Understanding your business’s value isn’t just important when you’re ready to sell—it’s crucial knowledge for securing loans, getting proper insurance coverage, and planning for your company’s future. This knowledge becomes especially critical when seeking financing, as lenders, particularly for SBA loans, often require professional valuations for business acquisitions. Here, we break down different approaches for determining how much your business is worth so that you can be prepared for opportunities on the horizon.
Understanding the three business valuation approaches
When determining a business’s value, professional valuators consider three different approaches, each offering a unique perspective on what a company is worth:
- The income approach looks at how much money your business is likely to make in the future.
- The market approach examines what similar businesses have sold for recently, similar to how real estate agents compare home sales.
- The asset-based approach adds up everything your business owns (equipment, inventory, property, etc.) at current market prices, then subtracts what you owe.
Professional valuators typically don’t rely on just one of these approaches. Instead, they blend them, weighing each one based on the specific business circumstances, quality and quantity of available data, purpose of the valuation, and industry standards.
The income approach: Understanding your profit potential
The income approach is one of the most widely used and trusted valuation approaches because it focuses on what matters most to investors and buyers—how much money your business generates.
There are several ways to apply the income approach, but they all begin with a careful analysis of your business’s earnings. The simplest version uses a multiplier based on your annual profits. These multipliers vary by industry because different types of businesses carry different risks and growth potential.
- Service businesses typically sell for 2-3x their annual profit because they often depend heavily on the current owner’s relationships and expertise.
- Manufacturing companies tend to command higher multipliers, often 4-5x their annual profit, due to their tangible assets and established processes.
- Technology companies can see even higher multipliers, sometimes 6-10x their annual profit or more, reflecting their potential for rapid growth and scalability.
For example, if your service business makes $100,000 in annual profit, its estimated value might range between $200,000 and $300,000. However, if that same profit came from a technology company with rapid growth, it might be worth $600,000 to $1 million.
Professional valuators often use more sophisticated versions of the income approach to provide greater accuracy, but understanding this approach is a good place to start.
The market approach: Learning from similar sales
The market approach operates much like determining house prices by looking at comparable properties in your neighborhood—it examines what similar businesses have recently sold for. This approach proves particularly valuable because it reflects actual sale prices rather than theoretical valuations.
To use the market approach effectively, you need to identify businesses that are very similar to your own. This means looking beyond simple industry classifications to find companies that match yours in size, location, business model, and financial performance. Key factors include similar revenue and profit levels, comparable customer bases, and matching market positions.
Professional valuators and business brokers will use specialized databases containing details of private company sales when valuing your business. While exact transaction details may not be public, these resources provide crucial insights into market trends, typical selling prices, and the factors that influence business value in different industries.
The asset-based approach: Adding up what your business owns
While income and market approaches often take center stage in business valuation, the asset-based approach provides important information on what your business owns. This approach starts by listing everything your business possesses—from equipment and inventory to buildings and intellectual property—and adjusts the value of the items to current market prices, rather than what you originally paid. Then, any debt you owe is subtracted.
Think of it like calculating your personal net worth: you add up everything you own at today’s values, then subtract everything you owe. For a business, valuators examine:
- Physical assets like equipment, vehicles, and buildings
- Inventory currently in stock
- Cash in bank accounts
- Money owed to the business (accounts receivable)
- Any intellectual property or patents
From this total, they subtract:
- Outstanding loans
- Money owed to suppliers
- Other debts and liabilities
For most operating businesses, this approach alone won’t tell the whole story. What your assets are worth on paper often doesn’t capture your business’s true market value, especially if you have strong earnings or significant intangible assets like customer relationships, brand recognition, or specialized expertise. Professional valuators will typically use the asset-based approach in combination with other approaches, particularly when evaluating manufacturing companies or businesses with substantial physical assets.
When to seek professional help
While understanding basic valuation approaches helps you make informed business decisions, certain situations demand professional expertise. These include seeking bank financing, engaging in merger or acquisition discussions, planning for taxes, considering a business sale, or managing partnership buyouts or disputes.
Professional valuators bring several crucial advantages to the process. They have access to detailed market data that isn’t publicly available, understand industry-specific factors that affect value, and provide an objective third-party perspective that carries weight with banks and potential buyers.
A professional small business valuation typically costs between $3,000 and $5,000. The process usually takes several weeks and involves thorough review of historical financial statements, analysis of market conditions and competition, management interviews, and assessment of unique business characteristics.
The final word on business value
Remember that different valuation approaches may produce varying results, and no single approach tells the complete story. Professional valuators typically use multiple approaches and weigh them based on your specific business circumstances.
Whether you choose to calculate a rough estimate yourself or engage a professional valuator, understanding your business’s value helps you make better decisions about growth, investment, and long-term planning. Regular valuation reviews should be part of your business management strategy, helping you track progress and adjust course as needed to build value over time.