Keys to Determine the Value of a Small Business
To determine the value of a small business, whether if this is your first business, or if you run a family-owned and operated business, there are a few key steps to approach valuation as objectively as possible.
Step 1: Understand Key Valuation Terms
One of the key terms you should know is EBITDA, which stands for Earnings Before Interest, Taxes, Depreciation, and Amortization—essentially, it is the net profit of a business.
Now that you are aware of EBITDA, the other important term to know is SDE, which is an acronym for Seller’s Discretionary Earnings. SDE is used to determine the true value of a business for a potential new owner, where you will add in the current owner’s salary or assumed a sum that they would earn in the current market environment.
Generally speaking, small business owners use SDE whereas large businesses use EBITDA calculations to value their businesses.
Step 2: Prepare Financial Documents
Before you start the process of valuing your business either by yourself or through the professional services of a business valuation specialist, it is critical that you first prepare your business’ financial documents.
These are some of the financial documents that you will need to have in order:
Last 3 to 5 years financial statements (Balance Sheet and Profit and Loss)
Current year financial statements to date
Annual tax returns for the past 3 to 5 years
Step 3: Make a Detailed Report of Your Business Assets and Liabilities
Essentially business assets include anything that adds value to your business. It can either be tangible or intangible.
Examples of tangible assets:
Real estate or property
Equipment or means of production
Inventory or stock
Cash on hand
Examples of intangible assets:
Patents, copyrights, and trademarks
Customer subscriber base
Brand and reputation
Liabilities include any debt or outstanding credit on your business’ books, and they subtract the overall value of a business. Liabilities can include:
Step 4: Research Your Industry
Familiarity with your industry is crucial for both buyers and sellers. Before buyers can confidently make an offer on a business, they’ll need to become well-versed (if not an expert) on that business’s industry. On the sell side, a deep understanding of your industry’s trends can help you reach an informed valuation that reflects your business assets as well as the current market.
As we mentioned earlier, a business’s SDE multiple—and the method of valuation—varies according to a few factors, including the strength of the industry. So, sellers should find out as much as they can about companies that are similar in size, business model, and revenue, if that information is available.
Sales of a comparable business within the same industry will provide good insights and a benchmark as to how much you can sell your business for. It will also help you to assess your market share and growth potential, which you can utilise that information to demonstrate to potential buyers what makes your business stand out.
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