Keys to Determine the Value of a Small Business – Part One

estate planning for business owners

Not sure what your business is worth? Start here. 

Knowing what your business is worth is extremely important. If you’re unsure, you can certainly start by conducting a valuation. This is essentially a way to determine your business’s value with a formula that takes into account your industry, assets, earnings, and any debts or losses. If you were ever planning to sell your business, interested buyers would want to know your valuation. But even if you have no plans to sell, knowing the value of your business can help you to create your company’s roadmap.

There is a lot of information here, so this is Part One of a two-part series of articles on knowing what your business is worth. Check back for Part Two, soon!

By Meredith Turits

1. Understand Your Valuation
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 (SDE)
If you’re familiar with EBITDA, you’re probably already familiar with SDE (Seller’s Discretionary Earnings), too, even if you’ve never heard the term. As a reminder, EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization—essentially, it’s the pure net profit of a business.

Like EBITDA, business owners calculate SDE to determine the true value of their business for a new owner, so your SDE will include expenses like the income you report to the IRS, non-cash expenses—whatever revenue your business actually generates. Unlike EBITDA, though, you’ll also add back in the owner’s salary and owner’s benefits into your SDE calculation. Large businesses generally use EBITDA calculations to value their businesses, and small businesses typically use SDE, since small business owners often expense personal benefits.

It’s crucial that prospective buyers understand SDE, too. Most likely, business owners will provide you with that number, so it’s important to understand how the business owner reached that value, and what these values reflect about the actual business.

To calculate your business’s SDE: Start with your pre-tax, pre-interest earnings. Then, you’ll add back in any 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.)

Finally, any current debts or future payments, called liabilities, are subtracted from the net income. More on liabilities in a bit.

SDE Multiples
Your SDE represents the true, monetary value of your business, but your SDE multiple values your business according to industry standards. (If you used EBITDA to value your business, you’ll use an EBITDA multiple.) As we mentioned, though, more often small businesses should use SDE for their business valuations, since small business owners usually pull a large percentage of their business’s revenue for their salary and living expenses.

There’s a different SDE multiple for every industry. Your particular business’s 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.

2. Organize Your Finances
Because the process for determining the value of a small business is complicated, you might want to consider consulting a professional business broker or accountant that specializes in valuation, rather than going it alone. That said, you’re fully capable of valuing your business using your own resources. First, though, you have to get your financial information in order.

Before even thinking about how to value a small business for sale, both sellers and buyers should organize their financial records—that’s crucial for accurate calculations. And beyond conducting your valuation, you’ll need your finances in order to transfer business ownership, regardless.

Sellers will need to have the following documentation in order to ensure a smooth valuation process:

  • Licenses, deeds, and any proprietary documents
  • Profit & Loss statements for the last three years
  • Tax filings and returns
  • Short overview of your business or personal finances

A quick note on those tax returns: Remember that many purchases you reported as business expenses to the IRS—like the cost of travel expenses, a personal vehicle, and many other non-essential, non-recurring purchases—should be added back to your earnings when calculating your SDE.

Buyers obviously won’t need all of these documents, but they should still review their own financials. It’s likely that any sellers you’re working with will want to see your credit report and basic financial profile.

Establishing a firm financial foundation will help you maintain realistic expectations about the value of your company (or the company you’re hoping to buy). The more thorough you are in this step of the valuation process, the more confident you’ll be in your calculations.

3. Take Stock of Your Assets
You might think that you can’t actually distill the value of your entire business to an exact number—and, sure, in a way it’s a bit of an estimate. But as a seller, you have to put some number on your operation, especially if you want to be compensated for what you’ve built, taking into account all kinds of equity.

Your best angle is to make a list of the production, property, and resources that comprise your business—assets and liabilities, cash and investments, employees, and intellectual property. Later, too, you can use this list to create an overview of your company’s value for potential buyers. This is another opportunity to seek the counsel of a mentor or a professional advisor, who can provide insight into your business’s assets from a more objective perspective.

Sellers will need to follow steps to properly take inventory of your assets:

Make a detailed report of your business assets and liabilities.
Here, business assets include anything that adds value to your company. This means intellectual property, your production line, your delivery truck—if it’s a part of your business, you’ll either need to account for it as an asset or a liability. There are two asset categories, and they’re weighted differently when calculating a business’s total value:

Tangible assets: When you think about valuing a small business, the most obvious factors in determining value are the company’s material resources and holdings. Examples include:

  • Real estate or property
  • Equipment or means of production
  • Inventory or stock
  • Cash on hand

Intangible assets: These are all the non-material assets that add value to your business. Intangible assets are crucial to your SDE multiple, so it’s important to identify and record their estimated value. These could include:

  • Patents, copyrights, and trademarks
  • Other intellectual property
  • Brand and reputation
  • Customer loyalty or subscriber base

You’ll also need to know your liabilities. Liabilities include any debt or outstanding credit on your business’s books, and they detract from the overall value of a business. (That’s why this number is subtracted from the SDE in valuation calculations.) Often, sellers keep their business liabilities and pay off their debt after their business is sold.

Liabilities that will factor into your calculations include:

  • Notes payable
  • Accounts payable
  • Business loans
  • Accrued expenses
  • Other debts or payables, as well as unearned revenue
  • Outline your business plan and model.
  • If you’re selling, your prospective buyer will need to understand how you generate revenue—and will continue to.

Business plan: A strong business plan helps you make accurate projections for earnings and market growth. Plus, it’s crucial to demonstrate to potential buyers how your business will continue to grow and turn a profit. Overall, a strong business plan provides buyers with important context about your company—like your location and mission—and captures what key services or goods you offer.

Business model: Your business model demonstrates how you make money, be it a subscription-based service, direct-to-consumer ecommerce, or B2B consulting. A valuation is a suggestion of value, but your business model shows potential buyers how they’ll actually reach their customer base to generate revenue if they purchase your company.

But buyers aren’t exempt from this step in the process! If you’re considering acquiring a business, composing a list of your target’s assets and liabilities will ground your decision in sound financial judgement—and make sure you and the seller are on the same page with valuation. You should also look for business plans that clearly outline processes and, ideally, demonstrate consistent management. A well-run business will make transitioning ownership, without losing profits in the process, significantly easier.

4. Research Your Industry
Familiarity with your industry is crucial for both buyers and sellers. Before buyers can confidently make an offer on a business, they’ll need to become well-versed (if not an expert) on that business’s industry. On the sell side, a deep understanding of your industry’s trends can help you reach an informed valuation that reflects your business assets as well as the current market.

As we mentioned earlier, a business’s SDE multiple—and the method of valuation—varies according to a few factors, including the strength of the industry. So, sellers should find out as much as they can about companies that are similar in size, business model, and revenue, if that information is available.

These similar businesses, often referred to as “comparables” or “comps,” can orient you within the marketplace and provide context about the sector. Knowing your peer companies will also help you assess your market share and growth potential. Then, you can demonstrate to potential buyers what makes your business stand out.

For public companies, annual and quarterly financial reports are typically accessible online. Depending on the degree of corporate transparency, you can also see what comparable businesses are selling for. Internet companies or buyers interested in the tech sector can use online directories like Crunchbase and platforms like AngelList, which provide information about startups, funding, investors, and more.

Read the full article here.

So what are your thoughts and questions so far? Let us know in the comments, and be sure to check back soon for Part Two: Approaches to a Successful Business Valuation.

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