Figuring out what a business is worth isn't always straightforward. There's no single formula that works for every business. But understanding the basics of business valuation will help you make better decisions, whether you're buying or selling.
Why Valuation Matters
For sellers, knowing your business's value helps you set a realistic asking price. Price too high and you won't get interest. Price too low and you leave money on the table.
For buyers, understanding valuation helps you evaluate whether a business is fairly priced and whether the deal makes sense for you.
Common Valuation Methods
There are several ways to value a business. The right method depends on the type of business and why you're valuing it.
Multiple of Earnings
This is the most common method for small businesses. You take the business's annual profit (or earnings) and multiply it by a number based on the industry and type of business.
For example, if a business makes $100,000 in profit per year and similar businesses sell for 3 times earnings, the business would be worth around $300,000.
The multiple varies by industry. Service businesses might sell for 2-4 times earnings, while manufacturing businesses might sell for 3-5 times. Retail businesses often sell for 1.5-3 times earnings1.
Factors that affect the multiple:
- Industry: Some industries command higher multiples
- Growth potential: Growing businesses are worth more
- Dependence on owner: Businesses that run without the owner are worth more
- Customer concentration: Diverse customer base is better than relying on a few big customers
- Competitive position: Strong market position adds value
Asset-Based Valuation
This method looks at what the business owns minus what it owes. You add up the value of equipment, inventory, real estate, and other assets, then subtract liabilities.
This works best for businesses where the assets are the main value, like manufacturing companies with expensive equipment or real estate businesses.
For most service businesses, asset-based valuation usually comes in lower than earnings-based valuation because the real value is in the customer relationships and cash flow, not physical assets.
Market Comparison
This method looks at what similar businesses have sold for recently. If a similar business in your area sold for $500,000, that gives you a reference point.
The challenge is finding comparable sales. Business sale prices aren't always public, so this information can be hard to get. Industry associations sometimes publish data, and business brokers may share general information.
Even when you find comparables, no two businesses are exactly alike. You'll need to adjust for differences in size, location, financial performance, and other factors.
Discounted Cash Flow
This method projects future cash flows and discounts them back to today's value. It's more complex and usually used for larger businesses or when you're making a significant investment.
For most small business transactions, the multiple of earnings method is simpler and more commonly used.
What Counts as Earnings?
When valuing a business, you need to figure out the "true" earnings. This isn't always the same as what shows up on the tax return.
Start with the business's net profit, then make adjustments for:
- Owner's salary: If the owner wasn't taking a market-rate salary, add that back
- Personal expenses: Remove expenses that are personal, not business-related
- One-time expenses: Remove unusual costs that won't continue
- Depreciation: Add back non-cash expenses like depreciation
The result is called "Seller's Discretionary Earnings" or "Adjusted EBITDA." This represents the true earning power of the business.
For example, if a business shows $80,000 profit but the owner was taking $50,000 less than market salary and had $10,000 in personal expenses, the true earnings might be $140,000.
Factors That Add Value
Some things make a business worth more:
Growing revenue and profits: A business that's growing is worth more than one that's flat or declining.
Recurring revenue: Subscription businesses or businesses with long-term contracts are worth more than those that have to find new customers constantly.
Strong brand and reputation: A well-known name and good reputation add value.
Diversified customer base: Not relying on one or two big customers reduces risk and adds value.
Systems and processes: Documented systems that don't depend on the owner make the business more valuable.
Good location: For retail and service businesses, a prime location adds value.
Long-term leases: Favorable lease terms, especially below-market rates, add value.
Factors That Reduce Value
Some things make a business worth less:
Declining revenue: If sales are dropping, buyers will discount the price.
Owner-dependent: If the business can't run without the current owner, it's worth less.
Customer concentration: If one customer represents more than 20-30% of revenue, that's a risk that reduces value.
Outdated equipment: Needing to replace expensive equipment soon reduces value.
Competition: New competitors or changing market conditions can reduce value.
Legal or regulatory issues: Pending lawsuits, regulatory problems, or compliance issues reduce value.
Getting a Professional Valuation
For important transactions, consider getting a professional business valuation. Certified business appraisers can provide an objective assessment of what your business is worth.
A professional valuation typically costs $3,000-$10,000, depending on the size and complexity of the business. It's worth it if:
- You're selling a business worth $500,000 or more
- You need to justify the price to buyers or lenders
- There are complex factors affecting value
- You're involved in a dispute or legal proceeding
Look for appraisers who are certified by organizations like the International Society of Business Appraisers or the National Association of Certified Valuators and Analysts.
Simple Valuation Rule of Thumb
While professional valuations are best for important decisions, here's a simple starting point:
For most small businesses, a reasonable range is 2-4 times annual profit. Service businesses tend toward the lower end (2-3x), while businesses with strong assets, growth potential, or recurring revenue might be at the higher end (3-4x or more).
This is just a starting point. Many factors can push the value higher or lower. But it gives you a ballpark figure to work with.
For Buyers: Evaluating the Price
When you're looking at a business for sale, don't just accept the asking price. Do your own valuation:
Start with the financials. Calculate the true earnings after making appropriate adjustments. Then apply a reasonable multiple for that industry.
Compare the result to the asking price. If the asking price is much higher, ask the seller to justify it. There might be good reasons (strong growth, valuable assets, etc.), or the price might be too high.
Also consider what you could earn elsewhere. If you're investing $300,000, could you earn more with that money in stocks, real estate, or another business? The business needs to provide a return that makes sense for the risk you're taking.
For Sellers: Setting the Price
If you're selling, start with a professional valuation or at least do a thorough analysis yourself. Then consider:
Market conditions: Is it a buyer's market or seller's market? In a strong market, you might price at the high end. In a weak market, you might need to be more competitive.
Your timeline: If you need to sell quickly, price more aggressively. If you have time, you can start higher and see what offers you get.
Competition: Look at what similar businesses are listed for. You don't want to be the most expensive option unless you have clear advantages.
Most sellers start 10-20% above what they're willing to accept, expecting some negotiation. But don't price so high that serious buyers don't even contact you.
Next Steps
Whether you're buying or selling, understanding valuation helps you make better decisions. For sellers, check out our Seller's Guide for more on preparing your business for sale. For buyers, see our Buyer's Guide for tips on evaluating businesses.
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