Small Business Valuation

Small Business Valuation


The concept of small business valuation has created challenges in the marketplace for years. Unfortunately, unlike publicly traded stocks, there has been little formal education offered in the business schools and accounting classes traditionally on the subject of small business valuation. While value can have a completely different meaning to various individuals based on perspective, there are some standard principles that are taught by respected organizations such as the International Business Broker Association (IBBA) and accepted by valuation experts around the world. In fact these principles that we will discuss below are practiced by the Small Business Administration (SBA) as the approved method to small business valuation.

There are a number of different ways to value a business including the Discounted Cash Flow Method, Market Multiple Method, and Asset Value Approach. Each of these different methods to approach the valuation of a small business can be appropriate for different applications however we will not cover these in great detail in this article. The most widely used method for valuing small businesses is the Market Multiple Method.

Understanding how to interpret cash flow statements for small businesses is an important first step in valuing a business. The IRS regulations related to small business expense guidelines allows a good deal of room for interpretation. The application of these regulations can vary significantly between one business owner and the next. As a result, the financial statements for small privately held businesses often reflect some expenses for items not traditionally considered business-related. In addition there may be other non-cash or other expenses such as depreciation that are not directly transferable to a new owner.

In order to review financial data in a consistent manner the industry has developed a standard process call Stabilization. This concept has been adopted by the appraisal industry, CPA’s, attorneys, the International Business Brokerage Association (IBBA), and the Small Business Administration (SBA) as the accepted approach to standardizing financial information.

Expenses that typically are adjusted out of the cash flow statement include owners salary, owners benefits (life insurance, health insurance, pension plan), debt service, depreciation (non-cash expense), and charitable contributions. Other expenses may be adjusted based the unique business owners accounting methods.

The adjusted (stabilized) expense information is applied to the original cash flow for the business to arrive at an adjusted cash flow. This is the actual net cash benefit to the business owner. This adjusted number is referred to as Net Owner Benefit (NOB) and/or Sellers Discretionary Cash Flow (SDC).

In a manner very similar to appraising a single family house, business appraisers continually solicit information on sold businesses across the country. Professionals are encouraged to submit transaction details (without disclosing the actual name of a business) to the database, and in exchange are awarded access to the database for professional reference.

Multiples (or ratios) can be derived by comparing selected variables such as annual sales, gross profit and SDC to the Sales Price. Due in part to the volume of transaction information, applied to businesses in similar industries, these multiples can provide a very accurate picture of valuation (as defined by the marketplace).

In practice, regardless of the formal approach to valuation, and the calculated value of a specific business, the business is only worth what it can produce in terms of current cash flow and future returns to the buyer. Buyers and lenders look at the ability to earn a realistic salary for operating the business while producing enough cash flow to comfortably cover debt service, and generating a fair return on invested capital (ROIC).