Methods of valuation for your small business
The method of valuation really depends on the type of business or stage of business. Here are the approaches we will discuss:
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Stable businesses with a profitable history
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Startups and growing businesses
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Holding companies and unprofitable businesses
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Market value
STABLE BUSINESS WITH A PROFITABLE HISTORY
Valuation Approach: Historical Earnings, Capitalized Cash Flow, EBITDA (Earnings Before Interest, Taxes, Depreciation, Amortization) Multiple, Seller’s Discretionary Earnings
Cash Flow Situation: Business is profitable with stable cash flow expected to continue.
If the business is mature, profitable, and you expect the cash flow to continue into the foreseeable future, then you would want to value the business based on past cash flow.
When you hear people talk about an earnings multiple or EBITDA Multiple, this is the approach they are using. What they mean by multiple, is that you take the business’s earnings and multiply it by a number (usually 2 to 5) to get the value the business. Applying a multiple of 3 to a company making $100,000 a year, would value the company at $300,000.
Buyers are paying for the income stream your business generates. How much a buyer is willing to pay depends on expected cash flow adjusted for how much risk they see in the business. The risk is that the payments might be less than anticipated, not arrive on time, or both. And unfortunately, businesses sometimes fail, which means the payments could also stop altogether. Riskier business will garner a lower multiple, and efficient, established businesses will command a higher multiple.
STARTUPS AND GROWING BUSINESSES
Valuation Approach: Future Earnings, Discounted Cash Flow (DCF), Future Cash Flow
Cash Flow Situation: Use this when historical earnings are not indicative of future earnings
If you’re a start-up company or have big growth plans, then valuing your business on the last 3 years’ results probably doesn’t give you the valuation you’re looking for. To best value this type of business, we need the expected earnings for the next 3 to 5 years.
The business is still valued based on its income stream. Only with this approach we take our best guess on future earnings, rather than rely on the past earnings, to value the company. Generally, the seller of a business prepares her/his cash flow projections with rose-coloured glasses, expecting the business plan to unfold just as planned, with no roadblocks or detours. Business valuators will adjust the future earnings when valuing the business to reflect the risk that the cash flow projections may be less than anticipated, slower than planned, or may not materialize at all. This is the "discounting" referred to in the name "Discounted Cash Flow."
HOLDING COMPANIES AND UNPROFITABLE BUSINESSES
Valuation Approach: Fair Market Value of Assets (net of all liabilities)
Cash Flow Situation: The cash flow (or profit) of the business is insufficient to provide a decent return, considering the assets and resources used by the company
If you can sell everything off and net more cash than if you valued the business using earnings, then you would obviously just sell off the assets. Essentially, if there is no goodwill in the business, use the Net Asset Approach.
Many small businesses today are not very profitable. The Net Asset Value approach is used if you try valuing your business using the Future Cash Flow Approach or the Historical Cash Flow approach (or both), and the value is less than the saleable value of the assets.
MARKET PRICE
Valuation Approach: Rule of Thumb Valuation, Auction, Comparable Transactions
Cash Flow and Asset Value mean less in situations where there is a ready market for your type of business. Many industries know their market price and have ratios or rules of thumb that buyers and sellers are comfortable with. Oil producers might sell for a value based on BOE/Day, a software app might be valued based on the number of subscribers and motels might sell strictly based on the number of rooms.
No matter which method is used to value your business, keep in mind that value does not necessarily equal price. Price is determined by negotiations between buyer and seller. Further, terms and conditions can have a huge impact on price.