How to determine small business worth when acquiring ownership of the small business where you’re currently employed

How to determine small business worth

Thinking of buying the small business where you’ve been working for years? It might feel like a natural next step in your career—you know the customers, the operations, and you’re passionate about its future. However, a challenging question arises: how do you determine its true value?

Valuing a small service business can be a daunting task, particularly when dealing with intangible factors like customer loyalty or employee experience. Below, we’ll dive into a simple yet effective way to approach this process without getting tangled up in complex calculations and confusing jargon.

Start with the Basics: Understanding Business Valuation

A business valuation helps you determine how much a company is worth if you want to buy or sell. For small service businesses, such as carpentry, upholstery, or bakery shops, this process often boils down to examining profitability, assets, market conditions, and growth potential.

There are three common methods for valuing small service businesses:

  1. Asset-Based Valuation: In this method, you add up the value of all the business’s assets and subtract liabilities. In a service business, assets might include machinery, tools, and furniture. For example, you could have about $25,000 in capital assets, which form the core tangible value of the business.
  2. Income-Based Valuation: This method evaluates the profitability of the business over a period of time and uses a multiplier to determine value. The goal is to estimate what future earnings might look like and assess whether the business generates consistent profit.
  3. Market-Based Valuation: This approach involves comparing your business with similar ones that have recently sold. While this can be challenging in a niche local market, it can still serve as a useful reference.

How to determine small business worth: 3 methods

Now, let’s apply one of these methods in a practical context.

Applying an Income-Based Valuation (Using Multipliers)

One of the easiest and most common ways to value a small service business is through an earnings-based approach, often referred to as using a multiplier.

This involves taking the average net profit of the past few years, multiplying it by a certain number, and then adding the value of assets.

Here’s a simplified version of that formula:

  • Business Value = (Average Net Profit * Multiplier) + Asset Value

The multiplier represents the perceived future value of the business. For most small service businesses, this multiplier typically ranges from 1 to 3 times the annual profit, depending on factors like business stability, the industry, growth potential, and associated risks.

Practical Example: Understanding the Numbers

Consider a small carpentry business with an average net profit of $40,000 per year over the past four years. If you use a multiplier of 2.5, the valuation would look like this:

  • $40,000 (Average Net Profit) * 2.5 (Multiplier) = $100,000

To this, add the value of the equipment, tools, and assets, which is about $25,000:

  • Total Business Value = $100,000 + $25,000 = $125,000

However, there are more things to consider when determining if this valuation is appropriate.

a graph of a business

Including the Owner’s Salary in Your Calculations

The owner’s salary is an important consideration, as it often reflects the work they perform daily. When buying a small business, you have to ask yourself whether you can continue to draw that salary while keeping the business profitable. Let’s say the owner’s salary has been around $50,000 per year. If this salary is deducted from net profits, it may leave little to no actual profit, indicating that the business might not be as valuable as initially thought.

This suggests that the value beyond tangible assets relies heavily on operations and customer loyalty rather than sheer profitability. It’s crucial to assess whether the business can continue operating at a profit while sustaining such a salary.

Evaluating Market Conditions and Future Prospects

Aside from financial calculations, you also need to consider market conditions and future prospects. For example, if rent is expected to rise significantly in the coming years due to city beautification projects, this could dramatically impact profitability. Consider the following scenarios:

  • Rent Increases: If rent is set to double, you need to recalculate operating costs to see if the business can still sustain its profit margins.
  • Staffing Issues: If a significant number of employees are nearing retirement age or planning to leave, you may face potential challenges in maintaining skilled labor, which can impact both customer satisfaction and the quality of service.

How to Protect Yourself: Owner Financing

One way to mitigate risk when buying a small business is to consider owner financing. This involves making installment payments to the current owner over time, often using profits generated by the business itself. For example:

  • You could pay 20% upfront and then make monthly payments based on the net profit. This reduces your risk because if the business doesn’t perform well, you won’t be stuck with large loan payments that you cannot afford.

This arrangement also gives the current owner an incentive to help you succeed, since their payments depend on the business’s continued success.

a cartoon of a man putting money into a machine

Practical Tips for Negotiating the Purchase

Negotiating is a crucial part of buying a business. Here are some tips to keep in mind:

  1. Consider Starting Your Own: Sometimes, it’s worth considering whether you could start a similar business from scratch. For instance, if setting up a similar business costs significantly less—perhaps $40,000 – $50,000—it might be more cost-effective than buying the existing one. However, starting from scratch means you won’t have an established customer base, which is a valuable asset.
  2. Focus on Tangible Assets and Profits: It’s important to keep your focus on the tangible elements of the business—assets, profits, and revenue streams. The current owner may have an emotional attachment that inflates their perceived value, but you should base your offer strictly on measurable business metrics.
  3. Consult an Accountant: Make sure you examine not only the business’s financial statements but also its tax returns. Tax documents provide an accurate picture of what has been reported to the government, ensuring transparency and reliability in understanding profitability.

Conclusion: Finding a Balance Between Valuation and Practicality

Valuing a small service business requires a balance of analyzing historical financial data, evaluating tangible assets, assessing future growth opportunities, and considering potential risks. Remember, a business is only worth what someone is willing to pay for it, and each buyer may value it differently.

On paper, a business may be worth $125,000, but factors like increasing rent and an aging workforce might make you reconsider its true worth. In some cases, starting your own version of the business might be a better option if it would save costs and help you avoid potential challenges with existing operations.

Ultimately, the value of a business isn’t just about the numbers; it’s also about understanding the risks and making an informed decision that aligns with your financial goals and future aspirations.

Don’t let financial challenges hold your desire to be your own boss back. Explore CentsIQ‘s tailored solutions for small businesses and start focusing on what you do best

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