Are you worried that you're not getting a fair price on that business you’re eyeing?
Well, this has always proved to be one of the trickiest parts of buying or selling.
After all, how can you be sure you’re not overpaying or undervaluing what could be your next big opportunity?
Missing out on key valuation details or relying solely on surface numbers could lead to a costly misstep.
In this article, we’ll guide you through the essential methods and strategies on how to value a small business to ensure you're making the right call.
By the end of this article, you’ll have the confidence to secure a deal that's truly worth every dollar.
How to Value a Small Business On Sale
Determining the value of a small business can be a complex process, especially if you’re an absolute beginner.
It requires a blend of financial analysis, industry insights, and market trends.
While various methods of valuation exist, the primary goal of this part remains:
To accurately assess the worth of a business so you can make more informed decisions.
Here’s a comprehensive guide on valuing a small business, from basic concepts to advanced evaluation methods…
Key Concepts For Small Business Valuation
Understanding the key concepts in small business valuation is essential.
It lays the groundwork for assessing a company's worth through various approaches as discussed below
Earnings, Assets, and Market Approach
Understanding the fundamentals of business valuation is crucial. That said, the three primary approaches include:
Earnings approach: This method focuses on the business’s profit potential.
Asset-based approach: As you can easily tell, this technique evaluates the company based on its tangible and intangible assets.
Market approach: This strategy considers comparable businesses within the same industry and market.
Each approach has its strengths and may be better suited depending on the nature of the business.
Common terms in evaluating a small business you should familiarize yourself with include:
EBITDA (Earnings before interest, taxes, depreciation, and amortization): You’ve probably already heard about this term. But what exactly does it mean? It simply reflects a business’ profitability by removing non-operational expenses.
Seller’s Discretionary Earnings (SDE): Refers to profits adjusted to include the owner’s salary and discretionary expenses.
Discount Rate: This is the rate used to convert future earnings into present value, representing risk.
Methods for Valuing a Small Business
Here are the top business valuation methods for small businesses to consider:
Method 1: Asset-Based Valuation
The asset-based approach is ideal for companies with substantial physical or intangible assets.
There are two primary methods here:
Book value method: Uses the company's balance sheet to calculate the total asset value minus liabilities. It’s a basic calculation, making it suitable for small, asset-heavy businesses but often ignores market conditions.
Liquidation value: Estimates the potential proceeds if assets were sold quickly, often at a discount. Useful for companies at risk of closing or selling under duress.
Example Calculation:
If a business has assets worth $500,000 and liabilities of $150,000, its book value is $350,000.
Method 2: Earnings Multiples
The earnings multiple approach is widely used in valuing small businesses, particularly those with a steady profit stream.
Common multiples include:
SDE Multiplier: Primarily used for small businesses, this metric accounts for the seller’s discretionary earnings. Multipliers typically range from 1x to 4x based on industry stability and business performance.
EBITDA Multiplier: Popular for larger businesses, EBITDA multipliers often vary between 3x to 7x, with higher multiples for businesses in high-growth industries.
Example:
If a business has an SDE of $100,000 and an industry multiple of 2.5, its valuation could be $250,000.
Method 3: Market-Based Approach
This small business valuation method usually involves pricing a company by considering the sales and purchases of comparable companies in the same industry.
With this method, you can easily determine an ideal purchase or selling price of a business relative to the local market.
Note that this method can apply to any type of small business. You just need to ensure you collect enough relevant data to help you with the comparison process.
However, the method would be even more suited for a rapidly growing industry or business.
Overall, this approach helps you align the business’s value with real market conditions. However, adjustments may be needed for unique features, location, or growth potential.
Example:
Imagine you’re valuing a small café. You find recent data from similar cafés in your area that have sold for multiples of 3 times their annual earnings.
Let’s say these cafés had average annual earnings of $100,000, resulting in average sale prices of $300,000.
If your café has annual earnings of $120,000, applying the same 3x multiple would suggest a valuation of $360,000.
This means, based on comparable transactions, your café would likely be worth around $360,000 in the current market.
Factors Impacting Small Business Valuation
Some factors usually play a role in establishing a fair market value, helping both you (the buyer) and the seller understand the business's true worth.
These factors include:
Revenue trends
Stable or growing revenue is a positive signal for you as it indicates a healthy, potentially scalable business. Declining revenue might lower the valuation as it suggests potential risks.
Profit margins
Higher profit margins often translate to higher valuations since they reflect operational efficiency and profitability. Small businesses with narrow margins might struggle to attract higher bids.
Market demand
A business in a high-demand or growing industry will generally be valued higher than one in a declining sector, as it promises future growth potential.
Customer base
Businesses with a large, loyal customer base often have more stable revenue, which increases valuation. High customer concentration risk, where revenue depends on a few clients, may lower value.
Location
For local businesses, a prime location can significantly impact value. High-traffic or high-demand areas boost valuation, while a poor location might reduce buyer interest.
Operational efficiency
Businesses with streamlined operations and lower costs are often more attractive, as they are easier to manage and have better profitability prospects.
Frequently Asked Questions:
How to do a valuation of a small business?
Valuing a small business typically involves analyzing financials, including revenue, profit margins, and cash flow, and then applying methods like market comparisons, and income-based, or asset-based approaches to estimate value. Consult professionals for complex valuations.
Which valuation method is most feasible for small business evaluation?
The income-based approach is often the most feasible, especially the Seller’s Discretionary Earnings (SDE) method, as it focuses on actual earnings and is commonly used for small businesses.
How much does a professional business valuation cost?
Professional valuers may cost you anywhere from $2,000 to $10,000. The actual costs depend on the complexity, required detail, and specific service provider.
Is a business valuation necessary for small businesses?
Yes, a valuation is crucial when selling, buying, or refinancing a business. It ensures fair pricing and provides insight into business performance and potential.
Final Word
Determining a fair price for a small business is vital for a successful acquisition. Key methods like market comparisons, earnings multiple, and asset-based valuation can help you understand its real worth. Each approach offers you unique insights, often best combined for accuracy. Consulting valuation experts can also add confidence to your decision, setting a strong foundation for future growth.
If you’re eyeing a small business acquisition, our expert team is here to ensure you get the best deal possible. With our acquisition program, we’ll guide you through each stage—valuation, due diligence, negotiations, and scaling. And when the time’s right, we’ll exit with a 3-10x multiple.
Book a free consultation call today, and let’s take the first step toward a profitable acquisition together.
