SME valuation is essential when you are planning to sell your business or preparing to get investment with some beneficial opportunities.
Small businesses planning a merger, buying out other owners, selling their business, or applying for a business loan should conduct a proper SME valuation. SME valuation is important and has benefits as well. However, there are different approaches to SME valuation based on the purpose and size of your business. Besides, the recognized methods of business valuation need to be adapted for SME valuation. The SME valuation aims to discover a small enterprise’s capital structure, future earnings prospects, and the market value of its assets.
This guide will help you understand all about SME valuations and how to calculate the value of the small business.
You may determine the economic worth of your SME business by implementing a variety of metrics. This is beneficial to entrepreneurs and small business owners who are wanting to buy or sell a company.
What is SME Valuation?
An SME valuation assesses the economic value of a section or all of a firm. These evaluations might be helpful in several circumstances. From determining the sale value of your business to divorce proceedings, you might need SME valuation in several instances.
The process analyses the company’s capital structure, management, the market value of assets, and future earnings. You might also require the help of a certified professional for this task.
Why is SME Valuation Important for Small Businesses?
There are several reasons why SME valuation is essential for small businesses. The list of reasons can go on as the valuation offers an avenue for growth and determines other aspects of the company. While we have listed many reasons below that involve changes in the firm and its ownership, personal circumstances might also force a valuation.
We have listed a few reasons why SME valuation is essential:
· The values generated by valuation will help you for purposes such as tax planning
· Valuation of your SME identifies growth opportunities that are great for expansion
· If you are applying for a line of credit or loan, an SME valuation might be required
· A business valuation also becomes mandatory if you are planning to offer equity to employees
· In case you wish to buy out other owners, valuation of a business is essential to understand the exact net worth
· Investors might also be interested in considering investing after checking your valuations
· Valuing your business’ net worth is crucial if you want to sell your business
Hence, no SME should ignore the importance of valuations. There are multiple ways through which you can leverage it to your advantage.
Pros and Cons of SME Valuation
When it comes to business valuation, you might have specific questions in mind. You might be wondering about the perks and drawbacks of evaluating your firm. SME business valuation calculation has both pros and cons to consider so that your company can make an informed decision.
· Allows discovering beneficial opportunities
· Aids decision-making by pointing out strengths and weaknesses of the company
· Valuations offer performance metrics that help companies
· Business valuations enable owners to get a good sale value of their firm
· Business valuations can expose weak areas of the firm, which can reduce the value.
· Sometimes, business valuations are based on assumptions that do not make them completely reliable.
How to Calculate the Value of Small Business
Calculating the value of a small business is essential whether you are planning to sell or preparing to get investment. Whatever target you are trying to achieve, it’s important to have a proper small business valuation. In order to achieve that, you need the right approaches and methods. There are 5 methods for SME valuation, read below to get a better chance to stand out in front of investors or sell your business.
1. Adjusted Net Asset Method
In this method, you have to begin by adding up the value of your company’s assets and subtracting its liabilities. You might want to put more focus on the numbers to get a more realistic value. This method requires you to use your business expertise to adjust the value of liabilities and assets.
The adjusted net asset method is also helpful when estimating the value of a company that’s facing loss or doesn’t earn much revenue. This valuation method is also viable for holding companies that own parts of real estate investments or other companies.
If you plan to sell your business soon, the adjusted net asset method could help you set a floor price.
2. Capitalization of Cash Flow Method (CCF)
Among the other two income-based methods, the capitalization of the cash flow method is more straightforward. This valuation method is also apt for valuing companies that have good revenue. To find the valuation using the CCF method, you have to divide the cash flow from a specific time by a capitalization rate.
The capitalization rate is your business’s expected rate of return. It is also the rate of return any potential buyer could expect to earn if they buy your firm. You should know that the ease of the CCF method also tends to affect its predictiveness.
If you own a stable and mature company that is not likely to experience swings in its revenue, this method would be an ideal approach.
3. Discounted Cash Flow Method (DCF)
This income-based approach uses the time value of money and future cash flow to determine the current worth. The DCF method is suitable for companies that expect to shrink or grow in the upcoming years of operation significantly.
The time value of money refers to the idea that money is more valuable today than it will be in the future. The DCF method takes this concept into account. As a result, the DCF method is also applicable if you are trying to compare investment opportunities.
Start with your business’s cash flow statement. You should also have an idea about the discount rate or WACC. Another important consideration is how many years’ worth of cash flow you would prefer to include.
4. Market-Based Valuation Method
With this method, you can determine the company’s current value by comparing the current sale rates of peer companies. If you have a small company, finding relevant companies can be challenging. You should still consider a few companies if you want to buy or sell a firm.
If you are seeking help from a professional valuation firm, they might also have access to relevant databases. Even if the relevant company is not in proximity or is in another state, the appraiser can adjust based on the geographical area.
Generally, businesses prefer using the market-based valuation method in tandem with other valuation methods.
5. Seller’s Discretionary Earnings Method (SDE)
The SDE method is solely meant to be used for valuing a small business. This method is rewarding for anyone who plans to buy or sell a business. The SDE method can allow individuals to understand how much income they can expect from the company every year.
You need to figure out how much funds it takes to run the firm to calculate the SDE. From the financial statements, you can find out the earnings before interests and taxes (EBIT). Next, add back the business owner’s compensation. You also have to add back the non-related, non-recurring, and non-essential business expenses.
It is not uncommon for there to be disputes about the numbers. Questions might arise around the re-added expenses to determine the value.
Challenges to Calculate SME Valuation
Key issues in small and medium-sized business (SME) valuation should be incorporated before the valuation calculation so that risks can be eliminated. The challenges are:
1. Collection of Information
Often, the quality or quantity of financial data of SMEs can be lower than a large firm. It is also worth mentioning that SMEs might not have a structure that includes a range of stakeholders. Also, they might not be actively preparing financial reports.
Because of this, financial statements might not be accurate or reliable. It might also suggest a different perception of financial risk. While valuing SME, anyone should consider all these aspects.
2. Selection of the Valuation Approach
There are three valuation methods — the cost approach, the market approach, and the income approach. The selected approach can lead to different outputs for the derived value. The SME evaluation firm should weigh in all the approaches while considering the company’s characteristics.
In all three approaches, the valuation process might come across issues. For example, you decide to take the income approach and apply the DCF method. The DCF method requires prospective financial information which an SME might not be able to produce.
To sum up, the SME evaluation firm should understand which valuation approaches will best fit the target company.
3. Analysis of SME Characteristics
In many cases, SME enterprises are family-run enterprises. Family-run businesses often attach importance to non-financial components such as business culture, reputation, image, etc. It is critical to figure out all the elements that might affect the business valuation.
For example, the board of directors might include the composition of the family. As a result, the related costs tend to be higher than in a normal circumstance.
In such cases, it is wise to try to reduce the budget allocated to the board. Also, there could be confusion between personal and corporate affairs. We also suggest that you should draw a clear distinction between the two.
How to Improve Small Business Valuation?
The valuation of your small business will depend on how much money it is making. Cost-cutting and increasing revenue are two critical elements when it comes to improving a company’s valuation. Each SME company should decide where they want to focus its efforts.
Many SMEs have experienced fantastic results after hiring a professional evaluator or appraiser. An experienced evaluator will find the current valuation and help spot the strengths and weaknesses of your firm.
Besides, an evaluation firm should also have the required experience to offer suggestions to improve the valuation of your SME firm. You should also be aware of the other ways to showcase your businesses’ valuation to potential investors or buyers. For instance, it’ll attract more potential buyers if you can convey how systems and processes can ensure that the business will run well even after you leave.
Or, maybe you can show your potential buyers that the employees are content and take responsibility for their duties. Low turnover is an attractive USP for any buyer. It can save the firm money and ensure a smooth transition to new management.
Valuate your small business
Regardless of business size, the valuation of net worth has several benefits and importance. Small businesses should not ignore the importance of valuation processes. SME valuations can help the company get insights into its performance and map out its net worth. Besides, you might also discover some arenas for growth during the valuation process. We also recommend opting for the services of a professional SME evaluation firm for accurate and reliable results.