How much is your small business worth? If you don’t know the answer to that question, then it’s time to figure it out. A business appraisal might not seem important if you have no immediate plans to sell your company, but the truth is that it may matter to lenders and investors.
Select Funding works with small businesses every day to provide affordable working capital and equipment financing to small businesses. While we base our lending on revenue, we recognize that having an accurate business valuation may help small businesses attract investors and meet their growth goals.
So, if you’re wondering why you need a small business valuation, here’s our breakdown of why it’s necessary, including a checklist to help you along the way.
Why Do You Need to Know What Your Small Business is Worth?
It’s common for small business owners to delay getting a valuation of their business until what is referred to as a transaction triggering event—something that increases the likelihood of you selling your business, or even requires you to do so. Here are some examples of triggering events:
- A shareholder dies, retires, or quits
- A shareholder gets divorced
- A shareholder wishes to sell their stock
- The company files for bankruptcy
If there is a triggering event, you need to be prepared and having your business appraised will minimize the time you’ll need to spend getting ready to sell to a potential buyer.
We should note that a triggering event is only one reason that you might need a business valuation. Here are some other reasons:
- You want to be sure you get fair market value if you sell. The last thing you want to do is agree to a price that’s too low, and pricing your business too high may scare buyers away and make it impossible to sell. Whether you’re selling out of necessity due to a triggering event or you want to retire, an accurate valuation is the starting point.
- You want to create a successful growth plan. Part of figuring out how to get to where you want to go is knowing your starting point. A full valuation of your business will reveal what you have and what you’re missing, making it easy for you to fill in the gaps and pursue your most important business goals.
- You need additional financing. Most business investors, whether they’re soliciting private investments or applying for small business financing, want to know what a company is worth before they put their money into it. A proper valuation will make it easy to attract investors because they’ll be able to see exactly what they’re supporting.
- You’re engaged in estate planning. A lot of small business owners dream of leaving their business to one or more heirs. If that’s the case, you’ll need to understand what your business is worth before you create your will and/or succession plan.
What we hope you can see from this list is that having a small business valuation makes sense whether you have plans to sell your company or not.
How Do You Determine the Value of Your Small Business?
There are several methods you can use to determine the value of your small business.
Asset-Based Approach
There are two ways to conduct an asset valuation. The first assumes that the business will continue its operations after a sale and takes the company’s assets and subtracts its liabilities. The second is a liquidation value, and that takes the assets and adds the projected sale price of each business asset together before subtracting the liabilities.
Market Capitalization
The market approach is best for publicly traded companies. The calculation is extremely simple. All you need to do is take your current share price and multiply it by the total number of shares outstanding.
ROI-Based Valuation
The ROI-based valuation uses a projected return on investment to calculate the value of a company. This is the type of quick valuation that you may have seen on Shark Tank, where the investors offer money in exchange for a percentage of a company. If they offer $300,000 for a 30% share, they’re assuming the company is worth $1 million.
Discounted Cash Flow Valuation
A discounted cash flow valuation uses your projected cash flow as the basis for valuation. This method is most often used for companies whose cash flow is not consistent and requires careful calculations to adjust cash flow based on current values.
Capitalization of Earnings Valuation
A capitalization of earnings valuation uses the company’s annual ROI, cash flow, and expected value in the appraisal process. This method is most commonly used for stable businesses because the calculations assume that cash flow will be consistent and allow the business to be profitable going forward.
Book Value Valuation
A book value valuation uses a company’s balance sheet to calculate its value. It’s a simple approach that involves taking the value of your equity (your total assets minus your total liabilities) to determine the worth of your business. This method is most effective for companies with low profits and valuable assets.
Multiples of Earnings Valuation
A multiple of earnings valuation has a lot in common with capitalization of earnings because it uses a company’s potential future earnings to determine its worth. You can complete this type of valuation by taking your current revenue and assigning a multiplier, but it’s important to keep in mind that multipliers can vary greatly depending upon the current economic climate, your industry, and other factors.
Fair Market Value Valuation
A fair market valuation is arguably the most subjective way to appraise a business because it relies upon comparing sales of other similar businesses–typically of the same size and in the same industry–to arrive at a price. To use this method, you’ll need enough market data to make the comparisons trustworthy.
Small Business Valuation Checklist
To help you determine the value of your small business, we’ve created this checklist. To make it easy, we’ve broken the list down into four sections.
Financial Documentation
The first category is financial documentation. We should note that if your business is still relatively new, you might not have as many years of documentation as we suggest. If that’s the case, gather what you have available.
- Three to five years of balance sheets
- Three to five years of profit and loss statements
- A complete list of liabilities, including the following items:
- Outstanding loans with payoff information
- Creditors and balances owed
- Contingent liabilities (pending lawsuits, environmental liabilities, etc.)
- Profit and cash flow projections
- Current bank statements for all business bank accounts, including trust accounts if applicable
- Copies of all leases, including property and equipment leases
- Tax returns and documentation of any tax issues
Company Documentation
Our next category is documentation about your company, including all details that may impact the business value.
- Entity information
- Date company was formed
- Type of entity
- Ownership information
- Number of shares owned by each business owner
- Who has a controlling interest in the company
- Company management
- Key members of leadership team
- Details about employment contracts
- Confidentiality and non-disclosure agreements
- Insurance
- Employees
- Average number of employees for the past three to five years
- Key roles and responsibilities
- Family members
- Roles
- Compensation
- Fringe benefits
- Tangible assets
- Real estate
- Equipment
- Inventory
- Intangible assets
- Legal rights (patents, trademarks, and copyrights)
- Licensing agreements
- Non-disclosure agreements
- Contractual obligations
- Locations
Market Information
Your industry and competitors play a key role in appraising the value of your company.
- Current market share
- Size of market
- Competitors
- Names
- Estimated market share
- Product differentiators
- Pricing strategy
- Barriers to market expansion
Information Analysis
Finally, you’ll need to do some basic analysis before you determine the value of your business.
- Profit margins
- Business stability
- Quick Ratio (Cash + Accounts Receivable + Easily Liquidated Assets)/Liabilities
- Stable Current Ratio (Total Current Assets/Total Current Liabilities)
- EBIT/Interest Ratio (Earnings Before Interest and Taxes/Interest Expense
Which Valuation Method is Appropriate for Your Business?
Nobody knows your company better than you do. Here are some guidelines to help you choose the most appropriate business valuation method for your business:
- The Market Capitalization Method is best for publicly traded companies.
- The Asset-Based Method is best for small companies with an identity separate from the owner; in other words, this method is not ideal for sole proprietors.
- Cash-Based valuation methods include the Discounted Cash Flow method and the Capitalization of Earnings method. Both methods are best suited for companies with five to seven years of established production and revenue earnings.
- Market Value valuation works best when the industry is saturated, with many competitors and frequent buyouts occurring.
- The Book Value Method is best for companies with relatively low revenue and high-value assets that may increase the company’s worth.
You may even want to try using several methods and comparing the results. There’s often some subjective element to valuation, particularly when using the market value method.
Get Working Capital to Increase the Value of Your Company
Whether you have immediate plans to sell your company or not, you should still have an accurate valuation of your company. While valuation is something you can do yourself, your calculations may reveal areas where you need working capital to increase your company’s value.
If you’re in need of an injection of working capital for your small business, Select Funding is here to help! Click here to read about our small business financing options and apply today.
