6.15.2021

How to Value a Small Business

Written by Kit Jenkin

scott graham OQMZwNd3ThU unsplash 1

You’ve done the hard work of starting your small business, and everything is going just as well as you’d hoped.  Now that your business is growing and stable, how much is it worth?  In this article, we show you how to accurately value your small business and why it matters.

Why Value Your Business?

There are many pressing day-to-day decisions that small business owners have to make, and valuing your business is probably the last thing on your mind.  However, it’s critical for you to understand how much your business is actually worth in addition to how much profit you bring in or how much debt you’re carrying.

There are several important reasons [1] to get a valuation done, such as:

  • Accurate tax returns
  • Allocating partner ownership/shares
  • Seeking investors/additional financing
  • Selling your business
  • Divorce or estate proceedings
  • Mergers

You can’t attract new investors or partners if you’re not sure how much your business is worth, and you don’t want to end up paying too much or too little in taxes because you didn’t properly value your small business.

It’s better to do a valuation now rather than wait until you’re forced to by the judicial officer in a divorce proceeding to determine assets.  You also don’t want to wait and leave it to others when the business needs to be divided or passed on to your heirs through an estate proceeding.

You could have other reasons for valuing your business, as well.

Value vs. Profit

While companies that earn large profits can also be valuable, the two terms aren’t interchangeable.  Value also includes the intangible assets that make up your business, including your plans for future growth.  Other aspects of value include being up-to-date [2] on:

  • Technology specific to your industry
  • Management techniques and training
  • Employee training
  • Best practices for your industry
  • Strategic planning
  • Financial reporting
  • Software used for human resources, customer payments, and payroll processing

If you don’t currently have a strategic plan for your business’ future, work on one.  If you don’t have a way to create clear, concise financial reports quickly, put a system in place that allows you to do so.

For small business owners with a physical location, you’ll also need to think about the current (and future) state of your tangible assets.  Is your equipment well-maintained and of high quality? Do you have maintenance and repair plans in place?  What about purchasing plans when equipment ages? 

You’ll also want to be sure you’re maintaining your building and keeping it in good repair, including the plumbing and HVAC systems.

You could be earning more profits than you’ve ever dreamed of, but if your building is run down, your equipment is 20 years out of date, or you’re using legacy software systems that no one supports anymore, your business may not be as valuable as you hope.

All small business owners should understand the factors and methods used to value a small business so they can work on increasing value, not just profits.

Valuation Methods

There are many ways of valuing a business [3], and the method you choose may depend on the type of small business you own.  We list a few of the more common methods (in no particular order) below.

Market-Based Valuation

This valuation method directly compares your business [4] to similar businesses, looking specifically at what buyers are willing to pay for those businesses in the current market. 

This is also known as the market approach method and may be the most straightforward of all the valuation methods out there.

Often, this is the method used when you’re ready to think about selling your business.

The main issue with using this method is determining which businesses are truly similar to yours in order to calculate an accurate valuation that’s also attractive to potential buyers.

Discounted Cash Flow (DCF)

DCF may be the most detailed method [5] to use, but because of that, it may also be the most accurate.  However, this one may require the help of an expert.  You’ll be creating a financial model that takes multiple potential future scenarios into account.

To do this, you’ll need to estimate the current value of your future cash flows (from all sources) and discount that value against the current cost of your equity and debt.  If that sounds confusing, don’t worry—there are plenty of business valuation professionals [6] out there who can walk you through the process.

This method only looks at your own business (present and future) and doesn’t compare you to anyone else.

Capitalization of Cash Flow (CCM)

While not as complicated as the DCF method, you’re still going to be dealing with some estimates and assumptions here. 

The CCM valuation method [7] presumes a constant rate of growth for your small business.  If you’ve seen fluctuations in growth on a regular basis, this may not be the most accurate method for you to use.

You may hear this called the capitalized income valuation method or the capitalization of earnings method, but all three names are referring to the same thing.

Using this method, you’ll divide the free cash flow [8] to the firm by the weighted cost of capital (minus the expected constant growth rate).  Free cash flow simply means the cash you have available to pay dividends, interest, and creditors.

If you’re unsure how to calculate your free cash flow or your weighted cost of capital, you may want to get professional help calculating your valuation using this method.

Seller’s Discretionary Earnings

While this method sounds intimidating, you may be more familiar with the terms adjusted cash flow, total owner’s benefit, or recast earnings.

In a nutshell, this valuation method [9] looks at how much a single full-time owner/operator would earn annually from their small business.  This may be one of the easiest methods for small business owners to use.

Where does the “discretionary” part come in?  This refers to any funds earned from the business that an owner uses for:

  • Health insurance
  • Personal vehicles
  • Life insurance
  • Personal travel, including vacations
  • Memberships in social (not business) clubs or organizations
  • Personal meals and entertainment

The funds must be solely for the owner’s benefit and paid for from business earnings in order to qualify as “discretionary” under this valuation method.

This method is typically used for small businesses with less than US $5,000,000 in revenue.

Note that these aren’t the only methods you can use to value your small business.  A professional can help you sort through the various valuation methods available to you and help you choose the best one for your business.

While it may be easy to focus solely on your balance sheets and financial statements when planning for a business valuation, you don’t want to forget about the value your software and other systems add to your business, including up-to-date, robust point of sale software.

A POS System That Adds Value

When creating a valuable business, you’ll want to choose a versatile and secure point of sale system that allows your customers to pay using the latest methods, such as with their phones using Apple Pay and Google Pay, or that can allow you to be more nimble by providing options such as mobile point of sale.

Epos Now allows you to do all of those things and more.  Of course, Epos Now works with Visa, MasterCard, and American Express to name just a few, and on top of all that, was recently ranked as one of the best POS providers in the country by US News and World Report.

Now that you’ve got a great value-adding POS system in place, you’re ready to take a look at just how much your business is truly worth.

Epos Now Call us now