Whether you are a business owner contemplating the sale of your business, raising bank capital or investor equity, pursuing a legal claim, preparing your succession, planning any array of accounting and IRS-related reporting events, or simply need a Business Valuation – you will want to obtain a valuation report. People sometimes ask how to value a small business for sale, and the best way is to get a business valuation report.

A business valuation report will:

Inform the list price and provide the fair market value of your business if you’re selling

Deliver the credible and reliable value of your business if buying out a shareholder

Provide the value of your shares, as reported to the IRS, if gifting to a family or friend

Add valuable credibility during negotiations or legal proceedings

Business valuation reports can be prepared for many different purposes. There are two types of business valuation reports: informational valuations (broker opinion of value reports) and certified valuations. An information valuation is used as an internal document for owners and stakeholders of the subject company. A certified valuation report is used when the conclusions may be used in a legal proceeding or when findings are likely to be challenged. It is also used for outside parties to make determinations regarding the subject company.

Common Uses:

• Buying a business
• Selling a business
• Partner buy-in/buy-outs
• Exit planning

Business Valuation Methods

How to value a small business for sale can be done using many different methods. A company valuation calculator can help estimate how much a business is worth. While a company valuation calculator can be helpful, it can also lead to inaccurate results. The calculations can be flawed because there are too many factors to do an accurate business valuation with typical company valuation calculators.

Some inputs are subjective and influenced by other factors like interest rates, the economy, industry, etc.  The methods listed below are more accurate for businesses with less than $10MM in gross sales. These are the most widely accepted methods and will provide results that can be defended using data. 

The Industry Buyer Method is heavily weighted in the asset’s adjusted book value. This buyer will be in your industry and could be a competitor. They know the business and will pay little in goodwill. Their offering is usually lower because they mainly buy your customer list and equipment at market replacement value. There are exceptions when the purchase is made for strategic reasons, which may get a much higher price.

The Basic Method is the fair value of assets plus 1 to 2 years of discretionary earnings. This method puts much of the value in assets the company holds but does factor in earnings. Documentation is very important to get the valuation your company deserves. Little or no documentation will result in a low offer or no offer.

The Discretionary Earnings Method considers transaction financing, salary potential, and returns on invested capital. This method is focused on what the new owner can earn and puts less emphasis on equipment and assets. Discretionary earnings are the ultimate filter for how healthy a business is. A company can have a lot of assets and make little or no money. The assets can be valuable but underperforming, and financial liability if the earnings aren’t there.

The Comparable Sales Method is derived from combining sales data from hundreds of completed transactions in similar companies. This method is pretty straightforward, but small businesses tend to be so unique that this method leaves much to interpretation. The potential earnings of small businesses vary greatly depending on who the owner is and his or her capabilities.

Cost to Replace Method is what it would cost to build a similar business from scratch. This method is useful, but you want to maximize “goodwill” or intangible things like future earnings as a seller. If your company is well positioned to increase earnings in the future, the cost-to-replace method will undervalue your business.

The Debt Capacity Method is obtained by deducting owner salary, depreciation, replacement reserves, and ROI on invested capital. What is left over is available for debt service. The debt capacity method is used in small businesses with revenues exceeding $2.5 million. This method is helpful when another company is acquiring your company for strictly financial reasons.

The valuation methods above are the most common. The valuation methods can be used individually or combined. The valuation methods used depend on the company that is the focus of the valuation. It is not in the scope of this post to discuss the actual application, but it will be covered in another post.   A business valuation is the cornerstone of due diligence. It should be done first because it gives you the proper financial lens to evaluate a business. Click below to learn a shortcut to give you a quick insight into due diligence for any company.