Starting a business is no small feat, it involves a lot of planning, time and effort. However, having a successful opening launch and keeping customers happy are but a few of the many challenges a business owner may face.
At some point, whether you have only been in business for less than a year or 20 years even, whether you started it yourself or the business has been with the family for generations, you must know the economic value of the business by performing a business valuation.
What is the value of my small business? How to value small businesses? What are the main small business valuation methods to use? What paper works are needed to prepare for a valuation?
You might find these questions overwhelming but read on and we hope through this article it will become easier to understand how to value a small business.
Small Businesses: Main reasons why a business valuation is needed
There are various reasons why small businesses require a business valuation:
- To set the baseline value for the business
- Especially when a business valuation was not performed previously
- In order to develop and implement strategies on how to improve profitability
- To understand the value or worth of the business
- To identify current business growth e.g. lagging, stagnant, declining
- To identify weaknesses and risks in the business and set course of action
- To identify business strengths so as to increase business value
- For exit strategy purposes e.g. terminate the business and sell the assets, determine the selling price for a share or the entire business, transfer ownership, etc.
- To evaluate an offer to buy the business and negotiate a strategic sale (buy and sell agreements)
- When raising financing to determine a business value for partner or shareholder (buyouts and investments)
- For debt financing requirements (apply for a bank loan, Small and Medium Enterprise SME financing, government loan)
- For litigation purposes e.g. shareholder or partner dispute, lost profits, etc.
- Tax reporting purposes
This is list is not exhaustive and there are many other reasons a business valuation is needed. Regardless of the reasons, doing a business valuation is an important step every business owner should do and that would prove to be beneficial not only for the business owner but for the long-term success of the business itself.
Small businesses from a Valuation point of view
Before going through the most common small business valuation methods let us briefly define what a small business is.
A small business or sometimes called small-scale enterprise has the following characteristics:
- A business which comes with potential
- Small asset base
- Privately or independently owned-usually single owner or a partnership
- The business is generally managed by the owner himself
- Possesses only limited sources of financing
- Small workforce
- Lower volume of sales and profit (compared to larger firms)
Most of today’s well-known, large, and public companies, e.g. Ben & Jerry’s started as small businesses. The American ice cream maker was started by two childhood friends Ben Cohen and Jerry Greenfield in New York. They learned how to make ice cream with a $5 investment, which they split paying $2.50 each. They initially came up with $8,000 in capital, a portion was borrowed from Ben Cohen’s father. The two friends applied for a bank loan of $18,000 but were only approved for $4,000. So with $12,000 in capital, they managed to lease and renovate an old gas station in front of the city hall park. Ben & Jerry’s ice cream store officially opened on the 5th of May 1978, with Ben and Jerry working the counter and scooping ice cream for every customer. And the rest, as they say, is history.
The legal definition for a business to be considered small varies from country to country and even industry to industry.
For example, in the United States, the Small Business Administration (SBA) is the government agency that supports entrepreneurs and small businesses. It also sets the table of standards for a business to be considered a small business. SBA bases it on the size of its workforce, its gross annual sales and the industry it is in. For example, a retail bakery is considered a small business if it employs fewer than 500 workers. An accounting firm is considered a small business if the average annual receipts are less than $12million.
Defining a small business is an important measure to help business owners protect and promote their business in the market. If a business qualifies as a small business, it can apply for a small business loan from the government and financial institutions, it can apply for business grants and avail of tax incentives exclusive for small businesses.
Now that we understand what a small business is, we need to know the reasons why a business owner needs to know the value of businesses.
Particularities that small business valuation methods need to address
Small businesses are challenging to value for different reasons.
- Dependency on Key Person: Very often the business is dependent on a key person. Especially transaction-based business valuation needs to analyze this as the business might have substantially less value of the owner leaves or even might be tempted to start a competing business later on. Furthermore, one needs to look at the owner’s salary levels and if needed adjust them what it would cost to hire a professional CEO at market terms. For small businesses, this might not even be possible and in such cases, valuations might need to base on EBITDA to owner (before salary expenses) at lower multiples.
- Hobby-Businesses: Some are “idea or hobby” businesses with little or no revenues (can be operating at a loss for some time). In the first year of Ben and Jerry’s, sales reached almost $180,000 which was twice the projected sales but did not make a profit.
- Customer Dependencies: The business may be serving or catering mostly to 1-3 key customers which generate the majority of the company’s revenues. E.g. this is very often the case for automotive suppliers which grow with their customer accounts. As the automotive industry is very cyclical, such customer dependencies can pose a great risk to the company’s profit and economic future.
- Seasonality: The business might be operating in a seasonal cycle which greatly affects its profitability. Going back to Ben and Jerry’s example, sales during winter were expectedly low as lesser people would want to buy ice cream. So sales during summer have to be higher to make up for the lean season.
- Self-Funded: Equity is provided entirely by the founder’s or owner’s (and even friends and family). Distributions of profits and owner’s salary can affect earnings sustainability since, unlike large companies where they have oversight committees and departments, small businesses are heavily reliant on the decisions made by founders and owners.
- Financial Records: The accounting or record-keeping system is less sophisticated and may not have sound financial practices. The financial records can be poorly done and are unreliable as it may not have been audited. This can be difficult especially when a business owner is trying to benchmark business’ performance year on year.
Despite these challenges, it is not at all impossible to value small businesses using common business valuation methods but it requires a more in-depth understanding. The more information a business owner has about the business, the more reliable the business valuation.
How to value small business?
Small business valuation methods are based on three principle valuation approaches:
- Start with the business’ Cash Flow by conducting income-based business valuation
- Capitalization of Earnings Method: Uses past (historical) profits and cash flow to estimate future profits and cash flow by capitalizing on the company’s EBIT or EBITDA. Here it is important to normalize the company’s profits and for small businesses, this often means to adjust the costs to reflect the market salaries of the business owner. Furthermore, the risk for small businesses can be higher than for large businesses, this requires to use an appropriate discount rate to capitalize on the business’ earnings.
- Discounted Cash Flow DCF: The value is based on the net present value of the business’s future cash flows. Solid DCF modeling normally is required to build a business valuation and a lot of assumptions are required. Also here, same as the capitalized earnings method, profits need to be adjusted for the owner’s salary at market terms and risks such as customer dependencies, key man dependencies need to be reflected in the company’s discount rate. In addition growth plans need to be fully funded and very often are limited to be executed by the available funding sources at hand.
- Net Asset Value Valuation: Look at the business’ net assets
- If the business is a going-concern (business continues), the value is derived from the difference of Assets and Liabilities
- If the business is for liquidation (business is terminated, “winding up”), the value is derived from what will be realized (net amount) when the assets are sold and debt is paid. This kind of provides downside protection.
- The valuation of intangible assets like, brand name and reputation, intellectual property, licenses, a trademark needs to be analyzed on a case by case basis. How easy are these to be monetized? How easy could those be sold in case of need? How much cash flow can these assets generate in the future?
- Market-based valuation: Comparing the valuation multiples similar peer businesses or transactions in the industry:
- Comparable Company (“Comps”) Analysis: Value is derived from the value multiples of selected comparable (peer) public companies. Identifying similar companies and the lack of similar companies are the main drawbacks of this method.
- Recent Transaction Analysis: Compare the valuation multiples of similar transactions in this industry.
- For small businesses where the owner cannot pay a decent salary to himself, a business valuation might need to base on EBITDA to owner at lower valuation multiples.
Which among the small business valuation methods is the best?
To end our Ben and Jerry’s example. After opening its first store in 1978, they sold tubs of ice cream at wholesale to restaurants and eventually recognized and took advantage of an untapped market- supermarkets and grocery stores. The company went public in 1985 and was sold to consumer goods giant Unilever for $326million in 2000. Not bad for a $12,000 investment.
This shows that small businesses can have a lot of potentials which should be reflected in a business valuation. Some of the valuation methods basing on net asset value considerations are not reflecting that. Therefore, small business valuation methods need to be carefully chosen and applied to small businesses.
The bottom line is that when deciding how to value small business there are many more factors to consider and which will influence the business valuation than when valuing a large business. This makes it more interesting but also more challenging. Using a combination of small business valuation methods can help you to better determine the current financial health and potential of a business. Each method can shed light on how the business creates value. There is no “one-size-fits-all approach and different small business valuation methods will likely result in different values but correctly using each business valuation method in the context of small business will give you a much better idea where the expected value of the business will lie.
You can also check out our other articles for small businesses:
- Financial Modeling for Startups and Small Businesses
- Financial Planning for Small Business Owners – Taking an SBA Loan
Please refer to our many financial model templates that are available to value small businesses.