Small Business Valuation – Methods | Approach | Techniques

Updated: Jul 8

Valuation Basics & Factors

Small businesses are valued for numerous reasons such as; purchases/sales, legal, matrimonial, estate, trusts and insurance as examples.

The basis for valuation is a function of the status of the business itself, and its future, furthermore the relative bargaining strengths of buyer v seller can play a material factor. A seller looking for a short exit is different to a buyer approaching a business owner who isn’t currently considering sale of the business.

The general approach in small business valuation is to calculate the cashflow benefits to the owner(s) and prescribe a multiple uplift to come to a valuation. E.g., The assessed owners’ benefit is 150,000 and the multiple applied being 3x, thus a valuation of 450,000. In effect it will take 3 years (payback period) to repay the 450,000 purchase price.

The multiple applied 1x-3x-10x depends on a whole host of issues, risk of future business conditions, likely growth and the respective bargaining strength of the buyer/seller dynamic as discussed earlier. It is also related to sales of similar businesses and the multiple they achieved.

Below we will work through the differing valuation methods, starting with Business cashflow – Owners benefits being the most common basis, as a going concern (successfully trading) with an owner who has put the business up for sale.

Business cashflow – Owners benefits

This is based on pre-tax profits with add backs for owners benefits and Interest plus depreciation. In certain geographic areas this rework of the Income Statement for selling purposes is referred to as a Selling Statement.

The effective logic is that the purchaser as owner is primarily interested in the benefits that specifically accrue to them. It should be noted that implicitly as part of the methodology that any owner’s salary is stripped out of the businesses cost base.

The owners benefit methodology assumes that the business owner is fully engaged in the business and the valuation of the business is directly related to the benefits that can be extracted from the business.

As an example, let’s assume that a business made 50,000 after tax, with tax of 12,500, interest costs of 10,000 and depreciation of 5,000, the owners salary taken from the business amounted to 50,000 and the spouse/children also had combined salaries of 40,000.

In this example the owners’ benefits would be reworked as showing 167,500 with a multiple applied coming to a business valuation, E.g., 3x would imply a valuation of 502,500.

The questions that will naturally arise, surround the add backs. Explanation as follows...

Tax added back – The logic being is that the owner can effectively take the profits out of the business, whether that is by salary, left in the business or taken by a dividend it is all the same. Tax will need to be paid by the owner. If you were applying for a job, you wouldn’t apply for a ‘Net’ salary after tax but for a Gross salary. This rework puts the earnings back into a Gross state.

Interest costs added back – Interest is related to the financing of the business. If there was no debt then there would be no interest. The calculation reworks back to this no financing as a basis (Apples with Apples basis as different owners would have different requirements as to financing and it would be different over longer periods of time). If finance is required to purchase the business, then it is a consideration for the ability of the business to pay going forward but is not consider as part of this valuation method.

Depreciation added back – This is somewhat more contentious. Assets of some form are required to sustain continuing operations. This is even more relevant in business with high capital equipment requirements such as say trucking or hire businesses. Hence, where material consideration needs to be made of future asset requirements and how these will be funded and the impact on the income statement. As with the trucking example if the average expected life is (say) 5 years then the business logically needs to incur 20% (1/5th) of the cost per annum as depreciation, some businesses can ‘sweat’ their capital equipment and as a new owner you could have numerous end of economic life assets that require replacing. In numerous small businesses (primarily more service related) the capital asset requirements are far less significant and most replacements being written off as maintenance expenses. Hence, where depreciation is added back it should be logically analysed.

Owners’ salary added back – The normal assumption in small businesses is that the owner is a full-time worker, hence owners’ benefits is a combination of that working salary and any profits. If any prospective purchaser does not wish to be fully engaged in the business, then provision should be made for additional salary costs.

Spouse/Children salaries added back – These need to be assessed whether they actual undertake productive work or used more as a tax efficient method to spread the business profits. If they undertake work that requires replacement then this has to be factored into the costs of the business going forward.

A worked example on this website can be found by clicking here

Asset approach - Fair Market Value (FMV)

The asset approach to valuation has some validity in cases where the business has a large underlying base of assets that generate current and future profitability. As examples consider a market gardener or plant nursery that has large levels of stock or ownership of the underlying land.

Following on from the previous example of a plant nursery the actual business if it leases the land would be valued and the freehold land would be valued at its fair market value. The two combined would form the valuation and in some circumstances the previous owner my hold the land and lease it to the purchaser of the business element.

Generally, all businesses purchased have the underlying assets fair market valued simply as they become the registered amounts in the new businesses balance sheet and have implications for tax and (where relevant) lending purposes to the buyer and seller.

Lastly, the fair market value of assets in the business are not necessarily the same as the written down book value shown in the business accounts. Just like with a stock take each item needs to be counted/appraised/evaluated as to its value. Asset registers for instance can be full of assets that simply do not (now) exist within the business, once I counted there were 3 mobile phones for every employee of a particular company.

Asset Liquidation value – (LV)

This methodology is primarily more for businesses that have stopped trading, and it’s a matter of selling off the residual assets of the business.

I’m sure you’ve seen liquidation stocks for sale, the numerous office and equipment items put up for public auction.

The difference between fair market value and liquidation value can be quite significant. Stock for instance at fair market value is likely to be the wholesale price, whereas the liquidation value can be part of a group lot and include shop soiled items etc, so potentially 10% of wholesale.

Liquidation value includes the cost of disposal, so will 'always' be lower than fair market value which assumes generally a going concern basis.

Gross Revenues – Fee Income multiple

This is an income-based approach to business valuation based on revenues. It is more prevalent in businesses that are service orientated with less in the way of capital assets and stock/manufacture.

As an example, within the Accounting profession practices are often sold as blocks of client fees for a designated multiple. Depending on the quality and demand the fee blocks can be sold for differing multiples. A retiring partner for instance may sell to another partner a fee block. As a broad range the blocks of fees / entire practices can sell from 0.8x to 1.2x.

Another example is websites with advertising that can sell up to 40x the monthly advertising revenue. The basis once again is there is limited costs with ongoing site maintenance.

Discounted Cashflow (DCF)

This basis of valuation is generally orientated towards use by larger scale businesses in terms of allocating capital to differing investment options. Effectively outflows and inflows of cash are ‘discounted’ depending on their time horizons by a respective rate of the cost of capital.

Given that small business valuations are based on recovery of the initial purchase costs over a short time horizon and that the future cashflows are determined by the purchaser then the DCF methodology isn’t generally used.

Owner / buyer Assessment

Ultimately a business has a value that two parties agree to. In some circumstances the value offered or required can be subjective and arbitrary. As an example, as a buyer if you wish to purchase another competitor for economies of scale/synergies etc then you may offer an amount outside the normal range especially if the potential seller isn’t particularly motivated to sell.

Another example is a large corporation buying out a small business which is competing on price and forcing the larger corporation to follow suit. On a market share and margin retention basis the small business was bought out for a considerable sum in excess of its logical ‘market worth’.

Owner / Buyer assessments are in reality a function of bargaining strength, otherwise the preceding methods of business valuation will come into play.

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