If you're a small business owner planning for an exit, you’ve likely wondered how to determine the value of your business. Knowing what your business is worth is essential when negotiating with potential buyers, ensuring you ask for the right price. But valuing a business isn’t just about looking at what you own—it’s about understanding the money your business can generate now and in the future.
Why Your Business’s Value Isn’t Just About Assets
One common mistake small business owners make is thinking their business's value is equal to the total value of its assets. If you sold all your assets today—whether it's buildings, vans, computers, or other equipment—you'd get their current cash value. For example, if all your assets together are worth £500,000, that’s the amount you would receive by selling them individually.
But here’s the catch: buyers don’t care about how much they can make from selling your assets. They want to know how much profit those assets can generate by running your business. Business value is ultimately determined by profitability, not asset value.
The True Measure: Profitability
To put it simply, your business’s value is based on its ability to make money. A buyer wants to know how much profit they can expect to make now and over the next 5-10 years if they take over your company. Therefore, your business’s value is all about the money it currently generates and its potential for future growth.
The Importance of Proving Your Value
To attract buyers, you must understand and demonstrate the value of your business. If you can’t provide solid evidence of how much your business is worth, it will be challenging to negotiate a good price. Buyers also want confidence in the management, so ensuring the business can run smoothly after the sale is critical.
Two Common Methods to Value Your Business
When it comes to valuing a business, there are several methods to consider. However, the two most common are the multiples method and the discounted cash flow (DCF) method. Let’s break these down.
1. The Multiples Method
This method is based on the idea that businesses in similar industries sell for similar prices. To use this method, you need to find a company in your industry that has recently been sold. You then take its sale price and divide it by either its total sales, EBIT (earnings before interest and taxes), or EBITDA (earnings before interest, taxes, depreciation, and amortization). This gives you a number known as the “multiple.”
You can then multiply this number by your own company’s sales, EBIT, or EBITDA to estimate your business’s value.
2. The Discounted Cash Flow (DCF) Method
This method focuses solely on your company’s projected cash flow. You’ll need to forecast your business’s cash flow for the next three to five years and then calculate its present value.
Present value is a concept that compares future money to what an investor could have earned by investing it elsewhere, considering the interest they would have made. If your company’s present value exceeds the investment amount, it’s considered a good investment.
Other Key Factors: Multiples and Profitability Adjustments
Business valuations aren’t just about this year’s profits. You’ll also need to consider two key factors:
Multiples: Multiples reflect how long your business will keep generating profits for new owners. For small businesses, this typically ranges from 2 to 10, depending on risk factors and the business’s size. A larger, more stable company will achieve higher multiples, while a smaller or riskier business might have a lower multiple.
Profitability Adjustments: Profits can fluctuate yearly, so it’s essential to consider growth or potential profit loss when applying a multiple. Analysing historical financial data, industry trends, and competitors’ progress will help you estimate the most accurate figure.
Wrapping It Up: Calculating the Value
The final step in valuing your small business is calculating its worth based on the factors discussed. While the math may seem daunting, understanding the fundamental drivers—profitability, growth potential, and risk—will help you approach the process with confidence.
By following these steps and getting a clear picture of your business’s value, you’ll be better equipped to make informed decisions when the time comes to sell. A well-documented, profitable business is always more appealing to potential buyers, making the process of securing a good sale price much smoother.
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