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What is your business worth? You might need to determine this value for a number of reasons, not the least of which is when you’re seeking investors or other types of small business financing. That’s the job of business valuation methods.
A common way of answering this question is by taking a look at your balance sheet, which will give you the “book value” of your business, or total equity (which is what your business is worth at a given moment in time). In truth, however, your business’s book value is just one of many business valuation methods out there, all of which take different factors into consideration.
Here, we’ll teach you about the three major methods all entrepreneurs should know—market value, asset-based, and ROI-based valuation methods—plus four more formulas, which are a bit more specific.
Even if you hire a broker to value your business, it’s important to understand how these calculations work. So let’s dive deeper into these major business valuation methods.
Before we dive into the details on the different types of valuation methods, we’ll need to solidify what exactly a business valuation is.
Put simply, all methods are ways to determine how much your business is currently worth. Included in these calculations are the values of your equipment, inventory, property, liquid assets, and anything else of economic worth that your company owns. Other factors that might come into play are your management structure, projected earnings, share price, revenue, and more.
Different methods will come in handy in multiple scenarios. Of course, you’ll need to use them if you’re in the process of selling your business. However, you’ll also need to consult them for other situations, such as establishing partner ownership percentages, when seeking financing, or even in divorce proceedings.
As we mentioned, there are many methods out there. The best valuation approach typically depends upon why the valuation is needed, the size of your business, your industry, and other factors. For instance, in a sale scenario, the majority of small private firms are sold as asset sales, while the majority of middle-market transactions involve the sale of equity. These scenarios would necessitate different approaches to business valuation.
Keep in mind that both business owners and buyers should hire brokers to assist in this process, as they can give you the most objective business valuation possible.
There are many kinds of methods out there, and some will serve you better than others, depending on your situation. That said, the following three business valuation methods are fairly standard, and all entrepreneurs should have them in their tool belt.
A market value business valuation formula is perhaps the most subjective approach to measuring a business’s worth: This method reaches the value of your business by comparing it to similar businesses that have sold. Of course, this method only works for businesses that can access sufficient market data on their competitors. It’ll be a particularly challenging approach for sole proprietors, for instance, because it’s difficult to find comparative data. You won’t have a public database to go by.
As this small business valuation approach is relatively imprecise, your business’s worth will ultimately be based on a negotiation, especially if you’re selling your business or seeking an investor. You may be able to convince a buyer of your business’s worth based on immeasurable factors, but a savvy investor can see through that.
All that said, this valuation method is a good preliminary approach to gain an understanding of what your business might be worth, but you may want to bring another approach to the negotiation table. That brings us to the asset- and ROI-based approaches.
Next up are asset-based business valuation methods. As the name suggests, these approaches consider your business’s total net asset value, minus the value of its total liabilities, according to your balance sheet.
There are two main ways to approach asset-based business valuation methods:
Businesses that plan to continue (i.e., not be liquidated), and that none of its assets will be sold off immediately, should use the going-concern approach to an asset-based business valuation. This formula takes into account the business’s current total equity (or assets minus liabilities).
On the other hand, the liquidation value asset-based approach to valuation is based on the assumption that the business is finished and its assets will be liquidated. The net amount is what would be realized if the business is terminated and its assets sold off. The value of its assets will likely be lower than usual, because liquidation value often amounts to be much less than fair market value.
The liquidation value asset-based business valuation method operates with a sort of urgency that other formulas don’t necessarily take into account.
Let’s take a look at ROI-based business valuation methods from a very practical standpoint. When you’re considering investing in something, what is your primary concern? Probably, it’s your return on that investment, or ROI. If you buy stock in a company, you want a return. But what’s considered a “good” ROI ultimately depends on the market, which is why business valuation is so subjective.
To see the ROI-based method in action, let’s take a look at the TV show “Shark Tank.” (You can learn a lot about business valuation from watching this show if you pay attention.)
The first thing a “Shark Tank” contestant does when they come on the show is tell the sharks how much of an investment they’re seeking, and what percentage of their company they’re willing to give up in exchange. At that very moment, they are valuing their business.
Notice the sharks immediately write something on their pads. Although viewers never see their pads, it’s likely that, in most cases, they’re writing down the valuation at 100%.
The math here is simple: Divide the amount desired by the percentage offered, and you have the business valuation at 100%. So if you ask for $250,000 in exchange for 25% of your business, then you’re valuing your business at $1 million. And with that simple statement, you’ve performed a mini-valuation right on the spot.
Still, if you’re using the ROI approach to seek investors or buyers, you’ll still need to convince those investors or buyers of this valuation. Here’s what the sharks need to know in the end:
All of these questions will inform an ROI-based business valuation. If you want to learn more about this method, watch the short video posted below.
The three methods we mentioned above are important umbrella approaches to understand. But as we also mentioned, there are several ways to approach small business valuation, and what works for one business may not work for yours.
Because we always favor more knowledge over less, here are a few additional methods you might want to learn:
Now that you have a basic understanding of the seven major business valuations, which method will you choose for your situation?
First, remember that it is not an exact science, and the method that works for your friend’s business might not work for you. What worked for your business in the past might not even work for you now. Factors like the size of your business, your growth rate, your industry, your stability, your profitability, and the reason why you need a valuation in the first place will all affect which method you choose.
Whether you’re a tiny small business or big small business, a new business or a well-established business, you’re likely to find your best method of determining your business’s value in one (or more) of these seven options. Also regardless of your business’s situation, you should absolutely hire a business valuation expert. That way, you’ll get the most accurate possible calculation of your business’s worth.