There are three basic approaches to valuing a small business: assets, market comparisons,  and earnings,.

Buyers and sellers are adversaries; sellers want to sell the business for as much as they can and buyers want to pay as little as they need to.  What process then should you use to value a small business?  

The assets approach is useful but mostly when the value of the earnings is less than the value of the assets or when the earnings are in a downward trend with a doubtful future. Then the value of the assets becomes significant, particularly the liquidation value.

The market comparisons approach is to compare the subject business with businesses recently sold of similar location, type, and size. The idea is to adjust the actual sale prices and terms to align with the subject. This method is commonly used in real estate appraisals. It may also be used for franchises that are in many ways common. This approach, however, does not work well for small businesses in general because of their lack of commonality and also because the data needed to make market comparisons—actual sale prices and terms—are not usually a matter of public record. The market approach, therefore, is not very useful to small business valuation.

The  value of a small business, and therefore its selling price, only makes sense when it's based on the cash flow or earnings approach. The cash flow approach is the one most important for valuing small businesses for the purpose of buying and selling. Using this approach, there are two methods of appraising: capitalization of earnings and preparation of cash-flow projections.

The cash-flow approach offer a comparatively reliable way to determine whether a purchase price is reasonable. It also offers the kind of valuation welcomed by bank commercial loan departments and the SBA.

The basic idea of the cash-flow approach is to estimate the sales and itemized expenses over a three-year span after the buyer takes ownership, and then to check if the resulting cash flow (operational earnings plus depreciation expense plus amortization expense) will be enough to cover one and a half to two times the debt service.

If the cash flow is inadequate to meet the debt service, then either the price being paid for the business is too high or there is something amiss with the way the cash-flow projections have been prepared.

Cash-flow projections are also comparatively reliable indicators of the overall reasonableness of the deal. They are reliable because they take into account not only the price being paid for the business but also the down payment, the terms of the loan, the buyer´s personal needs such as salary and benefits, acquisition costs such as professional fees, working capital, and so on. Cash-flow projections apply to almost any small business, no matter what the type, from grocery store to manufacturing company.

                Points To Keep In Mind
A business is worth only whatever someone is willing to pay for it at a particular point in time!

In addition to financial figures to value a business you should be aware of the following:

           Condition Of Equipment
           Goodwill
           Lease
           Terms Of Sale
           Number Of Customers And Percentage Of Business For Each
           Inventory

About the Author:
Bob Macek is a business consultant specializing in small mid-size businesses. He has been a Professional Business Broker since 1982.
If you have questions regarding the purchase or sale of small, mid-size companies. Contact Bob at: bob@probizusa.com