Valuing your small business is a beneficial practice for many reasons — and not just if you plan to sell. Learning what your business is worth gives you a foundation to build on and helps put a plan in place for the future.
Entrepreneurs are often find themselves handling multiple responsibilities within an organization. From developing products or services offerings to bookkeeping and marketing, small business owners have their hands full… You wear many different hats, and it can be hard to manage it all.
Still, with small businesses being sold at historical rates, it’s essential you keep your business ready for a potential sale (even if it’s another task on an already full plate).
Besides selling or buying, estimating what your business is worth can help with:
- Securing investments – Make no mistake, investors want to see a realistic value in any deal you offer them.
- Growing and developing your business – Realistic annual assessments can help you secure funding and focus your efforts on areas for improvement.
- Setting a fair price for employees – In case your employees want to buy or sell shares in your company, a business valuation estimate can help you establish reasonable prices.
Many small business owners expect the income they get from their company’s future sale to fund their retirement, which is yet another reason it’s essential to consistently work toward increasing your company’s value.
We’ve compiled this guide for small business owners to make the estimation of your business as easy as possible.
Factors You Should Be Aware of When Placing a Value on Your Business
First and foremost, each company has tangible assets. These include items such as property, machinery, and inventory. Calculating their price is pretty straightforward.
Every company has intangible assets as well. Intangible assets take into account items like brand recognition, trademarks, and patents. This type of asset can add tremendous value to a business, and for this reason, you should have a good idea of their worth.
Next in line are the financial metrics. Is your business profitable? If so, what’s your annual profit? What about the revenue your business brings in? Know your business’s financial metrics inside and out because potential buyers or investors want to know these figures down to the last dollar.
Finally, most businesses come with a set of liabilities. A liability is something the company owes, usually a sum of money. Put differently, all debts your business owes factor into the valuation as well.
Knowing what your company owns is essential for going through a business estimation. By looking at your tangible and intangible assets, you acknowledge what makes your business valuable. Even if you don’t want to sell, knowing its worth can provide priceless insights into future business decisions.
Beyond fixed and stock assets that are tangible and have a clear value, there are always intangible assets. These resources, which lack physical presence but bring long-term value to your business, include:
- Trademarks and copyrights
- Client value
- Company age
- Team strength
- Type of product
Intangible assets make it somewhat challenging to reach an accurate valuation. However, there are several small business valuation methods you can use to make the process easier.
Small Business Valuation Methods
Price-To-Earnings Ratio (P/E)
Small businesses are commonly valued by their price-to-earnings ratio (P/E), or multiples of profit. The P/E ratio is best suited to companies with an established track record of annual earnings. In most cases, working out the proper price-to-earnings ratio to use is determined by profits.
If a company has high forecast return growth, it might suggest a higher price-to-earnings ratio. If a business has an outstanding record of repeat earnings, it may have an even higher P/E ratio. For example, using a P/E ratio of five for a company that makes $200,000 in post-tax earnings implies it would be priced at $1,000,000.
How you arrive at the correct number for your price-to-earnings ratio can differ significantly from business to business. Tech startups and B2B companies often have high ratios because they’re generally high-growth companies. On the other hand, companies such as jewelry stores or real estate agencies often have a lower price-to-earnings ratio.
Since these differ so much, there isn’t a standard ratio that can be used to value all businesses. Your P/E ratio might be anywhere between one and ten, depending on your business and its growth projections. For the most part, ratios are between:
- 1 – 2.5 for small, owner-managed businesses
- 2 – 7 for small enterprises with earnings up to $500,000 a year
- 3 – 10 for small companies with profits above $1,000,000 a year
Entry Cost Valuation
The entry cost appraisal is advantageous if you want to start a business from scratch, as it gives you an impression of what it would cost. It can also act as a figure for valuing your existing small business.
To determine this type of business valuation, you need to factor in everything that put your business in its current position. This includes all startup costs (such as fees for legal expenses or obtaining specific licenses), all tangible assets that you purchased to operate, the cost of advertising and marketing budgets to develop your brand, recruiting and training employees, product or service development fees, and more.
Once you have a record of these initial costs, think about where you can save. For instance, you may rent in a cheaper area, pay staff the national living wage, or source from cheaper suppliers. Once you have this number, deduct it from the primary startup figure for your entry cost.
Your company’s net worth is the total value of its assets, minus its liabilities. This means that if you have debts with banks, financial institutions, and third-party companies, then your assets are worth the cumulative value without the debt you owe.
To conduct this type of business valuation, start with all assets stated in your accounts to discover your net book value. Afterward, refine this figure by accounting for items such as inflation, depreciation, and appreciation. For instance, any stock you own that will need to be sold at a discounted price would be valued at the discounted price.
Asset estimation is best used if you have a stable company with lots of assets. It doesn’t consider any future earnings, but can form part of a more extensive method for determining value.
Estimating your company’s worth can look a lot like deciding your home’s list price. If similar companies recently sold in your area or your niche, their prices can show you how to value your business. A market comparison might just be the most accurate yardstick you can find to value your business.
However, close comparisons are pretty tough to find. Full details of small business sales are not always readily available. They also don’t occur as often as home sales. When searching for comparability, look at factors such as industry, number of customers, number of employees, etc.
For example, consider two digital marketing companies that do the same work, employ the same number of people, and charge similar rates. If one company sells for $350,000, the other company will likely sell for a similar amount.
What Valuation Method is Appropriate for Your Business?
The model you should use to value your business depends on circumstances. Understand there will be methods you can’t use because your business doesn’t match the required criteria.
Nevertheless, it’s worth noting that each valuation method will potentially produce different results. For this reason, try at least a couple of methods to give yourself a rough estimate. You could also use a business valuation calculator or talk to an experienced business broker to get an accurate value.
The Bottom Line
In the end, we understand that after all the hard work and late hours you’ve put into your business, you likely have a number in mind that might be higher than a buyer is prepared to pay… You must take the emotion out of evaluating your business. Be sensible about your intangible assets’ value and try not to overvalue them.
If you have a hard time doing so, the easiest way to remove emotions from the valuation process is to get a third party to do it for you. This way, you’ll arrive at an accurate figure without agonizing about getting the mathematical figures right – and without letting your preconceptions get in the way.