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The 3 Key Methods of Small Business Valuation

#business accounting#business valuation#tips for business owners

Written by prositesfinancialAug 26 • 3 minute read

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Whether you’ve already decided to sell your business, or just want to keep your cards on the table for the future, having a good idea of what your business is worth is important. Any sale of a business comes with lots of questions and choices and deciding on the value of the business is the foundational element of the transaction.

There are several methods for determining the value of a company. The level at which you choose to value your business will vary depending on which method you utilize. Studying the basics of small business evaluation helps you get a fair price for your business when you sell it. Of course, a business evaluation will only give you an estimate of the value of your business. When it gets closer to the time to sell your business, you’ll want to seek out the services of a professional appraiser to get a more precise valuation.

Small Business Valuation Methods

Most valuation methods for establishing the value of a company involve looking at your business’s financial records and cash projections. These items help buyers know they are making a sound investment that will be profitable for them in the future. In general, there are three key methods of business valuation.

1. Asset-Based Valuation

This first method evaluates your business based on its assets and liabilities. Asset-based valuation calculates the value of your business by subtracting liabilities from assets to find the difference.

This method looks at your business as a collection of smaller components. Some of these components contribute value, while others take it away. The items that subtract value are the liabilities, while the items that contribute value are assets. Debts are liabilities, as they have an outstanding claim on any future revenue the company generates.

For example, a business with a total of $500,000 in assets, and a total of $250,000 in liabilities would be given a book value of $250,000 using the asset-based valuation model. This simple calculation gives you the book value. The book value is the owner’s equity on the balance sheet and is the lowest price you should be willing to accept for your business. By eliminating debts and increasing assets, you can increase your business’s book value.

If you need a quick sale of your business, you might consider using the asset-based valuation method. If you are selling the business to pay off debts, this method will allow you to do so quickly, saving time and money in the process.

However, if you are selling a very healthy business with excellent asset value and little debt value, this model may not make much sense, as you could sell your healthy business for much more than its book value.

2. Market-Based Valuation

This method of business valuation looks at similar businesses that have already sold and compares them to your business. To get an idea of how market valuation works, look up data on the sale prices of comparable businesses. For example, let’s say you own a coffee shop. Coffee shops similar to yours in your city have recently sold for an average of $300,000. Using the market valuation method, you would try to sell your business for around $300,000.

This method of business valuation is based on the idea of fair market value. Fair market value means the net worth of your business is whatever buyers are willing to pay. You increase or decrease the price you are asking for your business based on the going market rate.

3. Income-Based Valuation

This third business valuation model evaluates your business based on its financial history. It uses your accounting records to demonstrate that your business is both a low-risk and profitable investment.

It is important to establish that your business can be profitable with low risk for many reasons. Some buyers will take out a small business loan to purchase your business, and they need to be able to show that the business they are buying will generate enough of a profit to repay the loan in full and on time. If your business has a strong track record of profit and debt repayment, it will look better on paper in this situation, which could result in a higher valuation.

The income method will look at past profits and cash flow. It will utilize a profit and loss statement to calculate estimated future profits and debts the business will generate. With these calculations, you can find out what your business is worth based on the income valuation model. For instance, if you find the business will generate a net profit of $200,000 soon based on the average of the net profits from previous years, you would then try to sell the business for $200,000.

Inspire Your Business Valuation

By keeping excellent records, reducing debts and increasing assets while competing favorably with other similar businesses, you can help your business achieve a better valuation. Buyers will also come to the table with their views on what a business is worth, and negotiations will follow. Knowing the value of your company is the first step towards a successful business sale negotiation. Of course, remember to consult with a professional appraiser before trying to sell your business, so you can be sure you are asking for a price that is fair for all parties involved.

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