How is a Small Business Valued
How is a small business valued? Owners looking to sell, apply for a loan, or build a financial plan should know the value of their business. Business owners should have access to a way to know the value of their business. Unfortunately, there are limited resources online to help business owners determine their business value. Luckily, we are sharing our three-step formula for calculating the value range of your small business.
If you’ve watched Shark Tank, chances are you’ve wondered how businesses small businesses are valued. Unfortunately, the show creates an inaccurate perception of how small business is valued in the real world. As a matter of fact, it estimated that 2/3 of the deals agreed upon end up falling through. Our best guess is they fall apart because the valuations end up being inaccurate.
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The Small Business Administration defines a small business as a business with less than $7.5 million in annual revenue. The Census Bureau estimates small businesses account for 90-95% of American businesses. We typically define a small business as one with less than $1 million of SDE (defined below).
Despite the abundance of small businesses in America, you rarely hear about them selling or the sales prices. This is because small businesses are privately-held and typically not required to report this information.
Because people don’t hear about small business transactions in the news, public perception is skewed. When most people think of business transactions, they think of mid and large-size companies selling. Businss Valuation for larger businesses is very different from small business valuation.
If you are wanting to calculate the value of your small business, you’ll need several documents. We recommend using a detailed profit and loss statement for the most recent trailing twelve months. A true business valuation will look at 3-5 years of business financials. For our calculations below, one year will suffice. You will also need a balance sheet showing the businesses assets. The main assets we need information on are the furniture, fixtures, and equipment (FF&E) and inventory.
In mid and large-size businesses, the number that matters is EBITDA. EBITDA stands for Earnings Before Interest Taxes Depreciation and Amortization. Large and mid-size businesses focus on maximizing their profits to shareholders. EBITDA is a universal standard that can be used to compare businesses in an apples-to-apples fashion.
There is no universal standard for how a small business does its accounting. Because of this, EBITDA is relatively meaningless for small businesses. The number that matters is SDE or Sellers Discretionary Earnings. Another name for SDE is business cash flow.
Sellers discretionary earnings is the economic benefit (in dollars) the owner receives for owning the business. Some owners aggressively expense personal expenses through the business to reduce their income tax bill. Other owners hardly expense anything personal. To calculate SDE, add EBITDA, owner’s salary, discretionary expenses, one-time expenses / revenues, and normalizing adjustments together. This calculation provides an apples-to-apples valuation comparison for small businesses. (If you’d like help calculating your business SDE, please refer to our ‘what is SDE’ page.)
In the real-world, business valuation multiples depend greatly on the size of the business. There is a correlation between predictability of revenue and risk. The larger the business, the more predictable the revenue and the lower the risk. The smaller the business, the less predictable the revenue and the higher the risk. Industry also plays a role.
Generally speaking, large businesses have higher multiples than smaller businesses. It is important to keep this in mind. For mid-sized business, the valuation multiple can be 5-10 times EBITDA. With large, public companies, the multiple is usually much higher than 10. For example, as of this writing, Amazon has an EBITDA multiple of 79.
Use the following as a guide for determining which SDE multiple to use. The chart below will provide a range of value. The exact number depends on the non-financial factors of the business:
For SDE between…
$75,000 and $150,000:
$150,000 and $300,000:
$300,000 and $500,000:
$500,000 and $1,000,000:
Use a multiple of…
1 to 1.5
1.5 to 2.5
2.5 to 3.5
3.5 to 5
The first step is to calculate the SDE. If you haven’t already, refer to our what is SDE page for a downloadable template. As an example, let’s say SDE is the following:
Once the SDE is determined, use the chart above to figure out the correct multiple. Multiply the SDE by the bottom and top range. Using our example from above:
$400,000 has a multiple of 2.5 to 3.5
Bottom range: $400,000 x 2.5 = $1,000,000
Top Range: $400,000 x 3.5 = $1,400,000
Lastly, compute the value of the hard assets. This includes market value of furniture, equipment and fixtures (FF&E) and value (at cost) of inventory. Continuing with the above example, if equipment has a market value of $85,000 and inventory is $15,000. For this business, hard assets would equal $100,000. Therefore, the range of total value is:
Bottom range: $1,000,000 + $100,000 = $1,100,000
Top range: $1,400,000 + $100,000 = $1,500,000
Once you know the range, you look at the non-financial factors of the business. At Exit Brokers, we look at 8 factors to determine final value. These factors include growth rate, owner dependency, predictability of revenue, and 3rd party dependence. We provide a 10-minute questionnaire for free to identify a business’s Sellability Score.
This score tells us how attractive a business would be to potential buyers. The more attractive, the higher the value. The less attractive, the lower the value. Using the example from above, let’s say the business scored average on the Sellability Score. It would be safe to assume the value of the business is the average of the bottom and top range. In this case, the value would be $1,300,000 (($1,100,000 + $1,500,000) / 2 = $1,300,000).
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