Figuring out the value of a small business in Canada, like anywhere else, involves a series of careful calculations. Can you do them yourself? Maybe! Can you hire a professional? Even better.
What's the best way to value a small business?
If you own a small business and you want to determine its value, experts advise hiring a professional. Research shows that many of us see things we own as far more valuable than they really are! Professional valuation is a good idea for people who either want to buy or sell a business.
It's also a smart move for business owners when planning your future, says the Business Development Bank of Canada. The process can help you find your business's true strengths and weaknesses. A professional valuator can help you see things objectively.
If you plan on passing on the business to a family member, it's best to get an objective valuation. You will have to report its true value for your own taxes. Anyone who inherits it will also need to know its value.
For tax purposes, you would be wise to consult a tax professional before you sell. Your tax liability can be affected, depending on what valuation method you choose. Both buyers and sellers looking to value a business will come across terms such as EBITDA and rule of thumb.
EBITDA
If you hire a Chartered Business Valuator (CBV) to do a formal valuation, they will likely apply the EBITDA formula. It stands for: earnings before interest, taxes, depreciation and amortization. Your business's earnings are considered the most important part of a valuation.
The valuator will apply a multiple to your EBITDA amount. "The multiples vary by industry and could be in the range of three to six times EBIDTA for a small to medium-sized business," valuation expert Catherine Tremblay told the BDC.
Market conditions also play a role in choosing a multiple. Other factors include goodwill, intellectual property, and the location of your business. Once your valuator arrives at a number through EBITDA calculations, they will check it against other valuation methods.
First, the valuator will find the total value of all your tangible and intangible assets. Next, they will find out what similar businesses have sold for, says Tremblay. If they find any major discrepancies between the three numbers the valuator will adjust the EBITDA multiple.
Tremblay adds that business valuation is an inexact science. You may end up selling for less, or more, than your business's appraised market value. It depends on market conditions, how motivated your buyer is, and sheer luck.
How do I value a small business for investment?
The BDC has further advice for buyers looking to invest in a small business. Again, they recommend professional valuation and direct readers to the Canadian Institute of Chartered Business Valuators (CICBV). The CICBV is a reputable resource in an unregulated field.
To help you determine what a fair price would be for the business you want to buy, you can get one of three types of report. More detailed reports cost more, but they will be more accurate.
The three types of report are:
Calculation report: an approximate value for initial planning
Estimate report: good for preliminary negotiations, succession planning, and any complex situation where a budget is a factor
Comprehensive report: good in case of high risk, important issues, or legal proceedings
A calculation report is based on a review and analysis of the business's financial information. In some cases, the valuator will interview management. An estimate report is the same, but more detailed.
A comprehensive report includes the valuator's personal opinion. They will provide a deep analysis that may review:
Patents, bylaws, and shareholder agreements
Business's economic situation and sector
Market conditions and the competition
Clientele and any contracts, backlog of orders
Suppliers' contracts and commitments
A visit to the business
Financial and forecast data
Explanation of discount and capitalization rates used
What is the formula to value a small business?
The valuator will begin with the fair market value of the business. The three main things in the business they'll consider are:
Expectations
Future cash flows
Tangible capital assets
Asset-based valuation
This approach uses the following information:
Book value: The net worth of the business, calculated as assets minus liabilities, as shown in the financial statements.
Liquidation value: In this scenario, the business sells off all its assets, pays off all its debts and taxes and gives what's left to its shareholders.
Valuation based on earnings and cash flow
This method uses the following information:
Discounted cash flow: Based on the business's future cash flows.
Going concern value: Projections based on a comparison of current cash flows with future inflows.
How do you value a small business based on revenue?
Your valuator will use a variety of techniques in their calculations. Here are some of the most common:
Capitalization of typical net earnings. For investors, valuation includes future earnings from the acquisition. The calculation uses this figure to find the going concern value. It applies a capitalization multiple to the future earnings, then adds non-operating assets.
Capitalization of typical cash flows. In this calculation, future earnings are replaced with cash flows.
Discounting of expected future cash flows. This calculation finds the most likely future cash flows and discounts them at the valuation date.
Determination of adjusted net assets. This calculation subtracts liabilities from the determined fair market value of the assets. It is often used for businesses whose value is based more on assets than operations, such as real estate.
In addition to revenue investors and valuators will look at how well the business's team functions. Here is a list of desirable management capabilities from the CRA:
A range of appropriate skills and experience
A solid track record in all key business functions
An effective structure
Good communication, decision-making and consensus-building skills
The ability to grow
An alternative method to business valuation
Another way to value a business based on revenue is Seller's Discretionary Earnings (SDE). A broker might prefer this method to EBITDA if the business earns less than $1 million per year. Here is a breakdown of how SDE is calculated by Sean Murphy, of Murphy Business Sales in Halifax, NS:
Beginning with net income before taxes, add the following:
Salary of one full-time owner (not dividends)
Depreciation and amortization
Interest expense on long-term debt
Any one-time expenses that will not occur in the future
Any personal expenses incurred by the owners
Every business has a different set of tax liabilities, debt issues, owner's personal expenses, and so on. SDE tries to imagine what the business would earn without its current owner. If you were to purchase a business, SDE would show how much would be left to:
Pay yourself a salary
Service debt
Cover any capital expenditures that may be needed
Generate a return on your initial down payment
What is an industry rule of thumb?
A rule of thumb is a quick and easy way to estimate the value of a business. You may hear, for example, that the right way to value a business in your field is 75% of annual sales plus inventory. But can valuation really be that simple?
Chartered Business Valuator, Tara Singh addresses the question in her article "Thumbs Up or Thumbs Down? Re-examining the Use of Rules of Thumb in the Valuation of Business Interests."
A rule of thumb is a "ballpark estimate of value" for people trying to avoid paying for a professional valuation. Granted, professional valuation is expensive! Probably for that reason, rules of thumb remain popular. Resources such as the Business Reference Guide publish new rules of thumb for a wide range of industries every year.
The reason such guides are published every year is that rules of thumb change a lot, depending on a number of factors. Singh observes that rules of thumb can be a useful starting point for a more thorough valuation.
The problem with relying on rules of thumb alone is that they don't give you the full picture. When you need to go ahead with a sale, purchase, or complex legal issue, the true value of your business is essential information. It's important not to overestimate or underestimate your business's worth.
It pays to know the value of your business
In case of an estate freeze or corporate reorganization, not knowing your business's fair market value can land you in hot water with the CRA. The taxes involved in those situations require an accurate assessment.
In case of legal proceedings, a valuation conducted with a less than professional level of detail may not hold up in court.
Singh illustrates the problem with the example of a small service business. Say the industry rule of thumb is applied to a small service business such as a carpet cleaning company. The 2013Business Reference Guide rule of thumb for a carpet cleaning company is 50 to 55 percent of annual revenue, plus inventory.
Here is Singh's breakdown of the problem:
Carpet cleaning company A makes $100,000 in annual revenue
Carpet cleaning company B makes $100,00 in annual revenue
Company A started two years ago
Company B started 45 years ago
Carpet cleaning company A spends 20% of its revenue on advertising
Carpet cleaning company B has a long-time, established clientele
And carpet cleaning company B spends almost nothing on advertising
Rule of thumb weaknesses
You can see how using the rule of thumb wouldn't be enough to value this type of small service business. It ignores too many factors.
Other things a valuation based on the rule of thumb would overlook include:
Whether shares or assets are being bought/sold
How much debt the business has
Owner's compensation
Industry developments that make old rules of thumb obsolete
Interest rates and inflation
Marketability and/or minority discounts
Income tax considerations
Special interest buyers
Singh cites a number of legal cases in which inadequate valuation led to cases being lost or dismissed. Check out her article for details.
