This article will show you how to value a small business. We’ll introduce you to the six main ways used by entrepreneurs and professional valuers. We’ll also give you a checklist of 20 due diligence factors, which experienced business buyers, sellers and accountants use to assess the final value of a small business.
If you are preparing to sell your business, or you want to find a business to buy, we recommend talking to an experienced small business broker. Check out Business Exits, they have a high volume of small businesses for sale from coast-to-coast and a great exit conversion rate and provide free small business valuations.
How to Value a Small Business in Greater Depth
Valuing a small business is not an exact science. So much so that you will rarely find two business valuation experts come up with the same valuation for the same business. And we don’t recommend paying for a professional business valuation unless the business is worth in excess of $1m. This is because a credible independent valuation is likely to cost at least $25k. However, it’s just one experts view (your expert!) and the other party will ignore it if they have formed a different view.
Tip: We define an accurate business valuation as a price a willing buyer and a willing selling are prepared to agree on. This leaves much down to your ability to negotiate effectively. It also helps to speak to the business owner to understand how they valued their business and arrived at their price.
1. Seller’s Discretionary Cash Flow (SDCF) Method
This method is considered by most experts to be the most reliable for a small business valuation. It’s also more likely to be considered a fair method by both the buyer and the seller. Remember our tip, the right valuation is one you can both agree on!
Business Value = SDCF x Industry Multiple + Assets – Liabilities
The formula above summarises the math, which is simple once you understand how SDCF is defined. SDCF is defined as the business’ Earnings (or Net Profit) per year, plus the Owner’s Salary and any other tangible Benefits they take out of the business in the same year.
The owner’s salary and benefits are added into the calculation for small businesses, because the new owner will be able to take the same salary and benefits out of the business. Or if they choose not to, the earnings of the business will increase the same amount.
The industry multiple is determined by recent sale prices of businesses from the same niche. If a small business made an SDCF of $250k in it’s last full year of trading and sold for $750m then the multiple for that business was 3.
Sale Value = SDCF x Industry Multiple
$750k = $250k x 3
Typically small business sell for a multiple in the range of 1-3, though in some industries like tech innovation the multiples can be much higher. The best way to find out which businesses sold recently is to speak with business brokers and lawyers who complete business sales.
Use this method – if you want a simple and accurate valuation that both sides are likely to be able to agree on then this is likely to be the best way to go. The main exceptions to this are listed below.
2. Recurring Revenue Multiple Method
A business with guaranteed future income streams and earnings need to be valued by a different method, which recognises the value of sticky customers. From the buyer’s viewpoint, you get a business with income streams guaranteed into the future. From a seller’s perspective, the full value of the business is recognised.
Sale Value = Recurring revenue x Industry Multiple
As in the last method, the recurring revenue multiple for each niche is determined by the most recent sales of similar businesses. And specialist brokers exist to help with the sale of tech startups and membership organizations.
Use this method – if the majority of the business’ customers subscribe for 12-months or more to pay their membership fees. This is because it recognises that subscribing customers are legally committed to keep paying for their membership well into the future.
3. Asset Valuation Method
The asset valuation method is simple, you just work out the value of all the assets of a business and total them up to arrive at your valuation for a business. However, it’s not very suitable for valuing a business as a going concern. This is because a businesses assets are organised and used to generate value. but they cannot create revenue and profits on their own.
Use this method – if you are going to buy a business because of it’s unique assets and then change its business purpose. For example, you might want to buy a restaurant because it has premises in a great location and a fully equipped kitchen. But the current seller’s restaurant is failing so you do not want to include any value for the business as a ‘going concern.’
4. Liquidation Value Method
Similar to the asset valuation method, the liquidation valuation method also total the value of the business assets. Where it differs is that the value it places on them is based on selling those assets in a relatively short period of time, usually less than 12-months.
Use this method – if the business you are considering buying is going out of business. The business owner may not be aware of this yet, but there is no harm in making them a low offer based in this method. If they do not manage to turn things around, they may get back to you to discuss your offer.
5. Income Capitalization Method
This method calculates the value of a business’ future income using a range of assumptions, which differ according to business type and which expert you speak to. This method works well for large enterprises with a long trading record, but is less suitable for valuing a small business. It also requires the involvement of costing ‘independent experts’ and as a result we do not recommend it for small business buyers or sellers.
6. Rule of Thumb Method
This method analyses the sale price of similar businesses to determine what the value of the business you are considering. The issue with this method is that no two businesses are the same and so it’s a crude method whether you’re a seller or a buyer.
Use this method – this method is simple and easy to complete without too much effort. As a result, it’s great to use as a starting point to get a rough value of the business you are focused on. A scaled business broker will be able to help you calculate this value for free. Checkout Business Exits you’ll provide you with a valuation using this method for free.
20 Due Diligence Factors to Help You Assess the True Value of a Small Business
Buying a business will be one of the biggest purchases you have made in your life to date. As a result, we strongly recommend that you get a good accountant to help you complete due diligence before buying or selling your business.
However, you need to be able to understand how to value your small business for yourself, or you’re placing too much trust with someone else. Below we have provided a quick overview of the typical checklist a professional would use to assess the value of a small business. Other factors may need to be taken into consideration that only relate to a specific business type.
Tip: Many business sellers pay for an independent business valuation to help determine the value of their business. You should ask for a copy of this, however beware that it’s just one person’s expert view and three different experts are likely to value the same business very differently.
You need to understand the true value of any stock in the business. In a retail business, stock over-valuation is common by sellers. The value of stock may need to be discounted if it loses over time e.g. stock for a fashion based retail business.
2. Other Tangible Assets
The seller should provide you with a detailed list with descriptions of each item including age and condition. This is especially important in any business that relies on expensive equipment for its operations. The seller will also be able to provide you with copies of property deeds or lease agreements.
3. Intangible Assets
Also referred to as ‘going concern value,’ in some businesses, the intangible value of the brand is also valued. This is often the case for B2C businesses. Valuing a brand asset is very subjective so you’ll need to form your own view and get advice. Our starting point would be not include it in you valuation unless it is common practice to include brand value for this type of business.
In addition to premises leases, there will be a wide range of other contracts already in place. You will take over legal responsibility for these commitments when you buy the business. As a result, you need to check them all out. For example, what employment contracts are in place for the team you will inherit?
5. Tax returns
It’s not unusual for small business owners to push costs through the business that they derive a personal benefit from. For example, they may sponsor an ice hockey team because they like to go and watch. You need to understand these items to properly value the business.
6. Financial statements
The best place to start is to review the historic financial statements filed by the business online via a site like Dunn and Bradstreet. However, the latest accounts will not have been filed and you will need advice on these from an experienced accountant.
7. Historic Sales
You’ll want to invest a good chunk of your time to understand how sales has performed over the last 3-5 years. When you do this, you’ll need to get a real feel for the dynamics of the customer buying cycle. For instance, are sales seasonal? How sensitive is price? Is the margin healthy?
8. Sales Pipeline
You also need to understand the future sales forecast. If you are considering buying a B2B business, you need to analyse the sales pipeline to understand each stage of the sales process and it’s conversion rate to the next stage.
The business owner has a legal obligation to disclose all liabilities. As well as any outstanding potential future liabilities. For example, if a sacked employee has threatened to sue the firm, this is something they must disclose. You may need your lawyer to help you assess the risk of each outstanding liability.
10. Accounts Receivable
The age of accounts receivable is important. It will impact cashflow. And long-outstanding invoices have more likely to turn into bad debts. Being able to reduce average debtor days has a big positive impact. Conversely, if your customers are large enterprises you take months to pay, this is hidden cost and a risk that needs to be mitigated.
11. Accounts Payable
Also take a close look at accounts payable. If the business is taking 90-days to pay suppliers, why? What are the relationships with suppliers like? Who are the key suppliers without which the value of the business is reduced? Debts outstanding Outside of suppliers, what other forms of debt does the business have sitting on its books?
12. Customer Loyalty
Getting an accurate gauge of customer loyalty is a great way to predict the future growth potential of any business. We would caution against believing in the seller’s own research reports on this subject. Take them into consideration, but also communicate with a sample of customers directly to see how well their assessment matches watch you learn from a straw poll.
13. Lead Acquisition Costs
Otherwise known as marketing, it’s essential to understand how new customers are sourced. For a B2C business this is likely to include passing traffic, advertising and customer referral. For a B2B business this is likely to include business intelligence, content marketing and events.
It’s key to slow down and understand price. Not just whether the price is sustainable, but also how sensitive customers are to changes in price. A quick and dirty way to do this is to identify and analyse the businesses main competitors and how they price the same products and services.
15. Market Trends
These will help you to understand the long-term drivers of change and how these could impact future profits. The simple way to analyse market trends is to go online and find trade studies and trend reports.
As we mentioned earlier, you need to understand the dynamics of the business location. Is the population growing or in decline? Are premises increasing or decreasing in value? Where are your competitors located?
17. Brand Reputation
We covered customer loyalty earlier in this list. Understanding how the brand is perceived by it’s ideal customers will give you the best insight into how the business will trade in the immediate future.
17. Seller-Customer Relationships
It’s essential to discover whether any of the key customers of the business are close friends or relations of the owner. If these customers were to move away after the sale, how would that effect the value of the business?
In many business types, a huge part of the value of the business will be wrapped up in the value of its employees and how well they work together as a team. Understand how staff are line-managed and evaluate each employee contract to make sure it’s fit for purpose.
19. Salary Benchmarks
Are the team you will inherit being paid a competitive wage, or will you have to increase salaries soon after the sale to avoid losing staff?
Get advice on what insurance a business like the one you are considering should have in place. Then compare this with the insurance the business has in place and what it costs.
The Juice Press
This article shared with you how to value a small business in five different ways. It’s worth being familiar with all five methods if you are considering buying or selling a small business. You also need to identify the right method to use for the business you’re valuing.
Whether you are buying or selling a business, it’s one of the biggest financial transactions you’ll make. As a result, we recommend speaking to an experienced accountant to get further advice.
If you’re selling your business, or looking for one to buy, we recommend talking to an experienced business broker. Check out Business Exits who have small businesses for sale from coast-to-coast and a great exit conversion rate.