Business valuation tells you how much your business is worth in dollars—as opposed to blood, sweat, and tears.
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When you’ve built your own business from scratch, it’s hard to be objective. After all, you’ve poured so much of yourself into it.
The value of your small business gives you hard numbers—information you can use to sell your company, or court investors and lenders.
Three methods to determine the value of your business
When it’s time to put a price on your business, you have three main methods to choose from. We’ll order them from simplest to most sophisticated:
Book value, or liquidation value, is your net worth: Your assets, minus your liabilities. This is the most straightforward way to value your business.
Present value takes the book value of your business into account, but also looks at cash flow. It’s useful when you want to know the value of your business now, as well as what it may be worth in the future. Present value determines whether your business is a “going concern”—a term for a business that has the stability to continue to operate and earn.
Fair market value takes into account a number of factors, including the health of your industry, to put a price on your business. If you’re selling, this is the number potential buyers want to see.
Calculating book value for your business
Book value is easy to find. You can use your balance sheet to determine your net worth.
(This is when good bookkeeping comes into play. If you don’t have an up-to-date balance sheet for your business—not to mention income and cash flow statements—understanding the value of your business is close to impossible. If your bookkeeping is behind, we recommend Bench. Their team will get you caught up in no time.)
Remember, your book value consists of all your assets, minus liabilities.
Assets include retained earnings, investors’ equity, or intellectual and material property.
Liabilities include accounts payable (money you owe vendors and contractors), and debt owed to the bank or the IRS.
Book value is great for getting a ballpark figure, but if you’re serious about selling your business, you’ll need to find your fair market value or, at the very least, your present value.
Calculating the your business’s present value
Present value takes into account what your business is earning now, as well as what you can expect it to earn in the future.
When we talk about earnings, we mean seller’s discretionary earnings (SDE). This is an important number—more on that in a minute.
Once you’ve got your present SDE, you can work with your accountant or a business valuation expert to create financial projections, and figure out what your business’s SDE will be in the future, based on past trends. (This is another case when up-to-date bookkeeping is essential.)
Calculating seller’s discretionary income (SDE)
When you own a business, you tend to create expenses for it. One of those expenses is your owner’s draw—how much you pay yourself from the business accounts. Another expense is the tax you pay on your income. You may incur other non-essential business expenses, as well.
When someone buys your business, they don’t buy you with it. They want to know the value of the business alone, regardless of the impact an owner might have on it.
Your SDE is your business’s book value, minus any expenses incurred by you, the owner.
The SDE formula:
SDE = (Net earnings before taxes + owner’s draw + non-essential expenses) – liabilities
Here’s how to do it, step-by-step:
- Find your business’s net earnings for the year, before taxes
- Add to that the amount you paid yourself (personal draw)
- Add to that all non-essential expenses you incurred. These are one-time, non-repeating expenses—such as business travel or meals. Do not include cost of goods sold (COGS). (We’ll walk you through essential v. non-essential expenses in more detail below.)
- Deduct all liabilities—such as unpaid debt and invoices.
- You now have your SDE.
Non-essential vs. essential expenses
Essential expenses are fixed. They keep your business running, and they’re the same each month. For example:
- Rent and property taxes
- Business insurance
Non-essential expenses vary month to month, and they aren’t 100% essential for keeping your business running. For example:
- Meal and travel expenses
- Equipment repairs and upgrades
- Staff events
Calculating your business’s fair market value
Your fair market value is the price you can reasonably expect to get if you sell your business on the open market. To find it, you multiply your SDE by an industry multiplier, also called an “SDE multiplier.”
Understanding industry multipliers
Industry multipliers are set by business appraisers. They take a lot of factors into account:
- The size of your business
- Trends in your market
- Your industry
- Your tangible assets (real estate, equipment, cash) and your intangible assets (client list, intellectual property)
- How much of your business’s success depends upon your individual skills or reputation
- Other variables
Why use an industry multiplier?
In order to get a fair market value for your business, why can’t you just use your SDE, or your SDE plus some financial projections?
Your SDE is good for knowing how much your business can be expected to bring in each year. But it doesn’t take into account other factors—including the state of the market and your industry more broadly. Those factors are expressed in the multiplier.
Here’s an example. Let’s say you own two businesses. One sells screen replacement kits for the latest model of iPhone. The other makes typewriter ribbons.
As chance would have it, both companies have identical SDEs. So, which one is worth more to buyers?
The market for typewriter ribbons is not growing; if anything, it’s shrinking. Meanwhile, as more people buy the new iPhone, and more manage to crack their screens, your market will grow.
The industry multiplier for your screen replacement kit business will be higher than the one for your typewriter ribbon business—because the people who set the multiplier take those factors into account.
Who sets the multiplier?
If you hire a consultant or appraiser to help put a price on your business, they’ll determine a multiplier—and they should be able to walk you through how they determine it.
If you’re valuing your business on your own, you’ll need to get a predetermined industry multiplier from a third party. Firms that specialize in determining business values publish guides containing lists of industry multipliers. You’ll have to pay for the latest edition. Get started by checking out the 2020 Business Reference Guide from Business Valuation Resources.
Business valuation services
Appraising your own business eats up a lot of time and energy. If you’re interested in getting your business on the market ASAP, your best bet is to hire an appraiser.
An appraiser uses knowledge of different industries and the economy as a whole to determine your company’s value. An appraiser may be able to find a more accurate number than you would alone.
Keep in mind: Not all business appraisers are created equal. Make sure anyone you hire has the following credentials:
- ABV (Accredited in Business Valuation): A credential for Certified Public Accountants who have done 75 hours of business valuation coursework, then passed a business valuation exam.
- ASA (Accredited Senior Appraiser): These individuals have done over 10,000 hours of appraisal work, passed a number of exams, and had their work reviewed by peers.
- CBA (Certified Business Appraiser): These appraisers have passed a rigorous peer review process.
- CBI (Certified Business Intermediate): These appraisers are certified as having intimate knowledge of business sales and purchases.
When it comes to valuing your business, there’s a lot of money—perhaps your entire livelihood—on the line. Make sure you’re sure of an appraiser’s credentials before deciding to work with them.
Your business valuation checklist
If you go to an appraiser for help, be sure to have the following on hand:
- Financial statements for the previous three years
- Details about major assets
- Details about major liabilities
- Details about investors
- Your business plan
- Any financial projections you’ve already created
- Past and present budgets
- List of staff members, their qualifications, and their compensation
- List of competitors
- Customer or client list
- List of vendors and regular contractors
Before showing up to an appointment with your appraiser, check in advance to find out whether any extra information will be needed.
Up-to-date bookkeeping is essential for getting the accurate value for your business. If you’ve fallen behind on your bookkeeping, you’ll need to catch up. For that, try Bench. Their remote bookkeepers can quickly handle months or years of out-of-date books, so you can start on the fast track to appraising your business.