January, 26, 2023
There are 32.5 million small businesses in the U.S. according to the SBA, and based on a 2018 Census report, 51% of these small businesses were owned by individuals that were 55 years or older. This is the set up for what Forbes called the “Silver Tsunami” that will create significant opportunities for business acquisitions in the coming years. As these business owners reach a point where they want to retire, they may look to sell their business.
This brings me to the key question for this article - how do you value a small business?
We help a lot of aspiring business owners create financial projections for an acquisition (which is typically required by banks and SBA lenders), but one thing we have never had a good answer for is how to know what the value of a business should be. Quite frankly, since I am not a certified business appraiser, I have just completely avoided helping clients with business valuations, but what I have learned from client feedback is that potential business buyers and sellers aren’t coming to us looking for a certified business valuation, they just want some tools to help them get a ballpark estimate of the value of a business.
With that feedback in mind, I decided to learn all that I could about how to value a small business, the various approaches and calculations so that we could create a template that helps provide a framework for valuing a small business. In this blog post I plan to share everything I learned about how to value a small business and show you the template that we created to help you value your own business a business you are looking to buy. Here is what I plan to cover:
- Certified Business Appraisal
- DIY Business Valuation
Throughout the article I am also going to demonstrate how to calculate the value of a business using our business valuation calculator.
Ok with that as a plan, let’s dive in.
What is a Business Valuation?
A business valuation is the process of calculating the financial value of a business. In other words, a business valuation answers the question “how much is my business worth?”
Although there are different methods of valuation for a small business, which I will get into shortly, there are also different levels of valuation. You could compare this to valuing your home. You could get a rough estimate of the value of your home by checking your Zillow - Zestimate, but then for the mortgage you will need to get an appraisal of the home by a certified appraiser.
Valuing a business is similar in that you can get a certified business appraisal which might be required if the buyer of the business is using bank financing for the acquisition. However, if you just want to get a rough estimate of the value of your business or of a business you are looking to acquire, you can use a simple template to calculate a rough estimate of business value.
Certified Business Appraisal
A certified business appraisal can be completed by an appraiser that has gone through a certification process with an organization like the National Association of Certified Valuators & Analysts. For an SBA loan used for an acquisition, you will need to have a business valuation completed by a certified valuation expert, but before you go out and pay for one of these valuations yourself, your bank is probably going to have a specific set of appraisers that they trust and like to work with, so I would suggest waiting for the bank to direct that process.
In the meantime, you can complete what I am calling a DIY (Do-it-yourself) business valuation to get a ballpark estimate.
DIY Business Valuation
With a DIY business valuation you really just need a set of financial statements or tax returns from the business that you wish to value, and then you can use a business valuation calculator to enter in the appropriate financial information, make some assumptions about the future of the business, and then you can see how your business would be valued based on different valuation methods.
What are the Different Methods of Calculating Business Value?
There are many different methods of calculating the value of a business. I am going to focus on 3 common business valuation approaches commonly used for small businesses:
- Book Value
- Discounted Cash Flow
- Multiple of Earnings
Let’s look at a bit more detail for each method.
How to Calculate the Value of a Business
Next I will show you how to calculate the value of a small business using each of these three common methods.
How to Calculate Business Value Using the Book Value Method
The book value of a business is equal to the Assets - Liabilities - Intangible Assets = Book Value.
All you need in order to calculate the book value of a business is the most up to date balance sheet for the business. If you don’t have an updated balance sheet you can fill out our balance sheet template. Then you will simply need to pull the asset value, liability value and intangible asset value from the balance sheet as highlighted in the example balance sheet below.
In our example balance sheet you will notice that I also highlighted Goodwill which will need to be included in your calculation of intangible assets. Once you have your total assets, total liabilities and total intangible assets amount you simply need to take Total Assets - Total Liabilities - Intangible Assets = Book Value as seen in our business valuation calculator below:
One of the primary limitations of the book value method is that it doesn’t take into account future expectations at all. A business growing 50% per year with a book value of $325,000 would be valued the same as a business shrinking at 50% per year with a $325,000 book value.
Let’s look at the discounted cash flow method next which will bring in future forecasted cash flow into the equation.
How to Calculate the Value of a Small Business Using the Discounted Cash Flow Method
In order to calculate the value of a small business using the discounted cash flow method you will need to use the discounted cash flow formula. This is also known as the DCF formula.
The discounted cash flow formula is equal to the sum of the cash flow in each period divided by one plus the discount rate raised to the power of the period number.
If your eyes glazed over reading that equation you aren’t alone! It is kind of complicated, but our business valuation calculator should make it simple.
Here is what you will need to do in order to calculate your business value based on a DCF method.
- Cash flow projections
- A Future growth rate
- A Discount Rate
Based on these data points we can then calculate a business value. You can see how we enter in these assumptions into our business valuation calculator in the image below:
Now I am going to walk you through how to come up with these assumptions.
Cash Flow Assumptions for a DCF Valuation
The first step in valuing a business with a discounted cash flow method is to create your cash flow forecast. You could use our Existing Business Projection Template which will allow you to enter in your historical financial information as a baseline and then use that to forecast the next 5 years. The template will automatically produce a 5 year cash flow forecast. You can then take your projected cash flow for each year and enter it into our business value calculator.
Now that solves the first 5 years of cash flow projections, but your business will hopefully produce positive cash flow in perpetuity, beyond just the next 5 years, and that future cash flow has value us well. So in order to take that future cash flow into consideration we need to calculate what is called Terminal Value. This is a calculation of the value of all future cash flows based on a growth rate assumption and a discount rate.
When you enter in your first 5 years of cash flow assumptions and a growth rate and discount rate, our tool can automatically calculate your projected terminal value.
So let’s look at what you should use for a growth rate next.
Growth Rate Assumption for a DCF Valuation
Consider using a 3% growth rate assumption for your DCF valuation calculation, because 3% growth rate would be roughly in line with the growth rate of the economy or GDP in general.
One challenge with the DCF valuation method is that it relies heavily on a growth rate and discount rate assumption. In order to calculate the terminal value of all future cash flows, you need to assume a growth rate in perpetuity. So this is basically the growth rate you will assume the business will grow at forever. You might forecast a higher growth rate in the next 5 years and that is ok, but then eventually every business will reach maturity and the growth rate will likely align with the growth rate of the economy or GDP in general.
For this reason, it is a conservative approach to use something like a 3% growth rate number that is roughly in line with the overall growth rate of the economy. If you assume a 20% growth rate in perpetuity for example, you are going to end up with a very, very high terminal value that is probably unrealistic for your business.
Discount Rate Assumption for a DCF Valuation
Consider using the prime interest rate + 2.5% as your discount rate for a small business DCF valuation.
The reason that I suggest using the prime interest rate +2.5% is because that is roughly in line with what most SBA loans will charge as an interest rate. The prime rate constantly changes based on the federal reserve. In early 2023 it is 7.5%, so when you add 2.5%, you will end up with a 10% discount rate.
You may read that you should use your weighted average cost of capital (WACC) for your discount rate. Small businesses probably have no idea what their WACC is, this is more of a textbook answer, which is why I like to use the current SBA 7a loan rates as a discount rate for a small business. It is probably the most reliable number that all small businesses can use.
You will see that the discount rate you use will have a dramatic impact on the valuation calculation. Again this is a limitation of this valuation method.
Now that you have all of these assumptions, you will be able to calculate your business valuation using the discounted cash flow method.
How to Calculate Business Value Using a Multiple of Earnings Method
In order to calculate the value of a small business using a multiple of earnings method, you need to calculate the earnings of the business and then multiply it by a reasonable multiplier for your industry, growth rate, location, etc.
Although you could use net income or taxable income as the “earnings” number, these numbers can be easily manipulated. Commonly small businesses will use EBITDA (Earnings before interest, taxes, depreciation, and amortization) as the earnings number for a business valuation. You may also here the term Seller’s Discretionary Earnings (SDE) as commonly used as the earnings number in a business valuation.
What is Seller’s Discretionary Earnings?
Seller's Discretionary Earnings (“SDE”) is the total financial benefit that a business owner would earn if they ran the business full time for a year.
How is SDE different from EBITDA?
A common example of how seller’s discretionary earnings might be calculated differently than EBITDA is if you imagine a coffee shop owned by an owner that does not work day to day in the business. In this example, the owner would need to hire a coffee shop manager for, let’s say $50,000 per year. If the business has an EBITDA of $100,000 after paying a manager $50k, then the SDE would actually be $150,000 because you could add back that $50,000 for an owner that also plans to operate or manage the business. Since that new owner would not need the $50,000 manager, that $50,000 would become the new owner’s income.
Ok so whether you use EBITDA or SDE or some other earning calculation, then you will need to determine an earning multiplier to use for your small business.
The business value is then the earnings times the multiplier. The appropriate multiplier can vary greatly depending on your industry, and the specifics of your business and growth rate, etc.
I recommend taking a look at these industry multiples from Eval to get a rough idea of a multiplier that you could use. For example, the EBITDA multiplier for “Retail - Eating Places” aka restaurants in 2021 was 21.91. So for example if you had an EBITDA of $100,000, you would multiply by 21.91 to arrive at a business valuation of $2.1 million.
Now I wouldn’t just take one source of a multiple, I would find a few different sources of multiples that most closely align with your situation and take the average.
You can see how our valuation calculator will calculate your business valuation based on this approach below:
Average Small Business Valuation
Depending on your specific situation one of these 3 business valuation approaches might make the most sense, but sometimes the best approach is to take an average of all three approaches. Our business valuation calculator will automatically calculate the average valuation based on all 3 approaches as seen below:
If you need any help using our business valuation calculator or have a question about your specific situation please don’t hesitate to reach out, we would love to hear from you!