How to Calculate Your Business Valuation?
Business valuation calculations can be tricky. It is best entrusted with professional business appraisers.
Business valuation calculations are fundamental to every business. Be it to re-strategize existing operations or to consider a sale, these numbers are used as a reference to the overall worth of your company.
Business Valuation
Business valuation is a process of determining the total worth of a business in economic terms. Small companies and publicly traded ones alike use various business valuation methods to arrive at the best possible valuation for their company. Founders pitch for the maximum possible value, whereas investors look for opportunities for the best ROI.
Why is Business Valuation Important?
A successful industry heavily relies on efficient cash flow management. Sales revenue apart, founders are required to raise funds either from investors or other money lending institutions. Alternatively, the company might be structured in a way that eventually leads it towards an acquisition or an IPO. A reliable business valuation forms the basis of all these activities. Without accurate numbers, none of these economic transactions are possible, as the interested parties will not have any reference point to initiate discussions.
A proper business valuation can be carried out only when accounting records of a company adhere to US GAAP regulations.
Without clean financial records based on US GAAP regulations, professional evaluators will not have confidence in the company’s recorded EBITDA or the net income despite using the best business valuation methods.
Before entering the valuation process, the founders must have clarity about the purpose of it. Why are they evaluating the business? And what are they trying to accomplish with this? Let us look into scenarios that affect the business valuation formula.
Business Valuation In Different Scenarios
- Valuation for mergers and acquisitions – Companies with the intention of mergers and acquisitions focus on obtaining the best fair market value price. The bottom line here for the benefactors is the return on investment.These formulas focus on these aspects while evaluating businesses on the verge of a merger or acquisition.
- Valuation for estate and gifting – Calculations in this case are focused on an owner-centric approach. It is best advised to prepare for such valuations before estate planning. Similarly, in the case of ‘gifting’ scenarios or ailing health of the business owner that might lead to death, calculations preps have to start well in advance. The IRS suggests such methods for charitable donations as well.
- Valuation for disputes – Disputes in business can happen either in case of conflicting interests of shareholders or in case of a business partner’s liability towards a personal asset sharing scenario (Eg. Divorce). In such cases have to account for the withdrawal or transfer of shares among beneficiaries.
- Valuation for financing – Attracting investors to fund a company requires a business valuation formula that maximizes the company’s future profit potential. Suppose a company plans to approach investors or banks for funding. In that case, it must prepare well in advance so that all the necessary metrics align with this approach.
How to Calculate Your Business Valuation?
Now that we have discussed the various scenarios for valuation, let us explore different ways calculations. The methods used vary with each particular approach. Here are the three basic ones:
- Present value – Assuming industry growth, this approach evaluates a business’s present and future cash flows. It is known as the ‘income approach’ It values a company based on its income using capitalization of earnings, discounted flow, and formula-based methods.
- Book value – Also called the ‘liquidation value’ or the ‘asset-based approach’ is the simplest one. It indicates the net worth of a company by subtracting all the liabilities of the company from the assets to arrive at this value. But assets must be valued based on market value.
- Fair Market value – This approach uses market-based methods to value a business, by comparing it to similar companies in the industry. It’s easy for publicly traded companies where financial information is available.
Business Valuation Formulas & SDE
There are different ways to calculate the value , and one of the simplest methods is using the Seller’s Discretionary Earnings (SDE) formula. This approach is commonly used for small businesses, but the outcome may vary depending on the company’s structure, size, industry, and complexity. Here’s a brief overview of how SDE-based calculations are performed:
Calculating SDE
SDE is typically calculated from the previous financial year. Valuation analysts begin by noting the pre-tax net earnings of the target company for the given year. To this is added the owner’s draw from the business. Next, all the one-time expenses are added to this value except the cost of goods sold. From this value, all liabilities are deducted. Liabilities include debt, unpaid bills, and the likes. The final value derived from this calculation is the SDE.
Industry multiplier or SDE multiple
SDE value is a good starting point. The ‘industry multiplier’ or SDE multiple is the value that when multiplied with SDE indicates the future possibilities of the company. Professional valuation firms publish guides with industry-based multiple values.
SDE multiple varies with industry. For eg, the SDE value might be the same for AI and fashion industries. But it is the SDE multiple, based on industry trends that will make a difference in the business valuation calculations.
Add Business Assets & Subtract Business Liabilities
The last step in to add the assets and subtract the liabilities those of which were not already included in the SDE. An interested buyer is more likely to consider the legal structure of a business as a whole. This includes all the tangible as well as the intangible assets of the company. Here is how this works:
- Tangible assets are those that have a physical value. Aspects like real estate, accounts receivables, and cash on hand are all tangible assets that otherwise are not included in the SDE multiple. But they must be considered if the buyer plans to purchase all tangible assets.
- Intangible assets on the other hand are aspects like trademarks, patents, customer base, goodwill, and others. These are always part of SDE multiple as they have a major role to play in determining the true valuation of a company. Also, if the tangible assets are sold, these intangible assets go along with it.
- Liabilities are outstanding debt. They could be in the form of current loans, outstanding payments for suppliers, or past debts in the business. Usually, the seller takes responsibility for all liabilities. The practice is to pay off debts using the money made from the sale. However, it finally boils down to the terms of the sale agreement between two parties.
Considering all of the above the final business valuation formula looks like this:
Now that we have a fair idea of calculation in theory, let us look at an example. In the next section, we consider a hypothetical situation and compare two industries in different formats to see how this works.
Example of Business Valuation
Let’s delve into the valuation of two software businesses, one headquartered in Louisiana (Tech Innovations Inc.) and the other in Delaware (Digital Solutions Co.). This comparison aims to highlight the impact of geographical factors, such as the state of incorporation,with higher risk potentially leading to lower valuations.
Company Tech Innovations Inc.
Income Statement:
| Line Item | 2021 | 2022 | 2023 |
|---|---|---|---|
| Revenue | $630,686 | $700,000 | $750,000 |
| COGS | - | $150,000 | $160,000 |
| Gross Profit | $630,686 | $550,000 | $590,000 |
| Operating Expenses | |||
| Salaries | $50,000 | $55,000 | $60,000 |
| Rent | $12,000 | $12,000 | $12,000 |
| Marketing | $15,000 | $18,000 | $20,000 |
| Utilities | $8,000 | $8,500 | $9,000 |
| Insurance | $5,000 | $5,500 | $6,000 |
| Depreciation | $10,000 | $11,000 | $12,000 |
| Other Expenses | $5,534 | $5,000 | $5,000 |
| Total Operating Expenses | $105,534 | $115,000 | $124,000 |
| Net Income | $525,152 | $435,000 | $466,000 |
| Add: Interest | $5,000 | $5,000 | $5,000 |
| Add: Depreciation | $10,000 | $11,000 | $12,000 |
| Add: Owner's Salary | $40,000 | $45,000 | $50,000 |
| Less: Non-recurring Expenses | $15,000 | $10,000 | $8,000 |
| Seller's Discretionary Earnings (SDE) | $565,152 | $496,000 | $525,000 |
Balance Sheet:
| Line Item | 2021 | 2022 | 2023 |
|---|---|---|---|
| Assets | |||
| Other Assets | $343,050 | $370,000 | $400,000 |
| Estimated Value | $181,068 | $190,000 | $210,000 |
| Total Assets | $524,118 | $560,000 | $610,000 |
| Liabilities & Equity | |||
| Liabilities | $65,000 | $70,000 | $75,000 |
| Equity | $459,118 | $490,000 | $535,000 |
| Total Liabilities & Equity | $524,118 | $560,000 | $610,000 |
Company Digital Solutions Co.
Income Statement:
| Line Item | 2021 | 2022 | 2023 |
|---|---|---|---|
| Revenue | $455,980 | $500,000 | $550,000 |
| COGS | - | $120,000 | $130,000 |
| Gross Profit | $455,980 | $380,000 | $420,000 |
| Operating Expenses | |||
| Salaries | $50,000 | $55,000 | $60,000 |
| Rent | $12,000 | $12,000 | $12,000 |
| Marketing | $15,000 | $18,000 | $20,000 |
| Utilities | $8,000 | $8,500 | $9,000 |
| Insurance | $5,000 | $5,500 | $6,000 |
| Depreciation | $10,000 | $11,000 | $12,000 |
| Other Expenses | $5,898 | $6,000 | $6,000 |
| Total Operating Expenses | $105,898 | $115,500 | $125,000 |
| Net Income | $350,082 | $264,500 | $295,000 |
| Add: Interest | $5,000 | $5,000 | $5,000 |
| Add: Depreciation | $10,000 | $11,000 | $12,000 |
| Add: Owner's Salary | $40,000 | $45,000 | $50,000 |
| Less: Non-recurring Expenses | $15,000 | $10,000 | $8,000 |
| Seller's Discretionary Earnings (SDE) | $390,082 | $315,500 | $354,000 |
Balance Sheet:
| Line Item | 2021 | 2022 | 2023 |
|---|---|---|---|
| Assets | |||
| Other Assets | $252,050 | $260,000 | $270,000 |
| Estimated Value | $151,796 | $155,000 | $160,000 |
| Total Assets | $403,846 | $415,000 | $430,000 |
| Liabilities & Equity | |||
| Liabilities | $35,000 | $35,000 | $35,000 |
| Equity | $368,846 | $380,000 | $395,000 |
| Total Liabilities & Equity | $403,846 | $415,000 | $430,000 |
For a basic business valuation, one commonly used method is Seller’s Discretionary Earnings (SDE), especially suitable for small to mid-sized industries where the owner’s involvement significantly influences financial performance. Here’s how to calculate the value using the SDE method:
First, let’s calculate the SDE for each year:
For Tech Innovations Inc.:
- 2021 SDE: $565,152
- 2022 SDE: $496,000
- 2023 SDE: $525,000
For Digital Solutions Co.:
- 2021 SDE: $390,082
- 2022 SDE: $315,500
- 2023 SDE: $354,000
Calculate the average SDE:
- For Tech Innovations Inc.: ($565,152 + $496,000 + $525,000) / 3 = $528,384
- For Digital Solutions Co.: ($390,082 + $315,500 + $354,000) / 3 = $353,527.33
Determine the multiplier:
- The multiplier is a factor applied to the average SDE to estimate the value. The multiplier can vary based on industry, risk, and other factors.
- Let’s assume a multiplier of 2.5 for Tech Innovations Inc. and 2.0 for Digital Solutions Co.
Calculate the estimated business value:
- For Tech Innovations Inc.: $528,384 * 2.5 = $1,320,960
- For Digital Solutions Co.: $353,527.33 * 2.0 = $707,054.67
Factors Influencing Multiplier
However, various factors, including geographical considerations, can impact the multiplier. In this example, we’ll explore the influence of Delaware’s business-friendly environment on valuation.
Delaware is renowned for offering an optimal business environment compared to Louisiana, which is more energy-dependent. Several reasons contribute to higher valuation in Delaware:
- Court of Chancery: Delaware’s corporate-friendly laws and dedicated court provide expert counsel, boosting valuation.
- Company Structure: Delaware’s flexibility with single-member boards and no residency requirement for shareholders enhances valuation.
- Investor Preference: Confidentiality in director and shareholder information attracts investors and adds reliability.
- Tax Benefits: Delaware’s tax-friendly policies, including exemptions for non-resident-owned stocks, result in substantial tax savings for organizations.
SDE Table
| State | Year | Sales | SDE | SDE Multiple |
|---|---|---|---|---|
| MI | 2017 | 226 | 40,000 | 3.5 |
| FL | 2017 | 858 | 120,000 | 2.6 |
| KS | 2017 | 201 | 35,000 | 2.8 |
| AZ | 2016 | 1,239 | 180,000 | 4.2 |
| MA | 2015 | 1,421 | 200,000 | 3.8 |
| VA | 2015 | 1,951 | 280,000 | 3.2 |
| FL | 2018 | 6,100 | 900,000 | 3.1 |
| SD | 2018 | 1,135 | 150,000 | 4 |
| WA | 2015 | 1,500 | 200,000 | 3.5 |
| NY | 2019 | 650 | 90,000 | 2.2 |
| CA | 2019 | 300 | 50,000 | 2.5 |
| CA | 2017 | 2,442 | 350,000 | 3.2 |
| CA | 2015 | 6,996 | 1,200,000 | 3.8 |
| CA | 2017 | 1,479 | 220,000 | 3.5 |
| KS | 2019 | 421 | 70,000 | 2.7 |
| IL | 2021 | 998 | 180,000 | 2.1 |
| AZ | 2020 | 1,124 | 150,000 | 2.9 |
| OH | 2016 | 1,050 | 160,000 | 3.2 |
| NJ | 2015 | 801 | 120,000 | 2.6 |
SDE Multiples Analysis:
- Average (Mean): The average SDE multiple is calculated by summing up all the SDE multiples and dividing by the total number of entries.
- Formula: Average= Sum of SDE Multiples/Number of Entries
- Average = Number of Entries Sum of SDE Multiples
- Median: The median SDE multiple is the middle value when the data is arranged in ascending order.
- If there is an even number of values, the median is the average of the two middle values.
- Arranged SDE Multiples: 2.1, 2.2, 2.5, 2.6, 2.6, 2.7, 2.8, 2.9, 3.1, 3.2, 3.2, 3.5, 3.5, 3.8, 3.8, 4.0, 4.2
Here is a table of the statistics of the multiples:
| Percentile | Description | Value |
|---|---|---|
| 25th Percentile | First Quartile, 25% of data below | 2.6 |
| 75th Percentile | Third Quartile, 75% of data below | 3.8 |
These stats show the central tendency and spread of SDE multiples. Average is the typical value, median is the midpoint, and quartiles indicate distribution.
Revised Multipliers Explanation
We use multipliers on the Seller’s Discretionary Earnings (SDE) to value a business. We must choose a multiplier that reflects Louisiana and Delaware’s industry climate and risk factors.
SDE Multiples Analysis:
- Average SDE Multiple: 3.05
- Median SDE Multiple: 3.35
- 25th Percentile (Q1): 2.6
- 75th Percentile (Q3): 3.8
Selection of Multiplier (3.05):
- We use SDE multiples from the dataset to determine market valuations for similar industries.
- An SDE multiple of 3.05 is a balanced representation of market conditions, capturing realistic scenarios.
Business Valuations
Company Tech Innovations Inc. (Louisiana):
Multiplier: 3.05 (Representing Louisiana’s business climate)
| Item | Amount |
|---|---|
| Estimated Business Value | $1,721,827 (SDE: $565,152 * Multiplier: 3.05) |
| Total Estimated Value | $2,099,877 |
Company Digital Solutions Co. (Delaware):
Multiplier: 3.05 (Reflecting Delaware’s business climate)
| Item | Amount |
|---|---|
| Estimated Business Value | $1,195,735 (SDE: $390,082 * Multiplier: 3.05) |
| Total Estimated Value | $1,523,295 |
| Company | State | Multiplier | Estimated Business Value | Total Estimated Value |
|---|---|---|---|---|
| Tech Innovations Inc. | Louisiana | 3.05 | $199,175 | $477,225 |
| Digital Solutions Co. | Delaware | 3.05 | $265,643 | $482,693 |
The analysis compares values of Tech Innovations Inc. in Louisiana and Digital Solutions Co. in Delaware, using a 3.05 multiplier for both states. Tech Innovations Inc. is valued at $199,175, and Digital Solutions Co. at $265,643. Total estimated values are $477,225 and $482,693, highlighting the influence of state and climates on valuations.
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