How do you value a company when there’s no public market to gauge price, especially for small businesses? It’s not like you can input a bunch of numbers and variables and spit out a price. It’s really worth what someone is willing to pay for it; which often means how much a buyer can afford, and what the return on their investment will be.
You can wait to set the price when an owner, ex-spouse, beneficiary, or a departing owner exercises a right to purchase. But this approach often ends with disputes and litigation. That’s no way for a transaction to happen. There’s a number of other ways to set the price. Don’t just pick one and stick with it throughout the life of the company. You’ll want to adjust it as the company grows. You could base the price on capital accounts, but they don’t bear any relationship to the real worth of business.
You could base the price on a fixed price. That’s seems easy enough. It’s kind of like looking at the price tag on a product. This method might be a good candidate for a service business, a company in its first year, or a closely held business. But the value of a business fluctuates. Whatever price you choose will quickly be outdated. If you decide to go this route, then make sure to update the price every year or so. But most people forget to do this.
The other way to set the price is based on a formula. Here are a few to consider.
This sounds easy enough; just check the balance sheet and you’re good to go. But this formula doesn’t account for intangible assets like reputation and goodwill. In some cases that’s okay. It works well if you’re just starting out or are marginally profitable in a highly competitive business. It doesn’t work well for a profitable, mature company. If you go this route include a sample balance sheet to show how the book value is calculated.
Multiple of Book Value
If you’ve built up some goodwill, have a positive reputation, or have a valuable asset such as a good lease, you can set the price at a multiple of book value. This might work for companies like a retail business and other companies not in the personalized service sector.
Multiple of Earnings
This method takes the average of yearly earnings (three years is a good number) and chooses a multiplier. This method works well for businesses that have operated for a long time, have consistent profits, and have a good future. The multiplier depends on the industry, but normally is not higher than three. If you’re one of those lucky businesses with great earnings, a niche, and a solid cash flow, you might be able to go as high as ten.
This method is simple. You hire a professional appraiser who decides the value. Or the buyer chooses an appraiser and the seller chooses an appraiser who each come up with a value on their own. If each of their appraisals are disparate, the two appraisers hire a third appraiser to provide the final value. This approach can be really expensive and take a lot of time. Since it’s more art than science, it can also be subject to dispute. It’s really only good for a company whose main asset is real property.