by Sherron Lumley
One of the most important factors to consider in buying or selling a small business is how best to calculate what the business is worth. Without that critical calculation, it is impossible to determine a fair value for the business and negotiations on a potential deal will likely come to naught, regardless of whether you are buying or selling.
“The value of a business is in the eye of the beholder and can be satisfactorily determined only by negotiations between interested parties,” says Lawrence Tuller in The Small Business Valuation Book.
Just as no two people are the same, no two businesses are the same and no two valuations will be the same either. Keeping in mind that one method will not be appropriate for every business, there are a few major approaches to calculating business value. Three of the most widely accepted are called the Asset Approach, the Income Approach, and the Market Approach, and as their names imply, they focus in turn on assets, income, and market comparison. (For more details, check out this online primer on the three business valuation methods.
A quick look at three types of small businesses will help to illustrate the three methods: first, an older family restaurant; second, a widget manufacturing firm; and third, a newer dog-grooming franchise. Income will be used to place a value on the restaurant, assets will be used for the manufacturing company, and for the newer dog-grooming business, a market comparison will work best.
The Income Approach focuses on the benefit stream, estimating future income to determine the value of the business. Some call this benefit stream cash flow and others prefer the more technical term Net Operating Income (NOI). One year of NOI will be converted into a present value for the business by applying a capitalization rate to account for risk factors. It’s a little bit country and a little bit rock and roll, as every element imaginable can go into determining a “cap” rate. What it boils down to is the desired rate of return in view of the riskiness of the investment.
Let’s say that our restaurant in question is a risky business, times are changing, and the future is hazy. The riskier the business, the higher the cap rate and the lower the market value of the business. A solid and growing business could have a cap rate of 15 to 25 percent (.15 to .25), whereas a volatile business could have a cap rate between 35 and 50 percent (.35 to .50).
In the Income Approach to valuation, the market value (V) is the net operating income (I) divided by the cap rate (R). It looks like this: V= I/R.
If this hypothetical restaurant is failing, the tangible assets may be the primary consideration for value and the Asset Approach would then be the one to use. The Asset Approach to valuation assumes that the company’s assets could be easily liquidated if desired. It is going to provide a lower level of value to which adjustments can be made for such intangible factors like good will, the reputation of the company, customer loyalty, and business location.
Asset valuation is often used for manufacturing firms because of the high value of inventory, capital, and equipment. Using the Asset Accumulation method, all assets both tangible and intangible are considered, less all of the liabilities. Intellectual property and customer contracts are examples of assets not on the balance sheet that will be taken into account using this approach.
Finally, let’s look at the newer dog-grooming franchise. Here, the Market Approach, in which the target company is compared to a similar company, will work when the two companies in question are as alike as possible. This method examines value in the context of the competition—what similar businesses are worth—and works well for younger companies or high growth industries.
A few easy calculations can be made using the financial statements and particularly the balance sheet, which is a snapshot of the company at a given point in time. It shows what the company has (Assets), what it owes (Liabilities), and what is left over for the owners (Equity). For example, debt-to-assets is a quick ratio often used to compare businesses. It is found by dividing total debt by total assets, both of which will be stated clearly on the balance sheet.
Other Valuation Tools
One of the most straightforward valuation tools involves using annual sales along with a predetermined multiplier. For example, if a business has sales in one year of $100,000 and the multiplier for that business is 50 percent of annual sales, the value of that business is $50,000. So where does one find the multiplier? The Business Reference Guide, a 754-page guide now in its 20th year, provides rule of thumb calculations for over 700 types of businesses. The Business Reference Guide Online database (BRGO) is available as a one-year subscription from the Business Valuation Resources Store for $285.00, which includes the book. The website does have some free resources.
For more free information, Inc. magazine has partnered with the Business Valuation Resource to produce an online interactive chart for business valuation and a free database for general business values by sector.
These simple business valuation methods are just the first step. If a deal is on the table, contact an expert for outside valuation help. Appraisers, accountants, attorneys, and brokers are professionals who work in business valuation.
- Business Valuation for Dummies, by Lisa Holten and Jim Bates, 2008
- Buying & Selling a Business, by Robert Klueger, 2004
- The Small Business Valuation Book, by Lawrence Tuller, 2008