May 31, 2022 | Last Updated on: January 9, 2024
DISCLAIMER: This article was written in 2022 and has not been updated. For more up to date information about small business funding products and options, please browse our recent articles.
In this article, you’ll learn:
The value of your small business is important if you are considering selling at any point in the future, as the valuation informs your strategy as you move forward. Say you want to cash out for $500,000+ in five years – learning that the business is currently worth $100,000 could signal the need for major changes to reach your goal.
Let’s start by looking at the state of the market for small businesses.
The market for small businesses showed continued strength in Q1 2022, according to the BizBuySell Insight Report. Here are some key findings on the current market:
While the numbers paint a positive picture, there are headwinds in the form of inflation, rising interest rates, supply chain disruptions, and the Russia-Ukraine War. With all that being said, the market has been resilient since the onset of the COVID-19 pandemic in early 2020, providing a reason for optimism over the remainder of 2022.
Here are a few ways to value your small business:
Seller’s discretionary earnings (SDE) is a metric that is commonly used to value small businesses. You start by taking your pre-tax and pre-interest earnings and then add back any purchases that aren’t essential to your operations, such as business travel. You also include your own salary and benefits in SDE. The last step is subtracting current debts.
So, you’ve calculated your seller’s discretionary earnings. You have to adjust this number by the appropriate multiple to determine the business’s value. The appropriate multiple varies depending on the economy as a whole, industry, geography, and the size of your company.
The adjusted net asset method can be used to determine the value of a business if the items on the balance sheet make up a large percentage of the valuation. A real estate business could be valued using this method, but you shouldn’t value a SaaS business with the adjusted net asset method – SaaS companies’ future cash flows heavily impact their valuations.
Here’s how to calculate your company’s value with the adjusted net asset method:
You tally the business assets on your company’s balance sheet – including tangible assets and intangible assets – and subtract the liabilities. You should adjust the value of your assets to fair market value. Your equipment and vehicles, for example, are likely worth less than you paid for them. But real estate could be higher or lower depending on the market. The key is to take a “good enough” approach, as you don’t have to be 100% accurate to get a useful output.
The value of any asset is ultimately what other people are willing to pay for it. This principle works very well with the residential housing market; if you were looking to sell your house, you would estimate the value based on recent sales for similar houses in the same neighborhood.
So, by looking at sales of small businesses that share the same industry, geography, and size as your business, you can value your business. But here’s the problem: you may not be able to find published sales of similar businesses, particularly if you operate in a specialized niche.
With that being said, you should at least check to see if there are any comparable sales – if you luck out and find a good comp, you get an excellent data point for your small business valuation. You can also get creative with your search. Say you have a closet design company in a small neighborhood – you probably won’t find any recent comps in your neighborhood, but you can check for sales in other similar neighborhoods to get a starting point for your business worth.
The discounted cash flow (DCF) method is a valuation process based on the present value of future cash flows. To reach this number, you have to project each year of future cash flows and apply a discount rate to each projection. In many cases, the company’s weighted average cost of capital (WACC) is used for the discount rate. The analysis allows you to adjust future returns to account for the time value of money, as a dollar in five years is worth less than a dollar today due to inflation, uncertainty, and opportunity costs.
You may be wondering: how do you estimate cash flows that are far into the future?
The answer is that you can’t… but the DCF method has a solution: apply a terminal value. You can either use the perpetual growth method or an exit multiple. The former assumes growth at a constant rate forever, while the latter determines the company’s realizable value at the end of the forecast period.
The DCF method is great in theory, but in reality, it’s difficult to estimate next quarter’s cash flows – let alone the cash flows in three years. The terminal value solution is helpful, but applying a terminal value after too short a period of time defeats the purpose of doing the DCF analysis in the first place.
With that in mind, a DCF analysis is ideally used as one of a few valuation methods for your small business. If the DCF analysis provides a valuation of $600,000, for example, and three other valuation methods provide a valuation in the same ballpark, you may be on the right track.
In addition to creating your own business valuation estimates, you should seek out third-party opinions from a business broker, certified appraiser, and/or Certified Public Accountant (CPA).
You are going to have to spend some money on consultations with these professionals, but getting a qualified opinion on your small business valuation can be extremely useful, so the fee should be viewed as an investment.
While the value of your business is heavily influenced by your industry and the economy, there is plenty that is within your control as a small business owner. Here are 5 ways to increase the value of your small business:
The U.S. has been experiencing above-average inflation for over a year, creating a challenging environment for entrepreneurs and consumers alike. But the good news is that there are ways to combat the effects of inflation on your small business, including raising prices.
While many consumers have gotten used to the idea of increasing prices, you should be careful how you raise prices. Try to give consumers some advanced notice, and don’t get too greedy with your prices.
You should periodically review your expenses to ensure you are deriving a current benefit from each of them. Say you are spending $200 a month on five SaaS tools ($1,000 total), but you haven’t used three of the tools in a year – you should consider canceling the three subscriptions.
With some expenses, you might decide to double down. For example, if you are paying a social media marketing agency $2,000 a month and they’re expanding your customer base every month, you would want to see if they could provide more value with a bigger budget.
In some cases, you have to spend money to make money – particularly if you operate in a capital-intensive industry.
Say you have a landscaping business and you sometimes don’t have enough trucks to service your customers. You might want to start by seeing if the shortage can be resolved through better scheduling. But if you’re still having issues, you may want to purchase more trucks.
Your human resources are one of your company’s most valuable resources, so you should invest in maximizing their output. Here are a few ways to accomplish this objective:
There are many possible ways to invest in your staff, depending on your industry – it’s worth sitting down and brainstorming.
You can learn a lot from your competitors, identifying areas for improvement and differentiation.
For example, you have an Italian restaurant and your competitors’ parmesan is superior to yours – this is a clear area for improvement if you want to increase the value of the business.
Or say you have a plumbing business and every other plumbing business takes an average of 36 hours to respond to an inquiry. By responding immediately (during business hours) and advertising a guaranteed response time, you might be able to acquire a lot of new business.
The market for small businesses is constantly evolving, but the ways to value your company should remain constant. By using a few valuation methods and talking to a few qualified professionals, you can get an excellent sense of the value of your small business – giving you the information to make appropriate decisions moving forward.
And if you aren’t looking to sell for a few years, you have plenty of time to increase the value of your small business.
Do you have ideas to grow your small business but need funding to make them a reality? With Biz2Credit, you can get straightforward funding made for your business.
