How to Calculate Your Business Valuation?
Business valuation calculations can be tricky. It is best entrusted with professional business appraisers.
The market size for business valuation firms in the United States is projected to be $2.8 billion in 2025. The increasing complexity of business operations and the need for accurate valuations due to mergers and acquisitions drive demand.
Business valuation calculations can be tricky. Choosing the right method depends on your business type, industry standards, and specific circumstances. Combining several methods for a more comprehensive valuation may also be beneficial. Always seek the guidance of financial professionals for precise insights that resonate with the unique needs of your business.
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
- 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.
- 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.
- 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.
- Gaining Investor attraction – 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 calculations. The methods used vary with each particular approach. Here are the three basic:
- Present value (Income Approach) – 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, or DCF analysis which is considered as time value of money
- Book value (Asset Based Approach) – Also called the ‘liquidation value’ or the ‘asset-based approach‘. This method calculates a company’s net worth by subtracting total liabilities from total assets. It is essential that assets are valued at their market value to ensure accuracy in this calculation.
- Fair Market Value (Market-Based Approach) – This approach assesses the value of a business by comparing it to similar companies in the industry. It’s easy for publicly traded companies where financial information is readily available.
Business Valuation Formulas & SDE
There are different ways to calculate the profitability of small to medium-sized businesses, and one of the simplest methods is using the Seller’s Discretionary Earnings (SDE) formula. Here’s a brief overview of how SDE-based calculations are performed:
Calculation of SDE
SDE is typically calculated from the previous financial year.
The calculation of SDE typically involves the following steps:
- Start with Net Earnings – Begin with the pre-tax net earnings of the business.
- Add Owner’s Drawings – Add back the owner’s salary and any personal drawings.
- Add One-Time/Discretionary Expenses – Add back any one-time or non-essential expenses, excluding the cost of goods sold.
- Add Interest, Depreciation, and Amortization – Add back the Interest, Depreciation, and Amortization expenses because the original cost has already been incurred at the time of purchase.
The final value derived from this calculation is the SDE.
Valuation Using SDE
To determine a business’s value, an industry multiplier is applied to the calculated SDE. This varies by industry and future prospects which are profitable. For small businesses, typical multipliers range from 2 to 3.5 times the SDE, but this can vary significantly based on specific circumstances.
The final formula can be expressed as:
This formula takes into account both tangible and intangible assets, ensuring a comprehensive valuation.
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.
Income Statement for Tech Innovations Inc.:
| 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 |
| Add: Non-recurring Expenses | $15,000 | $10,000 | $8,000 |
| Seller's Discretionary Earnings (SDE) | $595,152 | $506,000 | $541,000 |
Income Statement for Digital Solutions Co.:
| 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 |
| Add: Non-recurring Expenses | $15,000 | $10,000 | $8,000 |
| Seller's Discretionary Earnings (SDE) | $420,082 | $335,500 | $370,000 |
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, consider the SDE for each year as calculated above:
For Tech Innovations Inc.:
- 2021 SDE: $595,152
- 2022 SDE: $506,000
- 2023 SDE: $541,000
For Digital Solutions Co.:
- 2021 SDE: $420,082
- 2022 SDE: $335,500
- 2023 SDE: $370,000
Calculate the average SDE:
- For Tech Innovations Inc.: ($595,152 + $506,000 + $541,000) / 3 = $547,384
- For Digital Solutions Co.: ($420,082 + $335,500 + $370,000) / 3 = $375,194
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.: $547,384 * 2.5 = $1,368,460
- For Digital Solutions Co.: $375,194 * 2.0 = $750,388
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.
- 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, 3.2, 3.5, 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 the data below | 2.65 |
| 75th Percentile | Third Quartile, 75% of the data below | 3.5 |
These stats show the central tendency and spread of SDE multiples. Average is the typical value, median is the midpoint, and quartiles indicate distribution.
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: 3.13
- Median SDE Multiple: 3.2
- 25th Percentile (Q1): 2.65
- 75th Percentile (Q3): 3.5
Selection of Multiplier (3.13):
- We use SDE multiples from the dataset to determine market valuations for similar industries.
- An SDE multiple of 3.13 is a balanced representation of market conditions, capturing realistic scenarios.
Business Valuations
Company Tech Innovations Inc. (Louisiana):
Multiplier: 3.13 (Representing Louisiana’s business climate)
Company Digital Solutions Co. (Delaware):
Multiplier: 3.2 (Reflecting Delaware’s business climate)
The analysis compares the values of Tech Innovations Inc. in Louisiana and Digital Solutions Co. in Delaware, using a 3.13 and 3.2 multiplier for both states. Tech Innovations Inc. is valued at $1,713,311.92, and Digital Solutions Co. at $1,200,620.8.
How Does Eqvista Help?
Business valuation is a critical process for business owners, providing numerous benefits that can significantly impact decision-making and strategic planning. This provides essential insights for planning, enhance financial opportunities, facilitate smoother transitions during ownership changes, and support compliance with legal requirements.
Eqvista specializes in performing valuations; by offering affordable pricing plans and a range of services under one roof, Eqvista helps businesses save time and money compared to hiring multiple service providers for different needs. Eqvista offers tailored startup valuation services for early-stage companies that utilize various methodologies.
Our valuation services include:
- 409a Valuation Services
- Startup Valuation
- Portfolio Valuation
- Gift & Estate Tax Valuation
- HMRC Valuation
Eqvista’s business valuation services are tailored to your needs and include complete customer support from NACVA-certified analysts. The process is straightforward and completed in a timely, professional manner. Contact us directly for more information. Get started today!
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