How much is a business worth? It’s a critical question for buyers and sellers alike. Unfortunately, there is no one simple explanation because valuation is more art than science. There are, however, multiple methods for determining the value of a small business, each with their own application.
First, let’s look at the four different types of value that can be determined for a small business.
- Fair market value is the price a willing buyer would pay a willing seller, where both parties have reasonable knowledge of relevant facts.
- Intrinsic value is based on stock values that investors would consider.
- Fair value is based on legal standards of valuation and may be used in divorce proceedings or a similar division of mutual assets circumstances.
- Investment value is specific to certain buyers and what they are willing to pay. This value can exceed the fair market value.
We’ll look at how to arrive at the fair market value of a small business using the following approaches to valuation.
THE ASSET APPROACH. The asset approach values the assets of a small business minus liabilities, using methods like book value. These values usually do not translate to the market value of most operating businesses; therefore, the asset approach does not properly represent the value of an ongoing business with positive earnings. This approach may be a good tool for businesses with declining revenue
THE MARKET APPROACH. The market approach uses comparable sales data to determine the value of a company of a like business in size and industry. There are multiple trustworthy databases where appraisers can find multiples of gross sales and earnings to compare to a business. This method is reliable in most cases and is a strong indicator of fair market value.
THE INCOME APPROACH. The income approach determines the present value of the income stream it will bring to a buyer using several complex calculation methods. This approach is also a strong indicator of a business’s fair market value. These methods use future projections of growth to identify what the business may be worth, and, oftentimes, historical earnings are a good indicator of future earnings. So essentially, in the income approach a business is worth a multiple of past earnings.
How is a Multiple Determined? In small business mergers and acquisitions, the multiple will likely be between one and three. For larger companies, with earnings before interest, taxes, depreciation and amortization greater than $1 million, the multiple can be between four and six. Multiples generally grow with business size, quality and the verifiability of the owner’s benefit.
Remember when we said, “Valuation is more art than science?” That’s because all of these business valuation approaches aside, the same business can be valued differently by each buyer. And a business’s valuation is dependent on a number of factors like the location, size, competition, growth rates, industry trends, quality of books, ease of transfer, control issues, time available to sell and the terms of the sale – and this isn’t even an all-inclusive list.
Because a business’s value is often subject to fluid factors like the economy and industry trends, it is best to leave its determination to a professional transactional advisor. Their access to comparable databases and understanding of the market cycle positions them well for developing an accurate representation of a company’s value.
Jessica Fialkovich is the president of Transworld Business Advisors – Rocky Mountain. Transworld is the top business brokerage firm in Colorado, listing 200+ businesses for sale annually. Transworld assists visionary entrepreneurs with buying a business or selling a business in Colorado, specializing in helping family-owned and closely held businesses with their strategic plans. Through their partner, Transworld Commercial Real Estate, Transworld also advises clients on commercial real estate acquisitions and dispositions.