Even if you don’t have plans to sell your business, you need to know its value. What will you tell the banker who is considering your loan request or the investor who has money in her pocket earmarked for you? Knowing what your business is worth is just as important as knowing the value of your home.
However, deriving the value of your business is open to interpretation. In short, the business is worth what somebody will pay for it. Valuing it involves numerous metrics. Some will have more or less weight depending on the nature of your business.
For an accurate value for use in official business discussions, hire an appraiser, but for a general idea of value, here’s what you need to know.
According to SCORE, there are three ways to assign value.
1) Asset Based Approach - How much would it cost to replace all of your assets with equipment in like-kind condition? For businesses without earnings that surpass the value of its assets, this is the simplest way to assign value.
2) Market Approach - If you own a home, you find its value by comparing it to similar houses in your neighborhood. By looking at other businesses in the marketplace with similar assets—both tangible and intangible, you can determine value in the same way. This approach can work against you if your business doesn’t operate like other comparable companies.
3) Income Approach – Finally, you can assign value by looking at your business's pretax and after-tax earnings or using another income metric such as gross sales. To that, add the value of your tangible assets and assign a multiple to account for future growth.
How to do the Math
The asset and market approach are straight-forward but using the income approach is a little more involved. Here’s how to do it. If you’re unclear on the terms, click on the links for more detail.
Step 1 - Determine future earnings- You could look at the past several years or if your business has changed drastically in the past year, use discretionary earnings from last year. Looking at past earnings gives you the best guess as to future earnings assuming nothing material changes.
Step 2 - Pick your multiple- If your company is growing, potential buyers or investors will pay more than $1 per $1 of your earnings. For small businesses, the range is often between 0 and 3. If you have discretionary earnings of $100,000 and you believe that you deserve a multiple of 1.5, your intangible assets have an estimated value of $150,000.
Step 3 - Add your net liquid assets- What would your business have left after paying off all debt? This would include all cash, stock, bonds, real estate, and equipment. Add the total value of your net liquid assets to the figure you calculated in step 2. If you have net liquid assets of $75,000, the total value of your business is $225,000.
If Only it Were That Simple
You may have noticed that much of what constitutes valuation is based on what you “think.” You may think last year’s banner earnings were a sign of things to come. An investor might want to look at the average over 3 to 5 years. You might think that you deserve a multiple of 2, but an appraiser might only see a 1.5.
If you are placing value on your own business, think conservatively. Just as you have personal assets with sentimental value, you’ll be tempted to add some “sweat equity” into the valuation.
If you ever negotiate with an investor or buyer, know that you’ll likely have to negotiate. They probably won’t pay 100 percent of its value and the value might be lower than you believe.
Sound a little complicated? If you need to value your business for official purposes, hire an appraiser to help but if you only want to better track the change in valuation going forward, do the math yourself or use an online calculator.
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