It is difficult to determine the selling price of a small business as such a valuation is very subjective. If you are buying a small business, you want to pay as little as possible, and if you are the seller, you want to sell your business for as much as you can get. Ultimately the buyer and the seller must meet each other somewhere in the middle regarding the value and price of the small business.The seller of a small business is often emotionally attached to their business. However, emotions can’t be taken into account in the valuation process of the business.
There are a number of valuation methods which can be used to value a small business. It is a good idea to use more than one or even all the methods below to ensure as accurate a valuation as possible.
The value of a small business can be calculated using the following methods:
Rule of thumb
The rule of thumb is a quick calculation and is a good place to start to get an idea of the worth of a small business. However, it can’t be the only valuation method used as it gives only a very broad indication of the value of a business.
The selling price is calculated as the annual positive cash flow of the small business multiplied by 4.
The liquidation value gives an indication of what a small business is worth should the owner be forced to close the doors and sell all the assets in less than 12 months.
To determine the liquidation value, the total liabilities are deducted from the total assets of the business.
The future value formula determines the current value of a small business taking into account current income and an estimated growth percentage for the future, and is calculated for a certain time period e.g. for the next three years.
The current value of income generated by a small business is multiplied by the estimated growth percentage. The estimated growth percentage is very subjective and based on a number of variable assumptions. Generally the future value method is not considered to give an accurate reflection of the value of a small business.
The value of a small business is calculated on the basis of owner benefits multiplied by an income multiple and determines the amount of money a buyer can reasonably expect to make from a small business in the near future.
The income multiple for a small business usually falls somewhere between 1 and 3 depending on the type of trade and the business’s track record. The higher the owner benefits (see below for calculation), the closer to 3 the multiple will be. If the success of a small business is strongly linked to the owner, e.g. a one-man business or a consulting practice, the income multiple will be closer to 1 as the clients/customers can easily follow the seller and cease to be clients of the business.
Hiring a professional to do a valuation for a small business is expensive and if they don’t have a good feel for the industry in which the small business operates, you might be able to do as accurate, or more accurate, a valuation if you do the valuation yourself, without the additional costs.
In addition to the value of a business, you will also want to calculate the expected return on investment for the purchase price you pay.
Keep in mind that valuations are not a scientific process but based on many subjective assumptions. It is therefore best to use as many different valuation methods as you can to get a feeling for what a small business is reasonably worth.
This article is a general information sheet and should not be used or relied upon as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your financial adviser for specific and detailed advice. (E&OE)