How to value a small business?

If you want to sell your business or buy a business, you need to know how to value it. Many business valuation methods are available, however, most of them apply to large businesses.  When it comes to small business, I think there is one valuation method that works in most cases and that is a multiple of cash flow or Seller’s discretionary earnings. Basically, you take the annual cash flow available to the owner of the business and multiply it by a “multiple” to come up with the value of the business.

To do a quick hip pocket business valuation, use a multiple of 2 or 2.5.  For example,  a small business’s Profit and Loss Statement for the year shows a net profit of $40,000 (without the owner taking a salary and any other non-business related expenses added back in) then multiply that by 2 and have a ballpark value of $80,000 or 2.5 which is $100,000.  Without further investigation, you could estimate this business is worth $80,000 to $100,000.

Now we have some statistics to back up the multiple.  The largest business for sale website, has released their BizBuySell Insight Reports which summarizes the data from 6,703 businesses that sold in 2011, here are some gems from the report:

Average Multiple of Cash Flow 2.36

Average Sale Price to Asking Price .88

What makes this data terrific is the fact that this is based on businesses that have actually sold, not what is on the market, but actual transactions that have closed.  Many businesses listed for sale end up never selling, sometimes because it is a poor business and sometimes because the list price is just not realistic.  The BizBuySell data is supreme because we are looking at the businesses that successfully sold and closed.

We can use this data to help come up with a List Price for a business for sale.  So lets take the example of a business with cash flow to the owner of $40,000 per year, if we want to sell that business, first use the 2.36 multiple times $40,000 to come up with a value of $94,400.  Second, we need to take into account that businesses closed at a price 12% below their asking price, so we divide $94,400 by .88 and come up with a potential list price of $107,270.

If your business has hard assets like equipment, inventory or supplies that are necessary to continue running the business then the value of those assets at fair market value are added to the sale price.

While there are many more components to successfully buying and selling small businesses and certain types like internet businesses can command a higher multiple, using a reasonable multiple of cash flow is a solid starting point supported with the data from 6,703 businesses that sold in 2011.