Putting a price on your business isn’t like selling a car on Craigslist. “Runs good, couple rust spots, passenger door won’t open.” Someone interested in buying your business is going to want more info than that.
Buyers are looking for objective measurements that tell them buying your business is a good investment. That means cold, hard financial data.
And if you’re looking to buy a business, it’s wise to learn how valuation works—so you understand how sellers are setting their prices.
Once you’re done reading this article, you’ll have everything you need to value a business.
Two approaches to valuing your business
We’ll take a look at both basic business valuation and advanced business valuation. The basic approach is good for small businesses and side hustles, or for getting a ballpark figure for your own sake. The advanced approach builds on that, and takes extra variables into account.
Essential data for business valuation
Whether you use a basic or advanced approach, the following records are absolutely essential for valuation.
- Income statements for at least the last three financial years
- Copies of all the business’s tax filings and returns
- All licenses, deeds, patents, and other proprietary documents
- An up to date balance sheet for the business
The more information you have about the business, the more accurate your calculations will be when you value it.
Basic business valuation
The basic approach is based on seller’s discretionary earnings (SDE). The purpose of SDE is to measure how much money a business brings in for the person who owns it—regardless of who that is.
If you own a business, the taxes you pay, your owner’s draw, and other non-essential expenses are tied to you. Your SDE consists of your net income, minus those expenses.
We’ll assume for this section that it’s your own business you’re valuing.
Calculating your SDE
You’ll calculate your SDE for the previous financial year—since you ought to have all the business records for it.
Expressed as a formula:
(Net earnings before taxes + personal draw + non-essential expenses) – liabilities
Here are the steps to take:
Take your business’s net earnings before taxes for the year
Add to that number whatever you paid yourself (your personal draw)
Add to that number all the non-essential expenses you incurred over the course of the year. These are one-time, non-repeating expenses. Do not include cost of goods sold
Deduct any liabilities—debts, unpaid bills, and so on
The final number is your SDE
Essential vs. non-essential expenses
Essential expenses are fixed—they’re key to how your business runs, and they’re the same month to month. Examples include:
- Rent and property taxes
- Business insurance
- Light, heat, and other utilities
Non-essential expenses often vary month to month. They’re not key to keeping your company in business. Examples include:
- Travel and meal expenses
- Equipment repairs and upgrades
- Staff events
Let’s say you’re calculating the SDE for your company Fizz Off, which makes bath bombs. Last year, you bought materials, rented a space for manufacturing, ran an online store, and paid a part-time employee who took care of packaging and shipping and ran your social media accounts. All of these are essential expenses—without them, Fizz Off wouldn’t be the successful business it is.
Those weren’t all your expenses last year, though. You travelled to a bath bomb conference in Bath, England. You bought five pounds of pink glitter, for a new experimental bath bomb (“Grapefruit Sunrise”). And you rented a table at a local craft fair. These are non-essential expenses—you incurred them the course of doing business, but they were one time transactions, not essential for keeping Fizz Off in business.
Step two: Apply your SDE multiple
Also called an “SDE multiplier,” your multiple is a number that you multiply your SDE by to get a fair but competitive listing price for your business.
How the SDE multiple is determined
SDE multiples are determined by business valuation experts, who take into account a number of factors:
- The size of your business
- Trends in your local market
- What industry you’re in
- Your business’s tangible and intangible assets
- How much the business depends on your personal skills or brand
- Additional variables
Why use an SDE multiple?
You may be asking yourself, “Why can’t I just price my business using my SDE?” Here’s why.
SDE consists of how much money a business can be expected to earn over the course of the year, minus taxes, owner’s draws, and non-essential expenses. It doesn’t speak to the long-term value of the business. The multiple takes that into account.
Now imagine there are two companies: A virtual reality design studio, and a typewriter parts manufacturer. Due to the mysterious workings of the universe, they both had the same SDE last year. Would you say they’re both worth the same to an investor?
Probably not. Even though a small chunk of the population continues to use typewriters, there’s not much growth potential in the industry. At least, not nearly as much as there is for a tech firm designing the next generation of VR.
The SDE multiple takes that difference into account, so each company can be valued appropriately.
Who decides on an SDE multiple?
If you hire a consultant or valuation expert, they should be able to walk you through the process of how they select an SDE multiple for your business.
If you’re handling your own valuation, though, you’ll need to get your own SDE multiple. Firms that specialize in business valuation publish guides with up to date multiples. Typically, you’ll need to fork out some cash for one.
Start by checking out the 2019 Business Reference Guide from Business Valuation Resources, then follow up with your own research online.
Advanced business valuation: Four approaches
Once you’ve valued your business using the basic SDE approach, you can flesh it out with advanced valuation. An advanced approach takes your basic valuation and fine-tunes it by taking more variables into account.
There are four major techniques for advanced business valuation:
- Capitalization in earnings
- Discounted cash flow
Before you can use any of these techniques, you need to take all your assets and liabilities into account.
Listing assets and liabilities
Everything currently on your books is either an asset or a liability.
An asset is anything you own that can have a dollar amount attached to it. That includes actual money. Assets are good—the more of them you have, the richer you are.
A liability is the opposite—something that costs you money, or a payment you need to make. These include loans, accrued expenses, and accounts payable.
Make a list of all your liabilities, as well as your tangible and intangible assets. It’s important to have these on hand when you value your business.
Intangible vs. tangible assets
Tangible assets are material. Think of the number of dollars in your checking account, or a piece of equipment you could sell for market value.
Intangible assets are harder to pin down. They earn you money, and they can be transferred to someone else—but it’s harder to assign a dollar value to them. You’ll need to estimate their value—or get help from a business consultant who can do it for you—before you take them into account.
|Tangible asset examples||Intangible asset examples|
|Real estate||Copyrighted material|
|Cash on hand||Intellectual property (IP)|
|Equipment, or means of production||Regular returning clients or customers|
Four methods for valuing your business
There are four major methods of advanced business valuation. You need to choose the one that is most appropriate for your business.
Treat this as a jumping off point. Once you’ve figured out which method is right for you, you’re ready to do further research or meet with a consultant.
|Method||How to calculate||What you need||Best for…|
|Market-based||Determine a value based on the sale price of similar businesses in your market||Sale prices for other businesses in your industry, possibly obtained with help from a consultant||Any business|
|Capitalization in earnings||Create a business forecast based on your previous years’ income and expenses, and base your valuation on it||Business records||Well-established businesses with a stable income or steady growth|
|Discounted cash flow||Figure out a value based on your business’s current cash flow, then discount some of that value based on risk (chance of future losses)||Business consultant||New businesses that have a lot of potential for growth, but are not yet profitable|
|Asset-based||Add up all the tangible assets of your business (taking into account depreciation), then subtract liabilities||Up to date accounts||Companies that are liquidating—selling off their assets and going out of business|
Valuing a business in different industries
While we’ve laid a solid foundation for figuring out any business valuation, there are some differences depending on what industry you’re in. In particular, SaaS, ecommerce, and retail businesses are valued differently from each other. If you’re looking to value one of those businesses, we recommend checking out the following resources:
Once you’ve put a dollar value on your business, you’re ready to put it up for sale—our guide to selling your business will get you started.