Every business owner should understand how much their company is worth. A valuation is particularly critical for exit planning strategies. Specifically, it tells you how much buyers are willing to pay for your company. This allows you to capitalize when your value is at its highest or take steps to improve your value if necessary. In this review, we discuss the valuation process for small to mid-sized businesses, along with highlighting all that an experienced business broker considers when determining the worth of your small or mid-sized business.
What is a Small Business Valuation?
A small business valuation determines the economic value of your small to mid-sized business. This is the amount that would be considered fair for a buyer (or business partner) to pay to acquire your stake in the company. There are many factors that go into a professional valuation from a business broker. Specifically, your broker will use your financial records to determine your net income, gross profit, earnings before interest, taxes, depreciation, and amortization (EBITDA), and/or seller’s discretionary earnings (SDE). This information is then considered along with rule of thumb data and the specific details of your company.
How Can I Determine The Worth of My Small to Mid-Sized Business?
If you are planning to sell your company, then the market will dictate how much your company is actually worth based on how much buyers are willing to pay. The purpose of a business valuation for small to mid-sized businesses is to determine this value before you hit the market. Otherwise, you run the risk of selling below your maximum value or not selling at all. In order to hit the sweet spot with your valuation where you maximize your company’s worth without calculating an unjustifiable financial figure, you can follow the steps below.
Step 1: Determine Your Purpose for a Business Valuation
All small and mid-sized business owners can benefit from a professional valuation. However, the reason for a valuation may vary for each owner. It is important to establish the purpose as it plays a role in the valuation type you choose (see below). Below are several reasons you may need to determine the value of your small or mid-sized business:
- Succession planning
- Buy/sell agreements
- Insurance purposes
- Mergers and acquisitions
- Estate and gift taxes
In other cases, you may simply decide to receive a professional valuation in order to find ways to improve your company’s business operations and profitability. Simply put, it is never a bad idea to receive a professional valuation.
Step 2: Choose Your Valuation Type
You should then choose the type of valuation that is best for you. There are three primary types — market-based, asset-based, and income-based valuations. Here is a close look at the differences with each type:
- Market-based: Also called a market approach, this valuation method is used for exit strategy planning. It is also used for business owners who are in the midst of contract disputes with business partners or need to justify the company’s value during a legal dispute. In essence, a market approach determines a company’s value on the market. In other words, it is the amount that a reasonable buyer would pay for the company.
- Asset-based: An asset-based valuation determines the fair market value of a company based on their assets. Specifically, it calculates the worth of your tangible assets. This may include your land, buildings, inventory, vehicles, and cash reserves. An asset-based valuation is often used during the due diligence stage of a sale.
- Income-based: This method determines your company’s value based on cash flow. This includes a review of your company’s past revenue performance and projections. This may be useful to calculate if you have strong earnings (and potential earnings).
Step 3: Collect Your Financial Records and Documents
A professional valuation from a broker is the best way to determine the value of your small or mid-sized business. Your broker will need access to your financial records in order to calculate an accurate value that your business partners, prospective buyers, and other third-parties trust. Specifically, your broker may request the following documents:
- 3+ years of your federal tax returns
- 3+ years of your profit and loss (P&L) statements (including your balance sheet)
- The average value of your on-hand, salable inventory
- A copy of your real estate appraisal (if the real estate is included in the sale)
- Equipment and vehicle lists
- Lease information
Step 4: Select a Business Broker You Can Trust
A valuation is not something you should calculate on your own. Even if you have a background in finance and accounting, prospective buyers and other third-parties are not going to trust a value that you calculated yourself. Instead, you want to seek an impartial value from a business broker. Specifically, you want to find a business broker who sees the entire worth of your company, rather than one who only focuses on your financial information and rule of thumb data.
Step 5: Receive Your Valuation and Determine Your Next Steps
Once you provide your broker with the documents they need, then your work is done for the valuation stage. The broker then calculates the value of your small or mid-sized business and explains how they arrived at the figure.
Your valuation can help you plan the next steps in your professional journey. For instance, if you are ready to retire and receive a value that allows you to do so, then now may be the best time to take action. In other cases, it may be best to increase your value by improving business operations, increasing marketing efforts, and keeping better financial records.
What is Included in a Professional Business Valuation?
You should receive a personalized valuation for your small to mid-sized business. As discussed, the considerations depend largely on the type of valuation as well. For this review, we will focus on what is included in the most common type, which is a market approach. Specifically, a business valuation generally involves an evaluation of your SDE (and other financial figures), rule of thumb data, the value of your current assets, and a variety of non-financial considerations.
Seller’s Discretionary Earnings (SDE)
Seller’s discretionary earnings (SDE) is based on cash flow and look at the before-tax profits. It uses your earnings before interest, taxes, depreciation, and amortization (EBITDA). However, it goes one step further. Your discretionary earnings also adds back your compensation, most discretionary expenses, and one-time costs. You can calculate SDE with the formula below:
- SDE = EBITDA + Owner’s Compensation (and other add-backs)
There are a range of add backs that may apply (see below). As you might imagine, the calculation of SDE is a complex process. Consequently, it is essential to work with an experienced broker you can trust.
Rule of Thumb Data
Rule of thumb data (acquisition multiples) are calculated averages based on recent business sales in your industry. In some ways, rule of thumb data is similar to the role of comparable properties in a real estate sale. It considers how much businesses similar to yours have sold for to determine the fair market value (FMV) of your company. Every industry has unique rule of thumb data.
For example, if your industry’s rule of thumb is three times the company’s SDE and your SDE is $300,000, then your company is valued around $900,000 according to the multiple. Of course, this is before adjustments are made, and rule of thumb data should not be used without professional adjustments.
The Value of Your Current Assets
Current asset value is a typical industry standard business valuation method. To determine this value, your broker will calculate the value for everything the company owns and then subtract liabilities and debts. In doing so, you gain an understanding of your net assets, which is usually reflected on a balance sheet.
Also, there is a notable difference between tangible and intangible assets. An intangible asset is an asset that cannot be felt or touched and it is subsequently harder to determine its value. For example, a patent is an intangible asset. A tangible asset, on the other hand, is physical and has more clearly defined monetary value, such as vehicles and real estate property.
The best valuations go beyond financial information. Additionally, your valuation should include reasonable adjustments based on a variety of considerations that do not show up in financial reports. These non-financial factors include:
- Your industry
- Unique competitive advantage
- Growth potential
- Quality of your workforce
- Local reputation
- Reason for selling
There are no cookie-cutter approaches when it comes to adjustments. Your broker should take a deep look at all business details to determine which non-financial factors should influence the value of your company.
Determine Your Company’s Worth With Sigma Mergers and Acquisitions
Sigma Mergers and Acquisitions has helped hundreds of business owners sell for fair market value. If you are interested in receiving a free, no-obligation business valuation and planning your exit strategy, then feel free to reach out to us today.