While the value of publicly traded companies is readily available, privately owned companies, including small businesses, rely on valuations to estimate their fair market value. Knowing the value of your business is important if you’re interested in taking on an investor, bringing on a new partner, or preparing to sell your business. It’s also important for tax reporting and estate planning. 

How to calculate the value of your business

There are several ways to determine a business’s value and each one has its own advantages and disadvantages:

Method 1: Market-based valuations

One way to determine the value of your business is based on market research. A market-based valuation estimates the value of your business based on the value of similar businesses — ones of a similar size and in a similar industry. 

Market valuations may be based on comparisons to similar publicly traded companies or recent sales of comparable businesses. These are called precedent transactions. 

A market-based valuation may be attractive to some business owners because it’s relatively straightforward. But it has drawbacks, too. It relies heavily on the quality of the research that went into the valuation, and it may not always be possible to find comparable precedent transactions.

Method 2: Revenue-based valuations

A second way to estimate your business’s value is by using a revenue multiplier. This method is quick and easy: Simply multiply the revenue by its valuation multiple — a business metric with benchmarks that differ from industry to industry — to calculate the total value of a business. For example, a business with an annual revenue of $200,000 and a valuation multiple of 2.5 would have a value of $500,000.

However, the accuracy of a revenue-based valuation relies heavily on selecting the right multiple for your business. Valuation multiples may vary based on the revenue of the business, as well as your industry. If you own a software business, for example, you may have a different valuation multiple than if you own a construction business, and a business with more than $1 million in annual revenue may have a different multiple than one with $100,000 in annual revenue.

Method 3: Asset-based valuations

The third and most in-depth option for calculating your business’s value involves delving into its financials. An asset-based approach focuses on the value of a company’s assets, minus its current liabilities. For example, a company with $1,000,000 in assets and $500,000 in liabilities would have a value of $500,000.

An asset-based valuation works well when a company is having liquidity issues, and most of its value is tied to its assets. But determining the value of a company’s assets can be complex since it involves estimating the value of intangible assets, like intellectual property. In addition, an asset-based approach doesn’t take into account a company’s prospective future earnings.

Comparing valuation and selling price

Although having an accurate valuation is important when negotiating a selling price, it’s not the only factor buyers and sellers should consider. 

Changing market trends can impact a business’s prospective earnings and should be considered when setting a price. Keep in mind, too, that some acquisitions may offer strategic advantages to the buyer that aren’t reflected in the business’s valuation. This may drive up the price. 

The importance of objective valuations

No matter what your ultimate goal is for your business, it’s important to have your valuation conducted by an objective third party with accreditation in business valuation. 

A valuator can select the most appropriate method to calculate the value of your business and ensure the calculation is performed properly. This would entail selecting the correct multiple for a revenue-based valuation and choosing appropriate precedent transactions for a market-based valuation. 

Receiving an objective valuation offers several benefits for business owners. Prospective buyers and investors will often require a third-party assessment as part of their due diligence, and a professional valuation can help you gauge if a seller’s offer is fair. Plus, if you plan to pass the business on to a loved one, knowing its fair market value is important for understanding the tax obligations of the sale. 

The bottom line

A business owner has several options for estimating the value of their business, and each method may be more suited to some businesses than others. Consulting a professional can help ensure that your business is valued fairly so you can make informed decisions about taking on an investor, planning your estate, or selling your business.

No matter the value, the needs of your business are our team’s top priority. Contact us today for customized lending and banking solutions.