If you are the owner of a small business, at some point you have likely asked yourself, “I wonder how much my business is worth.” Perhaps you’re considering selling, bringing in a partner or investor, thinking about estate planning, or maybe you’re just curious if your business strategy is adding value.
Is there an easy way to value your business? Can you estimate the value based on how much a comparable business sold for? Or is there a formula or “rule of thumb” that you can use? While these valuation methods are easy to apply and useful in certain circumstances, they have limitations. We’ll walk through these valuation methods, and discuss some of the things you should be aware of before using them.
The market method of valuation determines the value of an asset based on the selling price of similar items. Residential real estate, for example, is typically valued using a market method, which references “comparables” – recent sales of similar properties in the same neighbourhood. While one house is never exactly the same as another, it is usually possible to find reasonably comparable transactions.
So why not use this method to value a small business? According to Statistics Canada there are just over one million small businesses in Canada. While this may seem like a lot, compare that to the 14 million residential dwellings on record. Therefore, the likelihood of finding a comparable business, versus a comparable residential property, is significantly lower.
As well, Statistics Canada classifies dwellings into eight types, such as single-detached house, semi-detached house, row house, apartment, etc. Conversely, there are 923 different types of industries from potato farming to aerospace parts manufacturing. To make comparisons even more difficult, two seemingly similar businesses, such as two restaurants on the same street, may have little in common. For example, one may be more upscale, popular, or profitable than the other.
Even if you could find a comparable business, another problem with using this method is the lack of available information. While you can usually find out how much a house sold for, the same does not apply to businesses. Most small businesses are private companies or proprietorships; owners are not required to disclose change-of-ownership and sales information to the public and, therefore, very few do. As a result, the difficulty of finding a comparable sale usually rules out the market method to value a business.
Business value calculators
Search online and you’ll find several “business value calculators.” Typically, you need to plug in nothing more than a few numbers – for example, sales and profit from the last 12 months, plus the owner’s salary – to come up with a business value estimate.
However, valuing even a small business is rarely that simple. There are a number of key factors that these calculators typically do not incorporate, including: the industry in which the business operates; the economic outlook; the quality of the employee and management team; and many other business specific details.
Rules of thumb
In addition to business value calculators you can easily find “rules of thumb” online, in articles written by, or on websites of business brokers or other advisors. Most of these rules of thumb are based on some multiple of revenue, sales, or earnings. Some are as simple as taking your small business' yearly cash flow and multiplying it by four. For example, if your business generates cash flow of $60,000 per year, it would have a value of $240,000.
However, these rules of thumb can vary considerably. One calculates business value as three to five times EBITDA (earnings before interest, income tax, depreciation and amortization) another as five to six times earnings, and yet another as one or two times sales. How do you know which one to use for your particular business?
For a fee, rules of thumb for specific industry sectors are available from several US-based online and/or print publications such as Business Reference Guide and Pratt’s Stats. One publication lists over 600 types of business, including small retailers, auto repair shops, bed and breakfasts, daycares, dry-cleaners, and restaurants. While these resources are easy to use and convenient, they also have a number of limitations.
First, the publications are based on US data that may or may not apply to Canada. Second, they often focus on revenue or sales from products or services, rather than profitability – the business’ bottom line after deducting the cost of goods sold and expenses.
If two businesses have the same revenue but one is profitable and the other not, they are unlikely to have the same value. Lastly, even if two businesses in the same industry report the same revenues and profits, other factors could make one worth significantly more than the other. For example, one business may be in a neighbourhood with a growing population, the other in a town that is dying.
Rules of thumb can, however, play an important role in valuing professional practices, such as those of accountants, financial advisers, insurance brokers, and physicians and dentists. Typically with these practices, what is being sold is a “book of business” or a client list, rather than a company.
Buyers may have their own established business and only be interested in the revenue that a new client list can generate, and not the rest of the seller’s business; this may include employees, premises, office furniture, equipment and other various assets. Each type of professional practice typically has its own rules of thumb, and information on these is often readily available from the respective industry associations.
Valuing a business is as much an art as a science; it is seldom possible to find a comparable sale, or to simply plug numbers into a formula. Rule of thumb methods, despite their limitations, can be useful as very rough estimates of value. Since they are typically easy to apply, there is no harm in doing so, but other more appropriate valuation methods, such as the asset and cash flow methods, should be considered as well. These two methods will be discussed in upcoming articles.
As well, don’t hesitate to seek professional advice to value your business. Although advisors charge fees for their services, they can provide you with a more accurate estimate of how much your business is worth.
Liisa Atva is the author of The Ask: How Much Is a Small Business Worth? A CPA, CA, and Chartered Business Valuator, Liisa’s work has appeared in The Globe and Mail, Postmedia publications, Huffington Post, and The Journal of Business Valuation.
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