How do you put a price on the time, effort and passion you’ve put into building a successful small business? It can be hard to objectively assess how much your venture is worth after putting so much work in over the years. This is where business valuation calculations, ideally handled by a third-party expert, can play a role. Business valuations are used for mergers, acquisitions, tax purposes and more. Here’s how business valuations work and how to calculate the economic value of your company.
[Read more: 3 Things to Consider When Selling a Business During a Pandemic]
What is a business valuation?
A business valuation assesses the economic value of part or all of a business. Business valuations are used in a number of circumstances, including to determine the sale value of a business, to establish partner ownership, for tax purposes or even in divorce proceedings.
Generally, the valuation process analyzes all aspects of the business, including the company’s management, capital structure, future earnings and the market value of its assets. In the United States, business valuations are usually carried out by a professional who is Accredited in Business Valuation (ABV). This certification, awarded by the American Institute of Certified Public Accountants, is given to CPAs who pass an exam and meet minimum standards set by the AICPA.
If you’re seeking financing from lenders, investment bankers or venture capitalists, you may need an ABV-certified professional to help carry out your business valuation. If you’re simply looking to understand how much your venture is worth, you can carry out your own analysis using one of the business valuation methods listed below.
[Read more: How to Calculate a Business Valuation]
Business valuation methods
There are three common methods to evaluating the economic worth of a business. These categories are:
- Asset-based methods: Sum up all of the investments in the company to determine the value of the business.
- Earning value methods: Evaluate the company based on its ability to produce wealth in the future.
- Market value methods: Estimate what the company is worth based on similar businesses that have recently been sold.
In general, try to use more than one method to get the most accurate depiction of your business value.
There are pros and cons to each of these approaches to valuation. An asset-based approach, for instance, works well for corporations in which all assets are owned by the company and will be included in the sale. But, for a sole proprietor, this approach can be more difficult; which assets should be considered personal, versus business-related?
Generally, the two main earning value methods — capitalizing past earnings and discounted future earnings — are used when a company is seeking to buy or merge with another company. Market-value approaches are the least accurate and can lead to a business being under- or overvalued.
How to calculate a business’s value
Often, business valuations are performed by a licensed professional. To find an ABV who can help, look for someone registered with the American Society of Appraisers (ASA).
If you’re simply looking to get a basic idea of what your business is worth, there are a few steps you can take to get a rough estimate. Start by calculating your seller’s discretionary earnings (SDE). SDE is like EBITDA, with owner’s salary and owner’s benefits added back in. “Start with your pretax, pre-interest earnings. Then, you’ll add back in any purchases that aren’t essential to operations, like vehicles or travel, that you report as business expenses. Employee outings, charitable donations, one-time purchases and your own salary can all be included in your SDE,” wrote NerdWallet.
Once you have your SDE, take stock of your assets, do a little market research to see similar businesses have sold for, and pay attention to industry trends to see if you can ask for a higher valuation.
In general, try to use more than one method to get the most accurate depiction of your business value. “A general rule of thumb in business valuation is that you will want to use multiple methods. Using three to four methods will allow you to estimate fair value with more accuracy,” wrote the experts at The Balance.
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