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How To Value A Small Business

How to Value a Small Business

Lindokuhle Mkhize

Lindokuhle Mkhize

19 July 20238 min read

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How to Value a Small Business

Ah, small business valuation methods! Now that's a topic that can make even the most stoic of accountants break out in a cold sweat. Trust us. It's not as scary as it sounds. In this article, we'll explore the different small business valuation methods and how to value a small business. From valuation formulas to the hidden costs associated with running a business.

So grab a cup of coffee, put on your thinking cap, and let's dive in!

What are the ways to determine the value of a small business?

First things first, understanding the valuation process is crucial. Valuation is a bit like trying to decode a secret treasure map. Instead of finding gold, you're searching for the elusive value of a business's assets. Exciting stuff, huh?

Understand the valuation process

There are several ways to determine the value of a small business. Here are a few used methods:

Adjusted Net Asset Method:

Simply put, it's assets - liabilities = net worth of the business. Small businesses often have intangible assets not reflected on the balance sheet. Adjustments to account for fair market values of these assets come into play here. This method considers those intangible assets that don't appear on your balance sheet.

It factors in things like your brand reputation or loyal customer base. It's like adding a secret ingredient to a recipe – making all the difference.

Seller's Discretionary Earnings (SDE) Method:

This method focuses on the business owner's discretionary earnings. These include net profit, owner's salary, and other perks. A valuation range can be estimated by multiplying the SDE by a predetermined multiple that reflects fair market and industry norms.

Comparable Sales Method:

This method involves researching and analyzing the sale prices of similar businesses in the same industry. An estimate of the business's value can be derived by comparing factors such as revenue, profit, and market conditions.

Discounted Cash Flow (DCF) Method:

This method is not recommended for small businesses due to the complexity and uncertainty involved. The DCF method is used to estimate the cash value of a business. It requires forecasting cash flows from existing business. This determines a standard, appropriate discount rate.

Market Capitalization Method:

This method is used for publicly traded companies and small businesses—the current market price of a business's shares x the total number of outstanding shares = business value.

What are the factors in determining business value?

Like any good detective, you need to understand the valuation process to crack the code. Familiarize yourself with the factors determining your business or company's worth and value. Think financial performance, competition, potential for growth, and industry trends. These are like the breadcrumbs leading you to that golden number.

David Zhang here, the CEO of Kate Backdrop swears by the three metrics system:

"When it comes to valuing a small business, there are three key metrics to consider: revenue, costs, and profit. Depending on the type of small business you own or run, revenue can come in sales revenues, fees from services, etc. Costs include overhead costs such as rent, utilities, staffing salaries, or other expenses associated with running your business. Profit is what's left after subtracting all costs from revenue.

It's important to understand your small business's cost structure and how it drives profitability in order to assess its worth accurately. A thorough analysis of a company's financial statements can provide valuable insight into the potential future value of the business and help you determine the right pricing strategy for selling or investing in it."

Business valuation process

As a small business owner, you should disregard the Discounted Cash Flow Method.

Don't worry. We won't bore you with complicated math equations. However, what small business owners should disregard is the Discounted Cash Flow Method. It sounds fancy, but it's better suited for big corporations with crystal balls. Stick with us, and we'll show you another fantastic method!

Seller's discretionary earnings method

Here's where things get interesting. The seller's discretionary earnings method focuses on your earnings as the business owner. We're talking about profits, your salary, and maybe those little perks you enjoy. Multiply it by an industry-specific multiple, and voila! You have a ballpark figure of your business's fair market value.

Example - Assumptions to Value a Small Business for Sale (SDE)

Let's put theory into practice, shall we? Imagine a small bakery called "Cakes Galore." We'll assume it has an SDE of 100,000 per year. Then, using an industry multiple of 2, we can estimate the value of the bakery to be around 100,000 per year. Then, using industry multiples of 2, we can estimate the present value of the bakery to be around 200,000. Easy as pie, right?

Business assets

When valuing a small business, it's essential to consider not only tangible assets like equipment and inventory but also intangible assets such as customer lists, brand reputation, and intellectual property. These can add significant value to a business's future profitability.

You've made it through the maze of business valuation methods. Armed with knowledge, you can confidently determine the value of your small business. So the next time someone asks you, "How much is your business worth?" you can respond with a wink and a smile.


FAQs

What are the different methods used to determine the value of a small business?

Asset Method, Seller's Discretionary Earnings (SDE) Method, Comparable Sales Method, Discounted Cash Flow (DCF) Method (not recommended for small businesses), and Market Capitalization Method.

How does the Adjusted Net Asset Method account for intangible assets in small business valuation?

The Adjusted Net Asset Method considers intangible assets not on the balance sheet and adds their fair market values to the business's net worth.

What is the Seller's Discretionary Earnings (SDE) Method, and how does it estimate the value of a business?

The Seller's Discretionary Earnings (SDE) Method estimates a business's value by multiplying the owner's discretionary earnings (including profit and perks) by a predetermined multiple.

How does the Comparable Sales Method help determine a small business's value?

The Comparable Sales Method determines a small business's value by analyzing the sale prices of similar businesses in the industry and comparing factors like revenue, profit, and market conditions.

Why is the Discounted Cash Flow (DCF) Method not recommended for valuing small businesses, and what alternatives are suggested?

Due to complexity and uncertainty, the Discounted Cash Flow (DCF) Method isn't recommended for small businesses. Alternatives include the Adjusted Net Asset Method, Seller's Discretionary Earnings (SDE) Method, Comparable Sales Method, or Market Capitalization Method, depending on the circumstances.

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Lindokuhle Mkhize, a skilled creative copywriter and content lead at Trademarkia, brings a wealth of experience in driving innovation and managing teams. With previous success in starting and growing the Innovation and Marketing department at her former creative agency, Lindokuhle boasts expertise in leadership and delivering compelling content. Based in South Africa, Lindokuhle's work focuses on key themes of creativity, effective communication, and strategic marketing.