Paul Horton: Business Valuation Lawyer

If you’re thinking about selling your business, you need to know the different business valuation methods in order to get the best price possible.

First of all, you’ll need to know how much your business is worth so that you have an idea of where to set the asking price. With the rise of Internet databases and more readily available information on comparable business sales, valuing a business involves more accuracy and less guess work, but it’s still not a precise science and there is lots of room for divergent valuations.

There are several different methods of valuating a business, each of which takes a different perspective when looking at the business’s value. While there’s no “right” valuation method, if you calculate poorly, or decide to use your own methodology, you could certainly end up with several “wrong” prices and end up with the short end of the stick.

Business Valuation Methods

The three most common and basic approaches to business valuation are the following:

The Income-based Approach: This approach is most commonly used, and focuses on the amount of money a business generates for its owner. This method looks to the cash that flows into the business and accounts for things such as debt owed.
The Market-based Approach: This approach looks to other businesses in the same or similar industry that have been sold and bases your sale price on the average of other business. This approach can be risky, however, because it may not capture the true value of your business. For example, perhaps the other businesses have sold at low prices because their owners failed to value the business properly, resulting in a domino effect on businesses in the area.
The Asset-based Approach: This approach simply looks at the individual assets and bases the price of the business on the fair market value of the assets. The drawback of this method is that it doesn’t account adequately for intangible assets such as a business’s goodwill or forecasts of future revenue.

The Method of Multiple of Discretionary Earnings

The income based approach has several subsets that appraisers use to valuate a business. The most common, particularly for small businesses, is called the “Multiple of Discretionary Earnings” method. Discretionary earnings are simply your pretax earnings, salary, depreciation, and other expenses.

There are two steps in the Multiple of Discretionary Earnings method. Step one is to calculate the business’ discretionary earnings for the next several years. You can take your most recent earnings and estimate what’s likely to happen going forward or you can average your last several years and use that figure.

Step two is to multiply your figure by anywhere from 0 to 3. An average for most small businesses would be between 1.5 (higher for businesses that perform above average). This multiplied figure accounts for the tangible business assets that the business will use going forward. For example, if you calculate your discretionary earnings to be $50,000 and the business performs above average, you might multiply the figure by two, to reach a value of $100,000.

Other Business Valuation Factors to Consider

While the above methods factor in tangible assets and revenue forecasts, don’t forget about intangible issues such as customer goodwill (the customer loyalty and good reputation the business has engendered over the years). Assuming you have a high level of goodwill, you should be comfortable asking for the high end of your price range.

There are other factors individual to business owners. If you need cash badly and simply want to sell, you’ll probably have to be content with a lower price and quick sale. On the other hand, if selling to someone who shares your vision and affinity for the business is important, you may have to wait for the right buyer. Additionally, depending on the market and economic climate, you may be able to sell for higher or be forced to sell at lower than fair market value.