Starting a business is not an easy task - it requires a lot of planning, time and effort. Opening a new company, keeping it successful and keeping customers happy are just some of the challenges a business owner can face.
At some point, whether after one year of operation or after ten years, whether a new venture or a family business, it is necessary to carry out a business evaluation.
What is the value of my small business? How do I value small businesses? What are the main methods of small business valuation? What documents are needed to prepare for a valuation?
It may seem complex, but by reading this article, it becomes easier to understand how to evaluate a small business. How to Perform a Valuation of a Small Business
How to Perform a Valuation of a Small Business
Small Businesses: Why It’s Important to Evaluate.
There are several reasons why small businesses need an appraisal:
Establish the base value for the business;
Attract financiers and investors;
To develop and implement strategies to increase revenue and profitability;
To understand the company's value drivers;
To identify the current growth of the company, as in cases of stagnation, decline or delay;
To identify weaknesses and risks and define a course of action;
To identify strengths and increase the company's value;
For exit strategy purposes (e.g. closing the business and selling the assets, setting the sale price for a stake or the entire company, transfer of ownership);
Evaluate a purchase offer and negotiate a strategic sale (purchase and sale agreements);
To raise financing and determine the value of the company for partners or shareholders (acquisitions and investments);
To meet debt financing requirements (e.g. bank loan application, small and medium-sized enterprise (SME) financing, government loan);
For litigation purposes, such as disputes between partners or loss of profits.
This list is not exhaustive; there are many other reasons why a business valuation is necessary. Regardless of the reason, conducting a business valuation is a crucial step for any business owner and can be beneficial not only to the owner but also to the long-term success of the business.
Many of the companies known today started as small businesses, such as:
Magazine Luiza, founded by Luiza Trajano Donato and her husband, Pelegrino José Donato, is one of the largest Brazilian retail chains. The business began in 1957 with a small store in Franca, in the interior of São Paulo,
Cacau Show was founded in 1988 by Alexandre Tadeu da Costa. In the beginning, he used a white 1978 Beetle to make all his deliveries. He had the help of Cleusa Trentin, who prepared the chocolate. It became one of the largest companies in its field, with more than 2,000 stores.
Localiza was founded in 1973 , in Belo Horizonte (MG). Initially, it was a car rental agency, with six used Beetles available - purchased on credit. In 2016, it purchased Hertz Brasil, becoming Localiza Hertz.
The legal definition of a small business varies from country to country and even between industries. In the United States, for example, a bakery with fewer than 500 employees is considered a small business.
The definition of a small business is crucial for business owners to protect and promote their businesses. If a business qualifies as small, it can apply for government loans and grants and receive tax benefits exclusive to businesses.
Now that we know what a small business is, we need to know why it is important for the owner to understand its value.
Specificities that should be considered in small business evaluation methods
Carrying out a Valuation of a small company is challenging due to the following issues:
Dependence on a Key Person: In many cases, the company depends on a key person, which can negatively affect the company's value;
Hobby Businesses: Some are "idea or hobby businesses" with little or no revenue. In the first year, many businesses have good sales, but do not make a profit;
Customer Dependence: There may be dependence on a few customers who generate most of the revenue;
Seasonality: Seasonal businesses may have fluctuating profits throughout the year;
Self-financing: The capital comes mainly from the founder himself.
Financial Records : Accounting practices are often inadequate, making it difficult to analyze financial performance;
Financial history: limited and/or irregular;
Lack of comparable market data , especially if the company operates in a niche.
Despite these challenges, it is not impossible to evaluate small businesses using common methods, as long as the context of the business is understood.
How to evaluate a small business?
Valuation methods for small businesses are based on three main approaches:
Overview of Assessment Methods
Three main assessment approaches are commonly used:
Asset Based Valuation;
Market Based Assessment;
Income-Based Assessment.
Each method is applicable to different types of businesses and operating conditions.
Asset-Based Valuation
Asset-based valuation calculates a company's net asset value by subtracting liabilities from assets. This approach is useful for asset-intensive companies.
Tangible Assets
Physical assets include physical items such as inventory, equipment, real estate, and vehicles. Assessing their current market value, including depreciation, is crucial.
Intangible Assets
Intangible assets include intellectual property, brand equity and goodwill. Although they are complex to quantify, these assets can be significant, especially if the company has a significant market presence.
Market-Based Assessment
This analysis aims to compare the company with other similar companies that have recently been sold.
Comparable Sales Method
This method requires sales data from companies in the same industry and region, adjusting for differences in size and financial performance.
Industry Multiples
Industry multiples are another popular tool, using the average multiple of price to sales to revenue or EBITDA within the industry.
Profit-based valuation
A profit-based analysis focuses on the company's ability to generate future profits.
Current Cash Flow Analysis (DCF)
DCF is a forecast of future cash flows and a discount to the current value. It is often used in companies that have a stable cash flow.
Capitalization of profits
This method uses projected future earnings and applies a capitalization rate, which takes into account the company's risk and growth, to determine value.
Select the correct assessment method.
The best valuation method depends on factors such as industry, financial stability, growth prospects, and availability of market data. The use of multiple methods is recommended by many professionals to obtain a more consistent valuation.
Key financial metrics for assessment
Some metrics are essential to understanding the value of a small business:
Revenue and Growth Rate : Indicates market traction and growth potential.
Gross and Net Margins : Demonstrates the profitability and effectiveness of the operation.
EBITDA : Excellent for comparing companies in the same area of activity.
Owner Compensation Adjustments : Small businesses often need to adjust owner compensation to reflect actual profits.
Adjusting for Risk Factors in Small Business Valuation
Risk plays a crucial role in the valuation of small businesses, due to factors such as economic volatility, competition, and industry-specific risks. Increased risk generally results in a lower valuation.
Understanding the role of intangibles
Intangibles are very important for a small business.
Goodwill: represents customer loyalty, reputation and the effectiveness of operations.
Brand and Customer Loyalty: Strong brands or a loyal customer base add value, especially when they translate into consistent sales.
Using multipliers for quick estimates
Revenue or profit multipliers can provide a quick valuation estimate. But they are only estimates and need to be compared with more detailed methods.
Hiring professional appraisal services
Company valuations are complex and expert assistance can provide an unbiased and fair view. Valuation experts, as well as consulting firms, are experienced in the specifics of the analysis and can use advanced models and proprietary data.
Tax Considerations in Business Valuation
Valuing a company often has tax implications. Capital gains, inheritance and transfer taxes must be taken into account, especially for family businesses and inheritances.
Frequently Asked Questions
What is the most common method for valuing small businesses?
Many small business valuations utilize EBITDA multiples or asset-based valuations, depending on the type of business and financial health.
How does goodwill impact a company's valuation?
Goodwill reflects intangible assets, such as customer relationships and brand strength, which can significantly increase valuation.
Why do I need to adjust owner compensation?
Small businesses often adjust owner compensation to normalize profits for valuation purposes, reflecting the true replacement cost.
Can I evaluate my company myself?
While possible, professional assessment is recommended due to the complexity involved and the potential for unconsidered factors.
How can I increase my company's rating?
Strategies include increasing revenue, diversifying income sources, decreasing dependence on the owner, and documenting operating procedures.
Conclusion
Valuing a small business is a complex process that involves a variety of factors, from physical and intangible assets to risk assessment and market comparisons. By understanding the methods, adapting to the unique characteristics of the business, and eventually seeking professional help, small business owners and investors can arrive at an accurate and informed valuation.
Luis Valini
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