How do you put a price on the time, effort, and passion you've put into building a successful small business? It can be hard to objectively assess how much your venture is worth after putting so much work in over the years.
This is where business valuation calculations, ideally handled by a third-party expert, can play a role. Business valuations are used for mergers, acquisitions, tax purposes, and more. Here's how business valuations work and how to calculate the economic value of your company.
[Read more: 3 Things to Consider When Selling a Business During a Pandemic]
What is a business valuation?
A business valuation assesses the economic value of part or all of a business. Business valuations are used in a number of circumstances, including determining the sale value of a business, establishing partner ownership, for tax purposes, and even divorce proceedings.
Generally, the valuation process analyzes all aspects of the business, including the company's management, capital structure, future earnings, and the market value of its assets. In the United States, business valuations are usually carried out by a professional who is Accredited in Business Valuation (ABV). This certification, awarded by the American Institute of Certified Public Accountants, is given to CPAs who pass an exam and meet standards set by the AICPA.
If you're seeking financing from lenders, investment bankers, or venture capitalists, you may need an ABV-certified professional to help carry out your business valuation. If you're simply looking to understand how much your venture is worth, you can do your own analysis using one of the business valuation methods listed below.
[Read more: How to Calculate a Business Valuation]
Business valuation methods
There are three common methods for evaluating the economic worth of a business. These categories are:
- Asset-based methods: Sum up all of the investments in the company to determine the value of the business.
- Earning value methods: Evaluate the company based on its ability to produce wealth in the future.
- Market value methods: Estimate what the company is worth based on similar businesses that have recently been sold.
There are pros and cons to each of these approaches to valuation. An asset-based approach, for instance, works well for corporations in which all assets are owned by the company and will be included in the sale. However, for a sole proprietor, this approach can be more difficult — which assets should be considered personal versus business-related?
Generally, the two main earning value methods — capitalizing past earnings and discounted future earnings — are used when a company is seeking to buy or merge with another company. Market-value approaches are the least accurate and can lead to a business being under or overvalued.
In the United States, business valuations are usually carried out by a professional who is Accredited in Business Valuation (ABV).
How to calculate a business's value
Often, business valuations are performed by a licensed professional. To find an ABV who can help, look for someone registered with the American Society of Appraisers.
If you're simply looking to get a basic idea of what your business is worth, you can take a few steps to get a rough estimate. Start by calculating your seller's discretionary earnings (SDE). SDE is like earnings before interest, taxes, depreciation, and amortization (EBITDA), with the owner's salary and benefits added back in.
"Start with your pretax, pre-interest earnings. Then, you'll add back in any purchases that aren't essential to operations, like vehicles or travel, that you report as business expenses. Employee outings, charitable donations, one-time purchases, and your own salary can all be included in your SDE," wrote NerdWallet.
Once you have your SDE, take stock of your assets, do a little market research to see what similar businesses have sold for, and pay attention to industry trends to see if you can ask for a higher valuation.
In general, try to use more than one method to get the most accurate depiction of your business value.
"A general rule of thumb in business valuation is that you will want to use multiple methods. Using three to four methods will allow you to estimate fair value with more accuracy," wrote The Balance.
The role of financial projections in business valuation
Many of the methods used to evaluate the worth of a business require financial projections. These reports provide insight into the potential value of a company by estimating revenues, expenses, and other key financial metrics.
"Financial projections encompass several essential components that contribute to a comprehensive evaluation of a business," wrote Equitest, a valuation platform. "These components include revenue forecasts, expense forecasts, cash flow forecasts, and balance sheet forecasts."
These estimates give investors and lenders deeper insight into a company's financial health, including the risks and potential opportunities to be gained by committing capital. However, reliable and effective financial projections require careful consideration. Overestimating a company's worth can lead to investor losses and shareholder frustration.
How to increase your business valuation
There are several ways to increase your company's valuation — most of them focus on building a strong, sustainable foundation of profitability.
"Making cosmetic changes to a company at the last minute before putting it on the market is a recipe for disappointment," wrote the Business Development Bank of Canada. "Planning and preparation for a transition is the way to go and entrepreneurs need to take the time to do it right."
Start by working on boosting your profitability. Look for ways to increase sales while simultaneously becoming more operationally efficient.
"Focus on creating a diversified customer base that, ideally, generates recurring revenues," wrote the BDC.
It's also worth investing in building a strong, unique brand identity that fosters greater customer loyalty. Some of the most valuable companies in the world — such as Apple, Coca-Cola, and Google — all have valuable brand identities too. Building your brand value involves marketing, providing great customer service, and creating a memorable experience that boosts customer loyalty.
There's no silver bullet when it comes to increasing your business valuation. However, an outside adviser can help you assess where your business can improve to increase its worth. Spend some time auditing your strengths and weaknesses before attempting a merger or sale.
CO— aims to bring you inspiration from leading respected experts. However, before making any business decision, you should consult a professional who can advise you based on your individual situation.
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