If you are thinking of selling or buying a small business, one of the top priorities will be valuing the business correctly.
Many factors will affect the market value of a small business. When you put your small business up for sale, you and your advisors must consider what method to use for its valuation.
There are four common methods used to value a business: market-based, asset-based, ROI-based, and expected future earnings-based valuation. You should seek expert advice to find out which method is most accurate for your small business.
When buying or selling a small business, all parties need to consider how a business is valued to ensure they get a good deal. From selling a local cafe business to purchasing your very own side hustle, valuation methods are critical to getting a fair deal.
This article will discuss the common small business valuation methods and how they work. Read on to learn all about it!
Table of Contents
Why Might I Need a Business Valuation?
A business valuation may be needed in a range of circumstances that require the market value of businesses, securities, or intangible assets to be identified.
Reasons for business valuation include:
- Buying or selling a business
- Changes in ownership/capital structure
- Capital Gains Tax (CGT) rollovers
- Company divestments/acquisitions
- Formation of, entry to or exit from a consolidated group
- Thin capitalisation
- Insurance and risk management
- Succession planning
- Divorce (i.e. division of assets and liabilities)
To successfully and accurately value your business, your accounting professionals will require information about finances and assets, legal information, business profile, procedures, and plans, as well as staff, supplier and customer information.
Several valuation methods could be utilised, with the possibility of combining multiple valuation methods to achieve the final value. Some common methods of valuation use current market values, business asset value, future profit of a business, return on investment, and cost of starting a business from scratch.
What Factors to Consider when Valuing a Business
If you’ve decided it is time to sell your small business, there are several factors you will have to consider first. We have compiled a list of the top five points you should consider before going ahead with the sale:
1. Lease – If your business rents premises, you will need to liaise with your landlord to discuss the state of your lease. You may transfer it to the new owner, or if it is due to expire, they may need to be granted a new lease. If you own your premises, you will need to consider whether to sell it to the new owner or have them lease it from you.
2. Licences – The licences for certain businesses, like restaurants and cafes, are usually included in its sale. You will need to gather all the documentation for your current licences to include in your sale contract.
3. Stock – Will you be including your remaining stock in the sale of your business? If you are, you will need to value your remaining stock and factor that into the contract.
4. Tax Implications – Selling a business can lead to certain taxation complications. This includes calculating GST for the sale price of the business and Capital Gains Tax implications when selling a business. These complicated matters should be discussed with an accountant.
5. Contracts & Suppliers – Your business may have ongoing contracts with suppliers and customers. These may be short-term orders to fulfil or long-term service contracts. You will need to decide if you will transfer these contracts to the new owner or terminate them. Be sure to check with your lawyer regarding the contracts’ specific details, including termination clauses.
6. Business History – Your business’ duration of operation, how it started, its reputation, the condition of the facilities and whether or not its goal has remained the same is important information that will affect your business’ value.
7. Employees – Employee pay rates, morale, job descriptions, and whether or not technical/ specialist skills are required to operate the business. A critical piece of information here is whether or not the business relies on a few people, as this shows which skill sets will serve as the foundation of operation.
8. Legal & Commercial Issues – Nobody wants to purchase a business with pending legal or commercial problems. Involvement in pending legal proceedings, compliance with work, health, safety, and environmental laws, long-term commercial contracts (including their period of validity and value), and whether or not the business has the necessary permits, registrations, and licences will greatly affect value.
9. Goodwill & Intangible Assets – Does the business come with certain intellectual properties, other intangible assets, or goodwill? Depending on the industry, the value of intangible assets can play a major part in the market value of the business.
10. Financial Information – This includes profitability, whether there is working capital and sufficient cash flow, the amount of debt that the cash flow can service, recent annual turnover, whether profit is increasing or decreasing, and the value of key tangible assets. Whether there is enough working capital to pay the dividends of shareholders or not is also important.
Should I Get My Business Professionally Valued?
With the complete information provided, a business valuation by a qualified professional will give the client an objective assessment of the business’ market value under the current conditions.
Such assessment will be critical in deciding the best course of action for your business, including whether it is the right time to sell the business or not.
Not everybody owns their business forever; a good portion of entrepreneurs will sell their business when it has risen in value or profitability has reached stability. This is another instance where a professional business valuation may come in handy — coming up with an exit plan. In addition, the valuation will allow investors to view a ‘snapshot’ of your business, potentially attracting venture capitalists.
Another reason for professional valuation is when considering growing or expanding the business. The insights from a business valuation will show which areas can accommodate expansion and reveal any gaps that could be filled.
Related to this, a professional valuation may also help you secure financing options for your business needs. This can include anything from new equipment or premises to remodelling an existing location.
Other important reasons a professional business valuation may help are insurance, divorce (distribution of assets and liabilities), buying out a partner business, or estate planning or succession.
Who Can Value a Business?
You’ll need to liaise with a licenced business valuation professional to obtain a legally valid valuation. If you need a professional valuation, your accountant or business broker can recommend someone to value your business.
4 Methods of Valuing a Small Business
There are four common methods of valuing a business: market-based valuation, ROI-based valuation, asset-based valuation, and expected future earnings valuation.
We’ll outline each of these methods below.
A market-based valuation will use the historical price of similar, previously sold businesses as a reference for the valuation. This is similar to looking at recently sold homes in your neighbourhood to determine how much your property is worth.
Market-based valuations come in two primary types:
1. Going Market Rate Method: Selling Price = Selling Price of Similar Firms
The ‘going market rate’ method is the more basic approach to market-based valuation. As the name suggests, the only basis for valuation is the “going market rate” of businesses in similar industries and scales.
For instance, if a small start-up cafe sold for $200,000 last month, then market-based valuation suggests a similar cafe business for sale has around the same value. Of course, this only serves as a baseline rather than an exact dollar amount.
2. Revenue Multiplier Method: Selling Price = Turnover x Standard Industry Multiple
The revenue multiplier method is a slightly more complex approach to market-based valuation and one of the most common rules of thumb for valuing businesses. The revenue multiplier is often used in the valuation of professional practices, such as accountants, lawyers, and doctors, among others.
In these industries, a business valuation professional will use an ‘industry multiple’ unique to the industry to estimate a practice’s most probable sale price. The valuation is determined by multiplying the business’s annual turnover by the industry’s multiplier.
ROI Based Valuation: ROI = (Current Value of Investment – Total Cost of Investment) / Cost of Investment
ROI valuation is based on a business’ Return on Investment or ROI. Investment benefits are divided by the business investment’s total cost, resulting in a ratio or percentage. This ROI method refers to the level of internal and external risks associated with a specific business.
The revenue gained in the sale of an investment is referred to as “Current Value of Investment.”
Asset-based valuation is considered the main alternative to market-based valuation. This valuation method looks at the value of business assets and liabilities to calculate its market value.
A business’s current and historical data will need to be examined to perform this style of valuation. This information is usually found in the financial records, which is why these records are so important when selling a small business.
There are a few different ways asset-based valuation can be calculated:
1. Book value – Values the business based on the value of all assets in its possession. This covers both tangible (stock, equipment, vehicles, furniture, etc.) and intangible items (intellectual property rights, etc.).
2. Adjusted book (net asset) – This method looks at the business’s historical account data. In this method, valuers will adjust the initial book value to consider any increase or decrease in value. Both assets and liabilities are revalued to reflect their current perceived worth.
3. Liquidation value – In some cases, prospective buyers have no intention of keeping the business intact. Instead, they may plan to liquidate it and sell the business assets, hopefully at a profit. With this in mind, the liquidation value of a business looks at the price at which assets are likely to be sold.
4. Replacement value – Replacement value refers to the cost of purchasing the business’ assets from scratch. The current market cost of all the business’ tangible assets is added to achieve a valuation.
Expected Future Earnings Valuation
Expected Future Earnings Valuation: Selling Price = Net Annual Profit / ROI
This is also known as the earnings-based or cash flow valuation. The business value is calculated based on the potential growth of a business, rather than historical financial data.
In this method, the future earning power of a business is given paramount importance. The selling price is calculated by dividing the business’ net annual profit by its ROI.
However, values based on a company’s future performance are complex, since it requires carefully calculated projections. Expected future earnings valuation needs to be calculated to a very high standard by an experienced professional, especially when potential buyers or investors need to agree with the valuation.
How Do I Value a Small Business’s Assets?
There are three types of assets that require different methods of valuation. These are current or short-term assets (tangible), non-current or fixed assets (tangible), and intangible assets.
- Valuing Current (Short-Term) Assets – Included are inventory, accounts receivable, and other assets that are ‘liquid’. Liquid assets can be reasonably expected to be converted into cash in 12 months. To value these, a licensed business valuation specialist will review the business’ on-hand trading stock or inventory and balance sheet.
- Valuing Non-Current (Fixed) Assets – Long-term or permanent business assets include buildings, land, machinery and plant, tools, computer equipment, and motor vehicles. These are typically valued by deducting the accumulated depreciation from the original acquisition cost. The depreciated value of an asset may sometimes be different to its market value, so this is something to keep in mind.
- Valuing Intangible Assets – Intangible assets include copyrights, patents, goodwill, intellectual property (IP), and customer lists. Valuation for intangible assets is the most difficult, so seeking professional help is highly recommended.
How Can I Increase the Market Value of my Business?
If you’re planning to sell your small business, you may be wondering what you can do to improve its market value in advance.
Three ways to increase the market value of a business include:
- Reducing risk – Features of risky businesses include short leases, leases with a demolition clause, declining net profit, and poorly maintained premises, among others. Mitigating and minimising risk adds value to the business on paper and makes it more appealing to buyers.
- Improving the bottom line – Business owners can improve their financials through the optimisation of wage cost percentages and the gross profit percentage. Consulting a business accountant to understand your current numbers can help you find the best way to achieve this.
- Growing the business – active advertising through wide-reaching mediums such as social media can help exponentially grow your business’s customer base. A ‘dry’ social media page could be seen as an indicator of a failing business, so an active social media strategy is a great investment if you’re planning to sell.
Where can I Find Business Valuation Multiples by Industry for Australia?
Business valuation is complex, especially when using market-based methods, and there is no standard set of multiples used. Consulting with a licensed business valuation professional is the best way to ensure your small business is valued appropriately.
This article is provided as general information only and does not consider your specific situation, objectives or needs. WealthVisory makes no warranties about the ongoing completeness or accuracy of this information. It does not represent financial advice upon which any person may act. Implementation and suitability requires a detailed analysis of your specific circumstances.
Aaron is a Chartered Accountant with over 15 years experience in the accounting industry. Aaron has been able to provide advice around structuring, cashflow, tax compliance and working with clients to develop strategies.