It’s essential for startups and small businesses to understand how to value a company at various growth stages. Whether seeking loans, funding for expansion, or planning an exit strategy, knowing your company’s worth provides a vital financial snapshot for investors, bankers, buyers and stakeholders. It also helps gauge your company’s market position, assess growth potential and guide decision-making, in addition to being essential for tax reporting purposes. This guide will explore small business valuation methods that are particularly relevant for privately held companies.

Common Small Business Valuation Methods

When seeking how to value a private company, there are several methods available. Whichever one you ultimately choose, it’s important to use the same technique throughout the entire valuation process. Mixing several business valuation methods can lead to inconsistencies in your calculations. 

Asset-Based Valuation

Asset-based valuation focuses on the assets at hand. It calculates the difference between tangible assets (equipment, inventory) and intangible assets (liabilities), adjusted to fair market values. This method is often used for sales, mergers or liquidations of businesses.

For example, if a prefab kitchen cabinet company were liquidating and using asset-based valuation, it would do so by determining the value of its inventory, operational assets and delivery vehicles (considering depreciation). Then, it would calculate and subtract liabilities like loans and leases. It would then need to adjust both assets and liabilities to fair market value.

While this method provides accurate estimates of the value of equipment and goods in your possession, even including assets like real estate that don’t make immediate profit, it doesn’t account for future earnings potential or possible intellectual property value. This can result in undervaluing some small businesses.

Income-Based Valuation

The income-based valuation method is another approach to consider when determining how to calculate company value. This method focuses on potential future earnings and is commonly used for small businesses that generate revenue through commercial properties, performing investment analysis, or being involved in mergers and acquisitions. There are two distinct approaches used for this valuation: discounted cash flow and capitalization of earnings.

Discounted Cash Flow

This method values future cash flow, adjusted for risks. It’s ideal for new businesses with high growth potential that are not yet profitable. This method uses current cash flow numbers to make a future cash flow prediction. However, because it is a projection, it could be inaccurate due to any number of unforeseen factors.

Consider a floral business with varying cash flow based on seasonal sales. To calculate company value, you would take the current cash flow from a 3- to 5-year period and apply a growth rate. Then you’d use a discount rate to hedge future uncertainties with cash flow. This figure would represent the present valuation based on predicted future cash flow.

Capitalization of Earnings Method

This method considers cash flow and annual rate of return on investment to estimate the company’s value and profitability. It’s suitable for businesses with stable cash flow, as it relies heavily on historical profit data to determine value. However, this method doesn’t account for future uncertainties or risks, which can affect accuracy.

To value a company this way, divide normalized earnings (typically adjusted net income or cash flow) by the capitalization rate. The capitalization rate is the expected rate of return or the required rate of return on investment.

Market-Based Valuation

Market-based business valuation methods compare a business to similar companies in the market to determine its value. This approach can provide valuable insights based on real-world data and is particularly useful when learning how to value a private company. There are two primary methods used here: comparable company analysis and precedent transaction method.

Comparable Company Analysis

This method analyzes financial metrics and market values of similar public companies to estimate your company’s value. It’s based on real-world market data and reflects current conditions. That said, finding truly comparable companies can be challenging, especially for niche businesses. Additionally, public company data may not perfectly translate to private businesses.

This method is best used for businesses in industries that have many public companies of similar size and structure. A software-as-a-service (SaaS) company, for example, might compare its valuation multiples to those of similar public SaaS companies to estimate its value.

Precedent Transactions Method

The precedent transaction method values your business by examining recent sales of similar companies to estimate what your company might be currently worth. When applied correctly, this method can offer valuable insights into what buyers might be willing to pay for a business like yours in the current market environment. 

Because this method is based on real-world sales data, it can provide a realistic picture of market values. However, it can be difficult to find truly comparable transactions because companies should ideally be in the same industry as yours, as well as a similar size, with similar financial performance, and be operating in comparable market conditions. The amount of information about private company sales can also be a limiting factor.

Factors Affecting Small Business Valuation

Business valuation isn’t just about crunching numbers. By recognizing the factors that impact your company’s worth, you can better prepare for a valuation and potentially take steps to improve value over time.

  • Industry and market trends: Fast-growing industries often bring higher valuations, while declining sectors may lead to lower valuations even if your individual company performance is strong.
  • Financial performance and growth potential: Consistent revenue growth and improving margins typically result in higher valuations compared to flat or declining financials.
  • Intangible assets: Unique intellectual property, strong brand recognition or a loyal customer base can significantly increase valuation.
  • Economic and regulatory environment: Economic recessions often lead to lower valuations across all company types, while new regulations can create opportunities or pose threats to company value.

Preparing for a Small Business Valuation

To ensure a smooth and accurate process as you consider how to calculate company value, consider the following steps:

  • Organize financial statements and records: Prepare at least 3-5 years of financial history, including tax returns, to show consistent performance and growth trends that can positively affect valuation.
  • Document key business processes and assets: Document standard operating procedures (SOPs), as well-documented processes and valuable assets such as proprietary software can significantly increase your company’s perceived value.
  • Identify and mitigate potential risks:  Conduct a SWOT analysis to uncover vulnerabilities, then develop mitigation strategies to show how you’re proactively managing them.
  • Communicate with stakeholders and potential investors or buyers: Develop a clear, concise story about your company’s value proposition and growth potential. Effective communication often leads to higher valuations.

Valuation Experts Can Show How to Value a Company

Understanding how to value a company is essential when moving toward the next phase of your small business operations. Whether it’s getting a loan for expansion, looking for funding or contemplating exit strategies, knowing your company’s worth provides you with the necessary information to make sound decisions.

Due to the complexity of business valuation methods and how quickly growth can change, valuing your present operations can be challenging. Hiring a valuation expert can help you prepare everything needed to make the calculation. They can organize financial statements, determine potential risks, identify assets and communicate with stakeholders as well as potential buyers and investors.

If you’re seeking professional advice on how to value a private company, schedule a free consultation with Paro. We offer fractional CFO consultants who can work with you to determine what your business is worth using appropriate small business valuation methods.