Trends in Small Business Valuation

by | Sales and marketing

So what’s your company worth?

If you’re not sure, you have plenty of company. Putting a realistic market value on your business involves a skill set and a degree of experience most small business owners don’t possess.

Valuation involves a certain balance of art and science. What your company does, where and how well it does it, and numerous external factors all come into play.

Why put a Value on Your Business?

Most small business owners think of business valuation in terms of what they might receive for the company of they decide to sell. But there are other reasons for determining your business’s worth. A business valuation can help you:

  • Facilitate estate planning
  •  Conduct partner buy-outs or buy-ins
  •  Attract investor capital
  •  Arrange bank financing and lines of credit
  •  Resolve family disputes

But having established these other scenarios, if you are thinking of selling or testing the waters, the environment for doing so seems to be getting better. An improving economy always signals an increase in merger and acquisition activity. Additionally, a report by Pitchbook, a research firm which tracks private equity activity, shows that 30% of private acquisitions closed in late 2012 involved transactions valued at less than $25 million, so there’s considerable interest in small and medium-market deals.

How Small Business Valuation Works

Ultimately, your business is worth whatever you can get someone to pay for it. But how do you know what’s a reasonable or fair offer?

You should definitely seek the advice of a qualified business appraiser (your banker or accountant can refer you) when attempting to put a market value on your company, but here’s an overview of the valuation method you’ll likely encounter.

The Earnings Multiplier Valuation Method

In a perfect world, you could determine a price for your company by just comparing it to the prices of similar, but publicly-held businesses that were recently sold under similar circumstances. You could calculate an average price/earnings ratio for the recent transactions, and apply it to the pre-tax earnings of your company to arrive at a price.

Example: If recent transactions show that companies in your industry have sold at 4.5 times earnings, and your company earns $900 thousand in revenue, a ballpark acquisition number might be just north of $4 million.

The problem with this method is that PE ratios for public companies don’t always make a good apples-to-apples comparison to smaller, closely held companies. (For one thing, running a small business is generally perceived as being much riskier, so a high PE might be irrelevant.)

     This doesn’t mean an earnings multiplier isn’t the way to go – it is, in the case of many small business valuation scenarios – but adjustments need to be made.

     Two questions arise here:

  • What earnings are used in the calculation? Last year’s? An average of the last three years’? A projection of the average of the next five years’?If you’re valuing your company for a possible sale, it’s important to remember that the buyer is purchasing the future, not the past, so a good argument could be made that projected future earnings – usually pre-tax earnings – should be the basis for calculation.
  • What’s the multiplier? That is, what number is multiplied by the expected earnings? Two? Five? Ten? In a selling scenario, this multiplier will vary by industry, the perceived risk in acquiring and running the company, the general state of the economy (weak economies tend to generate lower offers), and how much the buying party wants the company.

Example: Assume your company has projected earnings of $600 thousand dollars for the next three years. (This number will have been discounted from a larger figure by a certain percentage, to accommodate the buyer for the “time value” of his money.) Then assume that you and the buyer have agreed to a multiplier of 2.5.

$600 thousand x 2.5 = $1.5 million.

So according to the earnings multiplier method, your company would be valued somewhere near $1.5 million. The final number would be negotiated between you and the buyer.

A Word of Caution about Business Valuation

Business valuations and business sales are very complex. This information illustrates a very basic approach to determining what a company might be worth.

Every situation is different and can be effected by dozens of factors that aren’t addressed here.

The main thing to remember is that for established small businesses, the trend toward the earnings multiplier method of valuation appears to be here to stay. If you’re preparing for a valuation or sale, work with our accountant or financial adviser to make sure you’re familiar with the principles involved, and how they’ll impact your situation.

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