How to Value a Small Business if You’re Looking to Sell
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A small-business valuation represents a company’s total worth based on its business assets, earnings, industry and any debt or losses. Conducting a valuation is an excellent opportunity to assess the financial health and potential of your business, or of a business you’re hoping to buy.
Whether you are planning to sell your business or you already have an offer, knowing how to value a business can help inform your company’s road map and future exit strategies. Entrepreneurs looking to buy an existing business should also be familiar with valuations and feel comfortable estimating value independently of the business owner or broker’s asking price.
How to value a small business
There are some key steps to begin valuing your business. In addition to doing your own research, consider consulting a professional.
1. Understand the terms
Unless you’re a natural-born business or numbers person (or, say, an accountant), business valuation isn’t the easiest process. You'll need to understand some key definitions first.
Seller’s discretionary earnings
Seller’s discretionary earnings (SDE) represents the total financial value that a single owner would get from owning a business on an annual basis. Also referred to as adjusted cash flow, total owner’s benefit, seller’s discretionary cash flow or recast earnings, the calculation includes expenses like the income you report to the IRS, noncash expenses. It essentially represents whatever revenue your business actually generates.
SDE vs. EBITDA
Different from earnings before interest, taxes, depreciation and amortization (EBITDA), SDE also includes the owner’s salary and owner’s benefits. Large businesses generally use EBITDA calculations to value their businesses, and small businesses typically use SDE, since small-business owners often expense personal benefits.
SDE multiple
Your SDE multiple values your business according to industry standards — there is a different multiple for every industry. Your SDE multiple will vary based on market volatility, where your business is located, your company’s size, assets and how much risk is involved in transferring ownership.
The higher your SDE multiple, as you might expect, the more your business is worth. If you used EBITDA to value your business, you would use an EBITDA multiple.
SDE calculation
To calculate your business’s SDE:
Step 1: Find your pretax, pre-interest earnings.
Step 2: Add back purchases that aren’t essential to operations, like vehicles or travel, that you report as business expenses. Employee outings, charitable donations, one-time purchases and your own salary can all be included in your SDE. (Buyers might ask about your discretionary cash flow when you offer them your valuation, so be prepared to include and value each major expense or purchase.)
Step 3: Subtract any current debts or future payments from the net income.
Step 4: Compare with your SDE multiple.
How much do you need?
We’ll start with a brief questionnaire to better understand the unique needs of your business.
Once we uncover your personalized matches, our team will consult you on the process moving forward.
2. Organize your documents
To ensure an accurate calculation, sellers and buyers should have organized financial records, which will also be crucial for the actual transfer of ownership.
Business owners need the following documentation in order to ensure a smooth valuation process:
Licenses, deeds and any proprietary documents.
Profit and loss statements and balance sheets for the last three years.
Tax filings and returns.
Short overview of your business or personal finances.
While buyers won't need all of these documents, they should still review their own financials. It's likely that sellers will want to see the credit report and basic financial profile of the individual or business they are selling to.
In addition to financial records, buyers may want to see a business plan, which can help make accurate projections for earnings, how your business will continue to grow and turn a profit, provide important context about your company and detail your key services or goods. It should also detail your business model, which demonstrates how you make money, and shows potential buyers how they’ll actually reach their customer base to generate revenue if they purchase your company.
3. Take stock of your assets and liabilities
Assets and liabilities are an important factor in a business’s overall value, and they’re important to know in detail for both sellers and buyers. Business assets are anything that adds value to your company, such as intellectual property, your production line or company vehicles.
There are two types of assets — tangible and intangible assets — and they’re weighted differently when calculating a business’s total value. Tangible assets are physical assets that are used for regular business operations and lose value over time. They include things like real estate, equipment, inventory and cash on hand.
Intangible assets are things that hold value, but cannot be seen or touched. They include things like patents, copyrights or trademarks, customer loyalty, reputation and intellectual property. Intangible assets are also things that cannot be separated from the company itself.
Liabilities are generally outstanding obligations that detract from the overall value of a business. They include accounts and notes payable, business loans, accrued expenses and unearned revenue. Business owners often keep their business liabilities and pay off their debt after the business is sold.
4. Research your industry
A deep understanding of your industry’s trends can help both buyers and sellers reach an informed valuation that reflects a business’s assets as well as the current market. Understanding the industry helps:
Determine the SDE multiple as well as the method of valuation used.
Assess market share and growth potential.
See what comparable businesses are selling for.
Small-business valuation methods
There are several business valuation methods. Each uses a different aspect or variable of a business to calculate its numerical value — either a business’s income, assets or using market data on similar companies. Your ultimate valuation should be the result of consistent calculations, not a mix and match of formulas or approaches.
Income approach
The income approach to business valuation determines the amount of income a business can expect to generate in the future. If you want to take the income approach, you can choose between two commonly used valuation methods.
Discounted cash flow method: This method determines the present value of a business's future cash flow. The business's cash flow forecast is adjusted (or discounted) according to the risk involved in purchasing the business. This approach works best for newer businesses that have high-growth potential, but aren’t yet profitable.
Capitalization of earnings method: The capitalization of earnings method also calculates a business’s future profitability, taking into account the business’s cash flow, annual rate of return (or return on investment), and its expected value. But where the discounted cash flow method accounts for more fluctuations in a business's financial future, the capitalization method assumes that calculations for a single period of time will continue in the future. So, established businesses with stable profitability often use this valuation approach.
Most online business valuation calculators use a variation of the income approach. But if you have more financial information on hand, you can try a more comprehensive business valuation tool that includes both profit and revenue, as well as assets and liability, in the calculation.
Asset-driven approach
Another common method attributes value to a business based solely on its assets. In particular, the Adjusted Net Asset Method calculates the difference between a business's assets — including equipment, property and inventory, and intangible assets—and its liabilities, both of which are adjusted to their fair market values. Asset valuations are also a great tool for internal use and can help you keep track of spending and capital resources.
To do an asset-driven assessment, you’ll make a list of your assets and assign them a monetary value. For equipment or other depreciating assets, that value is usually somewhere between the sale price and the depreciated value. A good rule of thumb is to estimate how much a piece of equipment would sell for today, and use that number.
Because you’re familiar with your own equipment and production, you can make pretty accurate estimates of each of your asset’s value and depreciation. Even if you don't adjust the asset's worth according to the current market, you can still get a good sense of a business’s material value. This method is especially useful if your business mostly holds investments or real estate, isn’t profitable, or if you’re seeking to liquidate. In any of those cases, buyers will be interested in the individual value of your investments or equipment.
Market approach
As you can deduce from its name, the market approach to valuing a business determines a company’s value based on the purchases and sales of comparable companies within the same industry. This approach will specifically help you determine an appropriate selling or purchase price based on your local market. Any business can use this approach to business valuation, as long as it can gather sufficient, relevant data on which to compare their business. It can be an especially useful approach for rapidly growing businesses and industries.
