How to Value a Small Business: Ultimate Guide

Susan GuilloryUpdated February 7, 2022

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There may be times in the lifecycle of your business – such as when you’re looking for investors, applying for a business loan, or transferring ownership – when you’ll need to know the value of your business. A business valuation simply refers to the total worth of your business. You can calculate your business’s value using a specific formula that takes into account your assets, earnings, industry, and any debt or losses. Doing a business valuation before you start seeking investors can give you a better understanding of what you’ll need to give up in exchange for the capital you seek (or what’s known as the cost of capital).There are several different formulas you can use to value your small business. Which one is appropriate for your business will depend on the size of your company and purpose of the valuation. Below, we explore five different ways to come up with a value for your business.

Why You May Need to Value Your Business

There are many reasons why you might need to value your business. One of the most common is for investment or sales purposes. If you want to find venture capital for your business, for example, you’ll need to be open to giving up a percentage of equity to investors. This equity, as well as how much of an investment they will be willing to give you, is based on the valuation of your business.You may also need to value your business if you are seeking any type of business loan or line of credit, applying for a small business grant, looking to buy out other owners of the business, or offering employees equity in the company. A significant life change, such as marriage or divorce, can also spur a business valuation. Even if you aren’t planning on any major changes in your business or life, you may want to know the value of your company to better understand your business’s growth.

Approaches to Valuing Your Small Business

There are several methods for valuing a small business. Each uses a different aspect of a business to calculate its numerical value — either a business’s income, assets, or using market data on similar companies. Here’s a quick look at five popular valuation methods.

Asset-Based Approach

The asset-based approach is a simple way to assign value to your business. It adds up the value of all assets of your company, minus the liabilities.Those assets can include:

Equipment and machinery
Technology
Inventory
Accounts receivable
Intangible assets (such as patents, customer list, brand/reputation)

For equipment or other depreciating assets, that value is usually somewhere between the sale price and the depreciated value. One rule of thumb is to estimate how much a piece of equipment would sell for today, and use that number.The liabilities you’d subtract from the total of all assets would include any outstanding accounts payable or debts. An asset-based approach to valuation can be a good choice if you have many assets or sell physical products.

Market Approach

To value your home, you would compare it to similar houses in your neighborhood. The market approach to valuing a company works in a similar way – the business’s current value is determined by comparing the recent sale prices of similar companies. You can take an average of the value of those businesses to get an approximate valuation for your own if you are able to discern what their values are. While finding relevant comps can be difficult if you have a small business, you may still want to look for at least a few comps if you’re planning on selling (or buying) a business. If you’re hiring an appraiser, they may also have access to databases with relevant findings.

Seller’s Discretionary Earnings Method

If you run a services business and don’t have a lot of tangible assets to calculate into your valuation, the seller’s discretionary earnings method (SDE) may be a good match. Typically only used for small business valuation, the SDE looks at your annual revenue before taxes and expenses. To calculate the SDE, you’ll need to determine how much cash it takes to run your business. You can start with the business’s earnings before interest and taxes, then, add back your compensation (because the new owner can choose a different salary) and benefits, such as health insurance. Also, add back any expenses that are non-essential, non-recurring, and/or not related to the business (such as travel or a one-time consulting fee). Your SDE represents the true, monetary value of your business.

Capitalization of Cash Flow

Another method for calculating valuation based on income rather than assets is the capitalization of cash flow (CCF) method. To value a small business with CCF, you divide the cash flow from a specific period by a capitalization rate. To determine the cash flow, you’ll want to look at sustainable and recurring cash flow from your business, which means you may want to make adjustments if there were any one-time expenses or unusual events. The capitalization rate is the business’s expected rate of return, or what a buyer could expect to earn (not including their salary) if they purchase the business. It’s often around 20% to 25% for small businesses.Recommended: What Is Working Capital & How Do You Calculate It?

Discounted Cash Flow Method

The discounted cash flow (DCF) method is another income-based valuation method. This method attempts to figure out the value of an investment today based on projections of how much money it will generate in the future. The purpose of DCF analysis is to estimate the money an investor would receive from an investment, adjusted for the time value of money. The time value of money assumes that a dollar today is worth more than a dollar tomorrow because it can be invested.The DCF method is a complex formula that looks at the business’s annual cash flow and projects it into the future and then discounts the value of the future cash flow to today (using a “net present value” calculation). Fortunately, there are online valuation calculators that can help you do the math. Recommended: What Capital Structure Is and How It Works

How to Prepare for the Valuation of a Small Business

If you’re doing a business valuation for informal purposes, you may want to do it on your own. If you need an analysis for a specific purpose, however, you may want to hire a professional appraiser or a business valuation expert (offered by some banks, lenders, and accountants). Either way, here are some steps you may want to take to prepare for an valuation.

Step 1: Get Your Financial Documents in Order

No matter which valuation method you choose, it will be based, at least in part, on your business’s finances. As a result, you’ll want to gather the last three- to five-years’ worth of your business tax returns and financial statements, including balance sheets, income statements, and cash flow statements. It’s also a good idea to comb over these statements to make sure everything is accurate and up to date.Other finance-related documents, such as sales reports and industry forecasts can also be useful.It can also be a good idea to have copies of your business licenses, permits, deeds, and certifications available, along with any ongoing contracts with insurers, creditors, vendors, and clients.

Step 2: Identify All of Your Assets

You may not be fully aware of all the assets your business has, and taking time to identify both tangible and intangible assets can be well worth it, since they’ll increase your business valuation.Your business’s tangible assets (such as cash, property, and equipment) should be listed on your balance sheet. This list may also include some intangible assets, like copyrights or patents. To get a full valuation of your business, however, you may want to think about other intangible assets that may be providing value. This could include an extensive email list, loyalty club, good rankings in search engine results, and positive online reviews. These types of assets could help improve your business’s valuation even if they don’t have a number value on its balance sheet.

Step 3: Identify Your Liabilities

You'll also need to know your liabilities. Liabilities include any debt or outstanding credit on your business’s books that detract from the overall value of the business. Liabilities that may factor into your valuation calculation include:

Notes payable

Accounts payable

Business loans

Accrued expenses

Any other debts or payables

Step 4: Research Your Industry

A solid understanding of your industry’s trends can help you reach an informed valuation that reflects your business assets as well as the current market. If you’re doing a market-based valuation, you'll want to know as much as you can about companies that are similar in size, business model, and revenue, if that information is available. Knowing your peer companies can also help you assess your market share and growth potential and allows you to demonstrate to potential buyers what makes your business stand out.

The Takeaway

A proper small business valuation can be important if you’re planning on selling your business, merging, buying out other owners, looking for small business funding, offering employees equity, or going through a major life event. What’s more, knowledge is power. Knowing what your business is worth — as well as being on top of what your assets and liabilities are — can help you make smarter financial decisions for your business.Looking for ways to fund your small business? There are all kinds of small business financing options to consider. With Lantern by SoFi, you can compare rates from multiple small business lenders without any obligation and just one application.

Photo credit: iStock/AsiaVisionThe tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.SOLC112250

About the Author

Susan Guillory

Susan Guillory is the president of Egg Marketing, a content marketing firm based in San Diego. She’s written several business books, and has been published on sites including Forbes, AllBusiness, and Cision. She enjoys writing about business and personal credit, financial strategies, loans, and credit cards. Follow her on Twitter @eggmarketing.

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