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Ready to sell? Small business owners must decide whether an asset, income or market-valuation approach makes the most sense for their business.
While there are all sorts of reasons you might need to estimate the value of your small business, like a divorce or a dispute over estate or gift taxation, the most typical one is when you’re considering selling your company.
Here are three common ways professionals calculate a business’ value:
1. Asset Approach
This method determines a business’ value by adding up the sum of its parts. It’s 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 Approaches
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 Approaches
These methods 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, as it tries 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 use if you need to value 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 says. “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 most useful 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 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 more tips to consider:
It’s More Art than Science
When it comes to valuation, the approaches used by smaller businesses aren’t much 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.”
Related: 5 Legal Considerations for Sellers
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, “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 a Pro
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 to 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.