After working hard to build your business, you may be wondering what it is worth. Business valuation involves a process of steps used to determine the cash value of a business. There are a number of reasons why you may want to place a value on your business, like if the business is up for sale, if you are plan on selling stock in your company, if you are trying to attract investors, or if a bank loan is required against the business. Learn what steps business owners can take to calculate business valuation.
Steps to Determine Business Valuation
1. Review the Purpose of Business Valuation
Preparation is an important component of business valuation. The business valuation process requires attention to detail and organization. You will first want to determine why you need business valuation as this can affect the final value. For example, say that your business is successful and you have seen your profits grow year after year. You want to sell your business but you are not in any hurry, allowing you ample time to get the best price possible. In this case, your standard of value is considered fair market value and you have the opportunity to sell to the highest bidder.
You will also want to gather information to help calculate the value of your business. This data may include business financial statements, marketing and business plans, operational procedures, vendor and customer information, and staff records. Having access to clear and accurate tax returns and financial statements is essential for demonstrating the earning power of a business. It is also ideal to have written business operating procedures in detail to better understand how the business works, what skills are required to operate it, and what job positions perform what duties.
2. Calculate Seller’s Discretionary Earnings (SDE)
One of the first things you must do to value a business is to calculate a number known as the “Seller’s Discretionary Earnings” or SDE. SDE is your business’s pre-tax earnings before non-cash expenses, interest expenses and income, owner’s compensation, and one-time expenses. Using your tax return does not usually give you a reliable number. This is because many businesses claim many deductions in order to lower their business income. SDE offers a more accurate portrayal of a business’s profit potential by calculating what a new buyer would earn if they took over the business.
To calculate SDE, there are a number of things that are added back into the net income that is reported on your business tax return. These include your salary, members of the family who are on payroll and have non-essential jobs, charitable donations, non-cash costs such as amortization and depreciation, business travel not essential for operating your business, personal expenses such as the purchase of a personal vehicle that were used as an expense on your business tax return, and one-time expenses that are not likely to occur again, such as a settlement from a prior lawsuit.
3. Determine Your SDE Multiplier
As a general rule of thumb, most businesses will usually sell for between 1 and 4 times their SDE. This concept is referred to as the SDE multiple. As there are various factors that can influence the SDE multiple, valuing your business using this method is considered more of an art than a science. When calculating your SDE multiplier, you will need to take various aspects of your business into consideration, such as the industry your business is in, the size of your company, any tangible or intangible assets you own, geographic trends, and similar variables that could affect business valuation.
Other major factors that can influence the SDE multiple is the industry outlook and owner risk. If you are selling a business that is in a popular industry and is expected to see growth in the near future, than you may be able to use a higher SDE multiplier. Who runs your business and how they run it can also impact your business value greatly. If your business is primarily dependent on the knowledge, skills, experience, or the workmanship of its owners, then transfer to a new owner is not easy which can reduce the SDE multiplier.
4. Add Assets and Subtract Liabilities
The final step in calculating business valuation involves adding business assets and subtracting liabilities. When selling a business, businesses generally consider the transaction an asset sale. This means that the buyer is purchasing the tangible and the intangible items that help make a business profitable. Tangible assets include any physical goods that are owned by a business and have value, such as any cash on hand, accounts/receivables, and real estate owned by the business. Intangible assets include any non-physical goods that provide value to a business, such as trademarks, reputation, goodwill, and patents.
Liabilities should also be considered when calculating business valuation. A business’s liabilities may include debt and other types of financial obligations that may require payment in the future. If your business has substantial liabilities, you could have difficulty finding a buyer. Having an asset sale can be beneficial for certain businesses with liabilities. During an asset sale, the seller pays off the business’s liabilities with the proceeds earned from the sale. Take the time to look at your liabilities before selling your business. You will need a variety of information such as your current debt, any past due debt, and how often the business pays its vendors on time.
Contact a Business Consulting Firm
Each of these metrics aid in determining a business’s worth, profitability, and potential for growth. Businesses will also want to consider their future earnings when valuing their business. Gather information to help you project what your business could experience in the next five years in terms of revenue, earnings, and expenses. As determining an accurate business valuation can be difficult, it is best to leave these calculations to the professionals. For more information about how to value a business or for assistance with business valuation, contact a business consulting firm.