One of the most difficult tasks an entrepreneur has during a round of financing is calculating the business’ valuation.
It truly can be an art. In which can spur negative outcomes for the future of your business if not done properly.
There are 8 common methods of putting a price tag on your business:
- The First Chicago Method
- The DCF
- Asset-Based Valuations (Book Value or Liquidation Value)
- Market and Transaction Comparable
- Venture Capital Method (this method calculate valuation based on expected rates of return)
- Scorecard Valuation Method (fixes the median pre-money valuation for startup deals in a certain region)
- Berkus Method (considers a range of dollar values to the progress startup made by entrepreneurs)
- Risk Factor Summation Method (compares characteristics of the target business to what may be expected in a fundable startup company)
While these methods can seem a bit intimidating at first glance, don’t worry, we plan to simplify the process for you by offering a step by step instruction of how to value a business.
What this list is supposed to do is show you that there are a number of ways to value your startup. Despite what other businesses may say, there are actually tangible equations for investment round pricing.
On top of that, it’s important to notice which methods are pre-money valuation and which one are post-money valuation.
Let’s start with that first.
What’s the Difference Between Pre-Money Valuation and Post-Money Valuation?
Pre-money valuation is common in investing circles.
It refers to the amount of value that is assigned to the company before the investment coin comes in. It’s usually used as a point of reference to figure out the amount of equity new investors will receive in a startup.
Post-money valuation, on the other hand, is a company’s overall value once outside financing or capital injections are included to the balance sheet. It refers to a company’s valuation once new investments derived from venture capitalists or investors have arrived to the enterprise.
Usually, using the pre-money valuation method is more common than the post-money method. This is because the value of the equity already existing is not lowered based on the amount of capital funders are able to raise.
The best way to establish a valuation is to understand what the market is giving your competitors, back when they were at the same financing stage that you’re at now.
There are a number of sites you can use in order to track these transactions.
If you’re looking to value a business yourself, we’ve included an easy-to-follow 3-step plan.
Let’s get into the meat of it.
How to Value a Business By Yourself
Performing a business valuation by yourself can be complex, and depending on your level of understanding, may not represent the exact price you’ll be selling your business for.
If you’re looking for a simple estimate in terms of the potential price of your business, try using a free business valuation calculator.
This will give you an estimate of your business’ value based on current sales, your specific industry and your current profit.
If you’re looking for a step up and hoping to know how much your business is worth through the eyes of a professional business broker, you can contact Business Exits.
This team allows business owners who are planning on selling their business to receive a business valuation for free.
However, if you want to calculate your business’ value manually, follow the steps listed below.
This will of course still be an estimate; however, it will give you a more in-depth look as opposed to an online calculator, and you’ll be able to practice the ins and outs of the process yourself.
1. Calculate Your Seller’s Discretionary Earnings (SDE)
Many experts agree that the first main point for valuing a business is to normalize the business’ earnings in order to receive a Seller’s Discretionary Earnings number, or SDE.
This number is the pre-tax earnings your business receives before any non-cash expenses, interest expense, owner’s compensation, one-time expense or expense and income that aren’t expected to continue into the future.
Businesses’ report expenses on their tax returns in hopes to reduce their tax load.
In other words, more than likely, you’ll claim a lot of deductions that actually lower your business’ income on your tax return.
Using numbers from a business’ tax return can potentially underestimate the amount of revenue your business produces in reality.
SDE provides a clearer idea of your business’ real value potential by calculating what the business’ earnings would be with a brand-new buyer.
Re-adding the expenses listed on your tax return that aren’t used to run your business is the first step to this process.
This involves your salary as the primary business owner along with any one-time expenses that hold zero possibility of returning in the future.
Here’s a list of examples of items that would be included back into the income shown on your business’ tax return in order to calculate SDE:
By understanding how an SDE works, you’ll be understanding the first step towards how to value a business.
2. Figure Out Your SDE Multiplier
Typically, businesses sell for between 1 and 4 times what their SDE calculation is.
This is referred to as the “multiplier” or “SDE multiple”. Retrieving the proper SDE multiple is more of a learned art than a studied science due to how much it varies.
These variables are based on:
You can think of the specific business multiplier and the industry standard multiplier as two different numbers.
One number gives you a general value, taking into consideration the industry averages. The other number provides a more specific value, based on the variable factors of individuals businesses.
The largest factors that influence the multiplier is typically industry outlook and owner risk. If your business greatly depends on you or another owner, it can’t be transferred to a new owner easily, and therefore the business’ valuation will suffer.
However, if you’re planning on selling a business in an area that’s expected to grow in the future, your SDE multiple will turn out much higher.
To figure out your SDE multiple, you can read up on BizBuySell’s quarterly report.
BizBuySell offers SDE multiples for various industries based on cash flow and business revenue.
You may also consider consulting a business broker or appraiser for a more personalized multiplier estimate for your business.
These assets are physical goods that are owned by the business, which hold value. A few examples of a tangible asset would be real estate, cash on hand and accounts/receivables.
These assets are typically not included in the multiplier.
If you’re purchasing them, every tangible asset should be included into the valuation separately.
These assets are non-physical which contain a value for a certain business need.
These may include trademarks, reputation, goodwill and patents.
These intangible assets are included in the SDE multiple since they’re usually only sold if the business’ assets are sold.
3. + Business Assets & - Business Liabilities
This is the last step of how to value a business: accounting for liabilities and business assets that aren’t included in the SDE already.
The majority of business sales, mostly small business sales, obtain the legal structure of an “asset sale”.
This means that the buyer is purchasing the intangible and tangible items that form the business into what it is.
Usually, the seller keeps liabilities, but terms vary from situation to situation, depending on the sale.
How to Value A Business: The Best Way
While these points are important in understanding how to value a business. And may be useful if you’re looking to try it yourself. The best way to value a business is to look to the market.
As we mentioned earlier, check to see what the market is paying for your competitors. If they’re at the same financing stage as you now.
By establishing your own valuation through your competitors’ market-based valuation. You will be making it difficult for investors to over quote your valuation. This is how to value a business to bring your price down in order to gain more equity for their own investment.
Taking charge and understanding the value of your business through your own research. Also help you understand the market a bit better which in turn and keep you ahead of the game.