How to Calculate the Value of a California Small Business?
When you want to sell your California small business, the first of many steps is to calculate business value. You don’t have to be a business appraiser or an accountant to do it, but there are important concepts to understand, so you are comfortable with the process and the outcome.
What’s important is to have a strategy. Selling a small business is a complex process, and without an in-depth plan, you can leave money on the table. Understanding the steps it takes and getting assistance from the right professionals will help you avoid this loss.
With the assistance of a business broker, you can sell your small business to strategic buyers. First, you will have to determine and understand the steps of selling a California small business:
- State the reasons for leaving and how
- Find out the value of your small business.
- Grow and continue to increase your small business value.
- Make available all your financial statements and business documents.
- Find motivated buyers to acquire your small business.
- Get an agreement in place with the buyer.
- Sign the contract.
- Shift your small business to the new owner.
The Business Valuation Process
Most business owners have a number in their heads of what they think their small business is worth. However, many times, the small business owner will have it wrong because they do not have the training, which is not part of their expertise.
Also, bear in mind that a qualified and motivated buyer will have their own opinion. If a buyer needs to get finance from a third party, the lender will also have an opinion which they will confirm as part of their loan underwriting process.
There are three ways you can get a report on the value of your business.
Broker Opinion of Value
Also known as a Broker’s Price Opinion (BPO), a Broker’s Opinion of Value involves a licensed business broker coming in to do a third-party evaluation of your small business to find the Most Probable Selling Price (MPSP).
They do so by using market data, the financial statements of your business, analyzing costs and assets, and researching and comparing your business’s income against what businesses have sold in the industry of your business.
As part of the Broker’s Opinion of Value, they will use different approaches to value a business. There are only three approaches, and these are:
- Income approach
- Market approach
- Asset approach
Conclusion of Value or Short Report
For more formal situations or valuations that a court of law is not using, you may require a deeper analysis of the business and what is happening in the business industry. This report is more detailed than a BOV.
Business Appraisal or Full Report
For legal transactions and litigation, you will need a complete report of your business. This is called a business appraisal or full report and is usually in response to demands from the IRS or a court of law, such as divorce, etc.
Beyond the value of your business, it also details the calculations used to determine that value and the steps taken to make those calculations.
The person who performs this appraisal needs to comply with both the Uniform Standards of Professional Appraisal Practice of the Appraisal Foundation (USPAP) and the Business Appraisal Standards of the Institute of Business Appraisers for their appraisal to hold any kind of authority.
Now that you know about the different business valuation reports, let’s look at the best ways to calculate the business value. Your business broker will handle this entire process, but to get the process started, they will need the following documents:
- The tax returns of the business for the last 3 or 4 years.
- A current Year To Date (YTD) Profit and Loss for the business.
- A recent Balance Sheet.
The appraiser will have questions of the business owner as they have knowledge that is an important part of the business value.
First: SDE or EBITDA of the Business
The first part of calculating the business value is determining the cash flow or Net Income the business is generating for the last 3 or 4 years. Your business broker will do this step for you as it must be accurate, or the business valuation will be wrong.
With the cash flow or Net Income of the business determined, the business broker will use this to calculate the all-important Seller’s Discretionary Earnings (SDE) or Earnings Before Interest, Tax, Depreciation, and Amortization (EBITDA.)
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Second: Do At Least Three Calculations Using Different Methods
With the SDE or EBITDA identified, the business broker will then use the approaches described earlier, Income approach, Market approach, or Asset approach to come up with at least calculations, so they guide the value of the business. It would be incorrect to apply just one or two methods as this also could distort the final value of the small business.
Third: Determine the Final Business Valuation
After the business broker has done at least three calculations, the final business value is determined. This includes putting weight on each calculation as the business broker may consider one valuation method being more relevant than another.
For example, the valuation method I think is one of the more important methods is the Market approach. This method looks at what other businesses in the same industry have previously sold. That is, if the business is a manufacturing business, it makes sense to see what other manufacturing businesses have sold over the years that generate about the same gross revenue and SDE or EBITDA.
Typically the business broker needs to buy this privately held database of information as it is not publicly available.
Get the Best Selling Price for your Company
In addition to the Market method, here are six different methods to calculate the value of a business. There are others, but be careful which ones are used as the wrong valuation method can distort or provide an incorrect final business value. Also, each has its advantages depending on the type of business you own or, as explained below, some of these methods should only be used under certain circumstances.
This business value calculator involves taking a company’s stock shares and using them to determine the business value. To calculate it, you multiply the number of stocks owned on the market by their value.
For example, if you have 100 stocks outstanding and they’re valued at $1 per share, then your company would be worth $100 using this method.
This method compares future earnings to cash flow to determine a company’s value based on profit. It also accounts for interest rates and future investments consistent with the company’s current model.
Discounted Cash Flow Method
The Discounted Cash Flow (DCF) method is the same as the Earnings Multiplier. Still, it takes inflation into account and projects the business’s future earnings to suggest its current value. Inflation will affect a company’s value, so this is a more specific depiction of a company’s future value.
Times Revenue Method
For businesses with significant revenue streams for their market, this might be one of the methods of finding the value of the business. It is typically used only by companies with a large gross revenue, say over $50 million per year, or a publicly traded company. A business does not typically use it in the Lower Middle Market or Main Street.
The calculation in this method is to take revenue during a certain period (one year, six months) and multiply that by various market factors. After these calculations, you will have a value based on your revenue (i.e., 5X revenue or 0.5X revenue).
The Book Value
The book value of your company is one of the more straightforward methods for finding business value. You can find it by subtracting your total liabilities from the company’s assets. Hopefully, this method is not used to calculate the value of your business, as this valuation method does not take into account the goodwill your business should have generated.
This is one of the most cut-throat ways to evaluate a business and, once again, not a valuation method you want to be used in your business valuation. A business typically uses this method when it is shutting down and closing its doors. After all the assets of the business have been valued and liquidated, the business close.
Ready your Small Business for Sale
Before you begin your business valuation, bear in mind that with time, the value will no longer be accepted as the business gross revenue and /or expenses will change. Doing things like getting your financial statements in order, understanding your profitability, and going through consultation with Andrew Rogerson, California certified business broker can all add value.
As you can see, the process of valuing and then selling a small business is very involved. The best solution is to hire a business broker to help make the transition as smooth as possible. They’ll also help you sell and exit your small business successfully so you can leave your company privately with no drama or complications and, most important of all, move onto the next phase of your life.
Get started with understanding the 7 steps in valuing your small business.