Guide to Small Business Valuation
So, what is your small business worth?
Quite simply:
What someone else is willing to pay for it.
When you’re valuing your business, at its core, there’s two ways to do it:
Estimate future cash flows from owning the business.
Look at what other people are paying for similar businesses.
Simple enough.
What’s tough is:
The future is uncertainty (shocker)
And every number reflects a story you’re telling about the business.
Thinking about every decade as we advance forward, we gain more and more data.
You'd think this data would help inform market participants (public and private) about what a business is worth.
But real valuation is no easy task.
There’s a dislocation between pricing a business and valuing a business.
Pricing a business looks at what others are doing - buying a house, choosing a restaurant, or picking a movie. Many lean on the wisdom of the crowd to determine value.
Valuing a business is much more intricate and looks at cash flow, operating margins, growth potential, and risk of a specific business.
We’re not looking to price a business, we want to value the business.
When it comes to valuing a business, here’s 3 ways it can be done:
Book value &/or Enterprise Value
Both enterprise value and book value are a common way to value your business if you’re grossing under $1M in total revenue.
Book value = Company total assets - Company total liabilities (excluding intangible assets)
What’s leftover is the value of the tangible assets the company owns.
This method isn’t widely used because of historical cost accounting and doesn’t incorporate the company's expected future cash flow.
Enterprise value = Company total debt + Company total equity - Company total cash
Businesses doing less than $1M/yr in revenue typically have a heavy reliance on the founder and its assets may be majority of where the value is tied to - most buyers prefer to buy small business as an asset sale.
EBITDA Multiple
Using EBITDA (earnings before interest, taxes, depreciation and amortization) multiples is the most common way I’ve seen small businesses valued if your business grosses more than $1M in earnings.
EBITDA is calculated as follows:
EBITDA = Net income + Interest expense + Depreciation expense + Amortization expense + Taxes
But if you’re a small business owner, you know there’s a little gray between what expenses occur within the business that purely benefit the business versus blend over and benefit you.
Such as:
A business owned vehicle
Insurance coverage (life, health, disability)
Business travel, entertainment, & meals
Home office expenses
All are business expenses, but some expenses incurred by the business may always have been expenses incurred by the owner had they not owned the business.
For this reason, there’s add-backs to form an adjusted EBITDA which reflects more accurately the earnings of the company.
Those adds backs could be:
Excess owners salary
Discretionary expenses of owner
Non-recurring consulting fees
One-time expenses (remodeling, repairs, moving expenses, etc.)
Charitable donations
Below market rent paid
Income unrelated to business operation
These add backs could increase or decrease EBITDA - the goal is to come up with the most accurate earnings of your business.
Once you have an adjusted EBITDA, the multiple used to determine your valuation is both company & industry specific.
Typically small businesses usually sell for around 3-5 times adjusted EBITDA, but I’ve seen other businesses sell for 5-11x EBITDA, it just depends on your buyer & how attractive your business is to them.
Attractiveness of your business can be enhanced by:
Having a high percentage of recurring versus one-time revenue
Having a business with less reliance on the owner to run the business (ex: the more the replaceable the owner, the higher the valuation & vice versa)
Having a history of customer retention & satisfaction/loyalty
Plans for growth and expansion
Having a strong network of partnerships and alliances
Having a history of profitability
Having a differentiation and/or competitive advantage in the marketplace (sometimes called an economic moat)
Having a more compelling company trajectory (the narrative/story)
This applies to all businesses looking to increase their attractiveness in the market.
Discount the company’s expected future cash flow
While more commonly used within mid-large size businesses from $50 - $100M+ in revenue (based on industry), this is the gold standard of valuation in corporate finance.
A discounted cash flow model (DCF) works best for more established companies with more stable cash flows and looks to estimate a company’s value based on its expected future cash flows.
These company cash flows stretch out for the entirety of a company’s expected life and then are discounted back to the present to form a price today.
A DCF allows for greater variability in key metrics that help build the valuation, such as:
Revenue growth
Cost of sales
Selling & general admin expenses
Labor costs, etc.
Which helps a potential investor arrive at free cash flow. At which point, more assumptions are made with regards to the company's discount rate, number or periods within the valuation time frame & lastly, the terminal value of the business (which represents all future cash flows for the companies lifespan beyond the forecasted period).
The best valuation method for your business is the one that best deals with uncertainty.
“When you show me the valuation of a company, every number in your valuation has to have a story that’s attached to it. And every story you tell me about a company has to have a number attached.”
Be sure when valuing your business to not blindly fall in love with what you believe the business is worth.
As the owner of your business, there’s bias attached to what it may truly be worth.
Be wary of this bias if you want to value your business & not price your business.