Entrepreneurs ready to sell must decide whether an asset, income or market-valuation approach makes the most sense for their business.
Although there are all sorts of reasons you might need to estimate the value of your small business—such as a divorce or a dispute over estate or gift taxation—the most typical one is when you're considering selling your company.
Here are the three most common ways professionals calculate how much a business is worth:
1. Asset Approach:
This method basically determines a business’ value by adding up the sum of its many parts. This is “the most predictable” of the three main valuation models, explains Marty Zwilling, founder and CEO of Fountain Hills, Arizona-based Startup Professionals Inc., "since any good accountant can add up all the assets, depreciate them, and come up with a number.”
2. Income Approach(es):
Generally, these methods determine value by calculating the net present value of the benefit stream generated by a business. They’re “more technical in discounting future cash flows, applying multipliers to EBIDA [Earnings Before Interest, Depreciation, and Amortization], and trying to use all the techniques that stock analysts use to value public companies,” explains Zwilling.
3. Market Approach(es):
These methods tend to determine value by comparing the soon-to-be-for-sale business to others in the same industry, of the same size, and within the same area. “The market approach is perhaps the most subjective,” Zwilling says, “trying to factor the size of the opportunity, market conditions that control comparables, and goodwill associated with customer connections, team experience,” and more.
Find the Best Fit to Get the Sale Price of Your Small Business
Which method should you put to use if and when you need to estimate the value of your company? “I always recommend that every business owner try every method described, and move forward with the one showing the best results for them,” Zwilling shares. “Obviously, the three approaches are not additive, but it’s certainly fair to pick the high points of each as they apply to your case, and weave the best justification you can for the number you pick.”
On the other hand, Curtis Kroeker, president of marketplace verticals for Washington, D.C.’s CoStar Group Inc., which operates sites such as BizBuySell.com and BizQuest.com, suggests a particular market approach—the multiple-valuation method—is likely to be the most useful one for small business owners.
After all, he says, “even in a more sophisticated valuation, an appraiser or business broker will take multiples into account—although that’s just one of the things they’ll consider, as they’ll base their final estimate on more specific details [after] working with the seller to determine what is the real cash flow of the business.”
As for why he doesn’t recommend going with, say, the asset approach, Kroeker says that it’s used “more for businesses that aren’t going to be on-going concerns. If the business is going to be an on-going concern, this approach will give you a very conservative value.”
Advice from the Experts
Kroeker and Zwilling share a few other tips worth considering:
Valuing a Business Is More Art than Science.
When it comes to valuation, the approaches used by smaller businesses aren’t all that different from the ones used by their larger counterparts. That said, “there’s a lot more ‘art’ involved in a small business sale,” according to Kroeker. “The techniques used and the overall process really are no different, but the details are different because a lot of the things that drive the value of a small business are more difficult to define and are subject to more discretion.”
“For large businesses, valuation is more a technical task,” Zwilling adds, “using the averages and formulas and experts associated with specific industries and public companies. For small companies, there is much more focus on ‘goodwill,’ comparables, and the experience and expertise of the management team.”
You Can “Do It Yourself,” to a Point.
Asked if small business owners should attempt to estimate the value of their companies on their own, Kroeker replies that it’s not a bad first step. In fact, he says, “it’s a great way to get the valuation process started, although I would stress that it’s just that—a way to get things started.”
When it actually comes time to sell, “that’s when you’re going to want to work with an appraiser or a business broker,” he adds. “It won’t be cheap, but you’re going to want to have that professional valuation done, [as it] can take into account a lot of nuances that your initial valuation isn’t going to give you.”
Adds Zwilling: “Most businesses really need a credible outside broker to set the valuation and negotiate the best deal, just like professional real estate agents will likely get your house sold more quickly and for more money.”
Walk through the Valuation Process with the Pros.
Once you’ve brought in an appraiser or broker, Kroeker says “it’s important as a first step in that more formal process for you to actually sit down with them and walk through your financials with them and figure out the real cash flow of the business.”
It’s also important for small business owners to “walk through everything with their appraiser or broker at the end of the process,” according to Kroeker, “to make sure you agree with everything they did and to make sure they had an accurate understanding of everything you told them.” Plus, it will help ensure you understand and feel comfortable with the valuation they’ve produced.