The 3 Steps to Small Business Valuation

Small business valuation formula

Small business valuation doesn’t need to be complicated. We’ve broken the small business valuation methods down into 3 key steps to help you successfully and accurately value your business:

  1. Determine why you need a business valuation

    For some this may be a logical place to begin. Small business valuation methods require valuable time and energy to complete; if you don’t have a sound reason for pursuing a small business valuation tool, then that time is probably better spent elsewhere. While this may be true, there is an even more important reason to beginning with the question of why you need business valuation: your business valuation results are directly influenced by why you are seeking the valuation.

    The small business valuation process depend on two key elements: how you measure your business’s value (e.g. the small business valuation formula and tools used) and the circumstances under which you conduct your valuation. If you are valuing your business because you’re planning to put it on the open market until an interested buyer makes an offer, the valuation method you use will be different from that used by a business owner who needs to settle a debt with one of his creditors. Knowing the question you’re trying to answer in valuing your business (e.g. fair market value versus forced liquidation premise of value) will determine which small business valuation method you use.
  2. Assemble the required information

    The second key starting point for all small business valuation methods is to gather the necessary information to complete the valuation. Your company financial information is essential to determining the value of your business. You’ll want three to five years of historic information to get an accurate measurement and will refer primarily to your income statement and balance sheet.
  3. Determine the best small business valuation methods

    There are three approaches you can take to small business valuation: Comparing recent sales to those of similar businesses, based on your company’s assets, or based on your company’s earnings power and risk assessment

    Since each method takes a different approach to answer the same question, it’s wise to use more than one method so you can cross-check your results. We’ll take a brief look at each of these methods below.

The three approaches to valuing your business explained

  • The market-based approach

    This approach to small business valuation will use historic sales to establish your business’s value in relation to other similar businesses. There are two common small business valuation methods used under the market-based approach: the comparative transaction method, and the guideline publicly traded company method. Both methods use pricing multiples to determine the relationship between your business’s economic performance and its value, or potential selling price. Typically the selling prices of similar businesses are used to estimate the pricing multiples for market-based small business valuation methods.
  • The asset-based approach

    As its name suggests, the asset approach to small business valuation aims to derive your business’s value based on the value of its assets. It bases its determination on the fair market value of the business’s assets less its liabilities.

    Asset-based small business valuation methods are more involved and costly, requiring considerable expertise in individual asset and liability valuation. If you have an asset-rich business, an asset-based valuation method may be appropriate for you to use, as its complexity and comparative cost will be outweighed by the relevance of its valuation. Alternatively, this approach is helpful if you’re seeking to allocate your business’s final purchase price across its various individual assets.
  • The income-based approach

    Again as the name suggests, the income small business valuation method uses the economic benefit to the business’s owners to determine its value. For an accurate measure based on this small business valuation method, you’ll need to properly select the appropriate discount rate, capitalization rate, and valuation multiples.

    There are three commonly accepted income-based small business valuation methods:

    • The discounted cash flow method: determines your business’s value as a stream of future income discounted to its present value
    • The capitalization of earnings method: divides expected economic benefit by the capitalization rate
    • The multiple of discretionary earnings method: adjusts your business’s economic business for long-term business liabilities, non-operating assets, and net working capital.

    Small business valuation methods don’t need to be complicated. The key to successful business valuation is selecting the most appropriate method and compiling the necessary resources.

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Laura

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