There are several ways a small business owner can value their business, each with its pros and cons.

One common starting point is the use of a business valuation calculator. These can be found all over the internet and allow you to input various information about your business to come up with a value.

However, it is important to note that each calculator (or formula) offers only one data point and needs to be considered in a broader context. In this article, we aim to provide that wider context by discussing 4 common frameworks for valuing your business.

Before we jump in, there are 2 things to consider:

1. Valuing your business is complex. We suggest that you first do your own research to get a broad understanding, and then once you are ready, find an expert you trust to help provide a professional, objective valuation.
2. There is an overlap between the frameworks as any approach to valuing a business must include some analysis of (1) the current market value of your assets, (2) your projected future earnings, and (3) the overall economic climate and marketing conditions.

4 Frameworks For Assessing the Value of Your Small Business

1. Ground Up – Asset-Based Analysis

Do an audit of your business for tangible and intangible assets, prescribe each asset with a value and use the total as a simple value of your business.

House Analogy

As businesses can be complex, let’s first consider how this approach would apply to selling something more tangible, like a house.

To value a house using this method, you would essentially ask how much it would cost to build it from scratch.

e.g. what is the cost of the land, what is the value of the house itself, what fixtures are included etc.

This price then needs to be adjusted for depreciation, essentially, your dishwasher was $400 when it was new, but it is now 2 years old.

Valuing a business

The kinds of assets that sit within your business vary wildly depending on the industry and type of business. For example, an online e-commerce store has assets like inventory, website platform, social following and customer data. In contrast, the manufacturer that the online store sources its stock owns assets like equipment, patents and long-term supplier contracts.

When looking for assets in your business, think holistically and identify value in all aspects of your business.

A word of warning, when valuing intangible assets, they need to be independent of the owner looking to sell the business. As in any traditional sale, the owner is looking to exit the business; the assets need to be just as valuable to the new owner as they were for the current owner.

For example, if you have a strong Instagram following that drives most sales, how is the owner's personal profile linked to the brand? To what extent would sales go down if the current owner stopped running the profile? This also applies to specialist knowledge, client relationships and even the business's reliance on the owner for day-to-day operations.

A good test is if it wouldn’t function while the owner is on an extended holiday, then you can’t include it as an asset.

Pros

• Easy to apply
• Offers a very tangible and justifiable result

Cons

• Can significantly undervalue the business
• Many assets are not easy to value

2. Relative Valuation – Market-Based Analysis

Find businesses similar to yours that have recently sold and value yourself relative to those sales.

House Analogy

To continue our previous analogy, if we applied this approach to valuing a house, we would look for comparable recent sales in our area and use that to construct a range of what we think our house is worth.

Valuing a business

This method often requires access to data. This data is not always widely available, so leveraging this method often means finding and working with a business broker or accountant who can help you and provide the industry data you need.

Start by doing some analysis to identify businesses comparable to yours. Consider the size, age, industry, financial data etc. Once you have a list of comparable businesses reach out to a professional for help.

Note that some industries simplify (or shortcut) this method by providing an industry-wide standard for valuing businesses. For example, it is very common in the real estate industry to value a business by applying a simple multiple of the number of houses under management.

Again a broker or account can help identify if your industry has any common standards for valuing businesses like yours.

‍Pros

• Offers a very tangible and justifiable result
• Takes into account market conditions
• For some industries, this method can be a simple multiple

Cons

• Unlike with property, it can be hard to source this data
• Depending on the type of business you have, it can be very hard to find a comparable business or businesses
• Using an industry-standard might undervalue your business

3. Future Returns – Investment Analysis

Calculate the future returns an investor could reasonably expect from your business over a 3 to 5-year period.

House Analogy

In the housing market, this approach is applied when an investor is looking to buy a rental property. They do a market analysis to understand what they could reasonably expect to receive as a rental income for the property, factoring in potential risks and then using that number to determine how much it makes sense to pay for the property.

Valuing a business

When using this method to value a business, the investor is looking at how much profit the business is likely to generate and then discounting to consider execution risk and the opportunity cost of losing access to their capital in the short term.

Unlike renting a house, there are many more things that can go wrong when running a business that could result in incorrect projections. This is what is referred to as execution risk and is often represented as a % discount applied to each year's projection, potentially increasing slightly every year to factor in the increased uncertainty.

It is also important to consider that money now is worth more than money in the future which sometimes feels counterintuitive.

If someone offered to give you 100k today or 5 months from now which would you choose? Money now, right? What would happen if someone offered you 99k today or 100k 1 year from now? You’d probably be better off taking the 99k today and investing it, giving you more money a year from now than if you’d waited for the extra $1000.

This simple thought experiment applies to your business's financial projections resulting in 100k in money coming into the business next year being discounted by up to 10% today.

Pros

• This method takes into account the future growth potential of the business
• It aligns with how strategic buyers will want to value your business. Strategic buyers will often pay more for a business.

Cons

• It can be difficult to tangibly justify your projections resulting in a drawn-out due diligence process or a requirement for the owner to remain in the business until some financial milestones have been reached.

4. The Impact Positive Business Valuation Framework

The Impact Positive Business Valuation Framework (IPBV) is a hybrid approach to maximising the potential value of your business by combining current assets and future performance.

The basic approach is:

1. Calculate your tangible and intangible assets
2. Add your 3 to 5-year projections
3. Reduce the risk (and associated discounting) by quantifying your operations machine's maturity, predictability and resiliency.

House Analogy

Start by valuing the land, house and included fittings to get your base price. Then determine the projected income an investor could reasonably expect to receive from a comparable property. Then finally, sign a 2 to 3-year lease with the current tenant to reduce the short-term risk for the future investor.

Valuing a business

Following the steps above, calculate the current business assets and future projections. Then invest in developing your operations maturity, restructuring your business model, signing longer-term contracts and eliminating any key person dependencies that could put the future projections at risk.

Pros

• Offers a tangible and justifiable result
• Doesn’t ignore or undervalue key elements of the business
• Provides a framework for making strategic investment decisions for how to best increase the long-term value of your business

Cons

• It takes time to develop a comprehensive view of the business
• Rules out some tactical buyers only interested in buying your business for its tangible assets (e.g. business flippers).

Valuing your business is not an exact science. There isn’t 1 agreed standard or framework that will be respected by all potential buyers across all industries.

Remember that valuing your business is different from pricing your business. Focus on continuously and consistently increasing the value of your business in the years leading up to the sale. As you take your business to market, switch from focusing on determining the value to determining the right price depending on your target buyer and personal objectives.

Find more information about pricing your business here