Business valuation mixes art and science in considering a number of factors that go into determining what a business is worth.

Why do you need a business valuation? There are many reasons, but the most common include:

Set a fair market value for sale.

Set a fair market value for a loan.

Determine the value of a business interest as part of a buy-sell agreement

Determine the value of a business interest for estate tax or other tax purposes.

This column will focus on business valuations for buy-sell agreements.

If you’re establishing a buy-sell agreement, you probably need some way to fund each owner’s financial obligation. Before any owner commits to buying another owner’s interest, you must have a mutually agreed-upon value for the business or a method to calculate the value.

What goes into determining the value of a business? What methods are used to calculate business value?

Here are some of the typical factors that enter into a business (non-farm/non-ranch) valuation calculation as expanded from https://fitsmallbusiness.com/business-valuation-calculator:

How long the business has been in continuous operation with essentially the same mix of products, services and markets.

Net profit, generally over a three- to five-year period.

Trends for revenues, profits, markets and other factors.

Website traffic.

Online and offline sales network.

The type of business model the company uses and how that compares with other companies with similar profiles; experiences; and markets, products and services.

If the company serves a niche market, how dominant the company is in that market and the stability of the market.

Main competitors and whether or not one of them could become a potential purchaser of the business.

Cash, real estate and other tangible and intangible assets.

One of the simplest ways to calculate the approximate value of your business is through seller’s discretionary earning (SDE). You basically calculate what a buyer would see from the business when you add back to your earnings, other perks, tax payments and many of the items you took as business deductions and then apply a multiplier. Think of this earnings as the amount a potential buyer gets if he or she doesn’t spend revenue on non-essentials in the same way you do. 

Some of these “add-backs” might include:

Owner or owners salaries.

Perks for personal travel reimbursement or vehicle payments.

Personnel in non-essential positions.

Such non-cash expenses as depreciation and amortization.

Leisure activities, club memberships and gifts.

Charitable donations.

Personal expenses — such as the purchase of a personal vehicle or medical expense reimbursement — included on the business tax return.

Such non-essential travel expenses as attending conferences, continuing education seminars and trade shows or exhibiting at these events.

One-time expenses unlikely to reoccur.

Such expenses as rent, salaries for necessary staff and taxes aren’t included in the SDE calculation.

The SDE multiplier is typically between one and four times the result of the amount of SDE. This factor is industry driven, but also into account such difficult to value or quantify considerations as company size, geographic location, good will, industry, market risk and the tangible and intangible assets of the business.

According to BizBuySell (www.bizbuysell.com), the biggest factors influencing the SDE multiple are usually owner risk and industry outlook. If a business is highly dependent on you or another owner, it can’t be easily transferred to new ownership and the valuation will suffer. If you’re selling a business in an industry or area expected to grow in the near future, the SDE multiple will be higher.

Business valuation worksheets are available online. These make a good starting point, so you only include what’s normal in the SDE and don’t overlook anything. 

Always consult an appropriately credentialed valuation professional as well as licensed insurance, legal and tax advisors when seeking a viable business valuation.