (SDE) measures what the owner of a business is able to take out of the business from cash flows. Potential buyers use this to assess the potential proceeds a business will generate if they were to buy and operate the business. SDE is the profit before you deduct taxes and interest and depending on the business, significant one time expenses or investments may get applied as well. A multiple may be applied, perhaps 1.25X or 3X for example, to account for future growth in SDE. To determine what multiple to use, the growth rate from previous years can be applied as well as comparables. These are what other owners in similar businesses generate.
A small business with straight forward revenue and expenses can use the owner’s salary for calculating SDE. Broader economic factors such as COVID 19 can have a material impact on a business in a particular year and in turn, change what an owner is able to take out of the business as income or salary. It is important to look at more than 2 years when calculating SDE and in some cases, remove a year if it is believed to be an outlier that does not represent the health of the business and future potential earnings.
What if there is more than one business owner?
Whether your business is a partnership or an entity with equal shareholders, if there is more than one person taking an owner salary or income, an SDE valuation should account for all owners.
Discounted Cash Flow (DCF) is a more involved methodology and requires at least 3 years of profit and loss (P&L) statements and a current balance sheet and applies an estimate for future revenues, operating expenses and one time expenses. This provides an estimate of future cash flow from the business. Using a DCF analysis is helpful for making future investment decisions as well as determining the value of a business.
So what is the “discount” in Discounted Cash Flow? The discount is a rate known as the Weighted Average Cost of Capital (WACC). Most businesses invest capital to grow or operate the business and the amount of capital required is different based on the industry, size of the business and even location. It costs more capital investment to grow a trucking business than an architectural firm.
The WACC is applied to cash flows over several years, typically 3 years for a small business (a larger entity may apply over 5 years). Where DCF can get tricky is if a growth rate used for revenue is too high or too low or choosing a WACC that is not representative of the business.
Whether applying Seller’s Discretionary Earnings or Discounted Cash Flow analysis, it is essential to have good financial data. This means your expenses are coded correctly, revenues booked accurately and your books are reconciled with bank statements.
Net Asset Valuation is calculated by subtracting the liabilities (what you owe) from the assets. If the NAV is positive (assets are more than liabilities) allows an owner to exit the business by selling assets, paying down liabilities and then filing for dissolution. In the event an owner is not interested in or is unable to sell the business, knowing the net asset valuation is important because it outlines the financial solvency of the business should the owner sell or liquidate assets to pay down liabilities.
Terms Used in Small Business Valuation
It is important to understand the terms used in a business valuation. Yes, the number is important and it is also wise to understand the terms used and how they impact the valuation. If the valuation is less than you hoped, you will want to know what steps to take to improve the valuation and these terms can be factors to improve the valuation of your business.
Profit & Loss statement (P&L) is the standard financial statement that summarizes the revenues, costs and regular expenses of a business for a specific period of time. Accounting software like Quickbooks and Xero generate countless P&L statements, most business owners will use monthly, quarterly and annual reports to track their business and for obtaining a business valuation.
Balance Sheet is a financial report that summarizes assets and liabilities for a business. If your business has shareholders, their holdings are also included.
EBITDA is an acronym for Earnings Before Interest, Taxes, Depreciation & Amortization. Operating margin (profit) does not include these items and not all businesses pay material interest on loans (or gains from money market accounts) or have assets that depreciate or need amortization.
Non-cash adjustments is an accounting term used to write down or make adjustments to business financials that do not involve a cash payment. However, they do change your financials. Depreciating equipment, amortization, and compensating an employee with stock (instead of cash) are some examples. These adjustments do not impact cash flow.
Net Working Capital is the capital (cash) you have to invest in your business operations. It is calculated by subtracting your current liabilities from your current assets. Assuming that number is positive, that is the NWC for your business.
Present Value is tied to Future Value (FV). Future Value is the value of current asset (real estate, equipment etc.) at a specific point in time. The Present Value (PV) works from the other end by taking the Future Value of an asset and applies a discount. The discount rate used is based on what the money would be worth if invested.
Terminal Value is used to carry business projections past the period an owner can estimate. Typically, a business can reasonably estimate 2 or 3 years of revenue and costs. The terminal value carries beyond using a set value for future growth.
WACC is the Weighted Average Cost of Capital and used as a “discount rate” when performing a valuation using Discounted Cash Flow Analysis which is the methodology ExitGuide uses when calculating a valuation for your business.
How To Prepare for a Business Valuation
There are a number of resources available to perform a small business valuation including a financial analyst that focuses on valuations, a business broker or services like ExitGuide. As mentioned throughout this guide, having accurate and current financial information is an absolute must. If the financials are not up to date or contain errors, it will impact the valuation generated.
DON’T WAIT, PLAN YOUR EXIT WITH EXITGUIDE
Transitioning out of your own business can be confusing and emotional. You have invested a lot into your business and taking steps to exit is not easy, in fact, most owners have never been through the process. You do not have to “figure it out” on your own. ExitGuide helps owners from start to finish by answering basic questions about the process, helping you develop a plan specific to your circumstances and then connecting you with expert resources to guide you to a successful outcome.