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Valuation Methods for Small Businesses

November 8, 2024 By Lesley W. Bennett

There are numerous reasons you may  want to know the value of your company. In addition to reasons related to a potential sale of the business and allocation of the purchase price to various assets or asset classes, valuation is also important for other purposes such as mergers, business conversions, borrowing, shareholder/member/partner agreements or disputes, estate tax valuation or buyout upon the death of a member, and gifting for estate planning. Many times, appraisals by certified appraisers are necessary or advisable.   

Below are some common valuation methods for small businesses. Valuation professionals often use varied approaches to find a balanced, well-rounded number that more accurately depicts your company’s value. 

1. The Multiple of Earnings Approach

Many valuations are based on a multiple of earnings before taxes, interest, depreciation and amortization (“EBITDA”).  This provides a measure of a company’s operating performance, excluding non-operating expenses and non-cash charges.  

Multipliers vary based on industry, market volatility, business location, risks, and many other factors. Often, the higher the EBITDA, the higher the multiplier will be.

Next, EBITDA will be “normalized,” or adjusted for unusual or non-recurring items. This adjustment provides a more accurate measure of the businesses “normal” operations.

Normalized EBITDA will often be further adjusted to determine the seller’s discretionary earnings (“SDE”), to provide a measure of expected financial value a new owner would gain on an annual basis. These adjustments are sometimes referred to as “add backs” and typically include owner’s compensation, perks and benefits, as well as excess expenses paid to related parties, such as rent if those expenses exceed market value.

Lastly, normalized EBITDA or SDE may be further adjusted, or weighted, so as to give more effect to recent earnings than earnings from two, three or more years ago. This may be referred to as a “weighted average” of earnings over the prior three to five years.

Finally, the valuation professional will determine the appropriate multiplier for your business.  This multiplier will be based on many factors, including the nature of your business, recent transactions in the same and similar industries, and various other market conditions and risk factors.  Often the multiplier is between 3 and 5, however, but could be lower or higher.

2. The Discounted Cash Flow or Capitalization of Earnings Method

The discounted cash flow or capitalization of earnings methods rely heavily on many of the same earnings calculations discussed above; however, rather than applying a multiplier to one year’s earnings, this method projects earnings for a number of years and then discounts that stream of income to its present value.  Instead of a multiplier, the valuation professional must determine a “discount rate” or “capitalization rate” which will reflect a number of different factors such as interest rates, inflation, business risk, etc. 

3. The Adjusted Net Asset Method

Some valuation methods for small businesses focus solely on business assets rather than cash flow, revenue, or earnings. The Adjusted Net Asset Method looks at the monetary value ofyour business’s tangible assets such as real property, furniture, fixtures, and equipment, inventory, accounts receivable, etc., net of loans, financing, payables, and other liabilities. This method is more appropriate for asset heavy businesses as opposed to service businesses and operating companies.

Work With a Business Law Attorney for Personalized Support

Again, there are many reasons you may need or want to value your business.  Typically, a business valuation professional will be advisable or required.At Wilson Ratledge PLLC, our business law attorneys can help you with whatever needs you have that might require valuation, from succession and estate planning, to selling your business.  We can also help you understand the many factors that go into the valuation, and how they affect your needs, plans and goals.a.

Call Wilson Ratledge PLLC today at 919-787-7711 to schedule a consultation with our team. 

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