How To Value a Small Business That’s Losing Money
Whether you are developing an exit strategy, raising capital, offering stock shares to employees or family members, drawing up a buy/sell agreement, or selling your business, you’ll first have to know what your small business is worth.
There are a number of different formulas to value companies, but many rely on net income. When a company isn’t turning a profit, determining business worth can be easier said than done.
That’s not to say that business owners can’t value a business that’s losing money. They’ll just have to work a little harder to do it.
Common Business Valuation Methods
Businesses are most commonly valued in one of three ways:
- Multiple of Earnings. This method establishes a valuation by multiplying the business’s net income by a “multiple,” a number like two or three. The number used for the multiple is based on the industry and other factors, and each industry and business type has its own range of generally accepted multiples.
- Market Comparison. This method uses the sale price of similar companies to arrive at a valuation. If you own a tire store, for example, you would research the price other tire stores sold for and use it to determine a sale price for your business.
- Asset Value. This method values a business by calculating the sum of its parts. To arrive at an asset value, you would add up the fair market value of each of your business assets and subtract liabilities. The total is your business valuation.
You can include both tangible assets, like equipment and inventory, and intangible assets, like brand recognition and customer lists, in your asset value calculation.
A business that’s losing money can use the market comparison or asset value method, but using the earnings multiple method just won’t work for an unprofitable business. Simply put, a negative number multiplied by any number will still be negative.
The market comparison model will show buyers what others paid for similar companies, but it won’t tell them what returns they can expect from their investment. Likewise, the asset value model shows how much it would take to recreate the business, but it gives no data on the profit a buyer can expect.
Other Methods for Valuing a Business
A number of other methods are commonly used when a business isn’t profitable. Each has its own advantages and drawbacks. A business broker or business appraiser can help you to determine the best formula for your situation. But when you want to sell your company, remember that regardless of the valuation you use, a business is only worth as much as a buyer is willing to pay for it.
Multiple of Revenues
To arrive at a valuation using this method, you would divide the sale price of similar companies by their revenues for a given period to get a multiple, take an average of the multiples in your sample, and multiply it by your company’s revenues.
This method isn’t considered a reliable indicator of a company’s value because it doesn’t include profit (a major consideration for most buyers). Because the multiple of revenues method tells you nothing about a company’s profitability, it is most commonly used for startups and young companies that have not yet turned a profit, but can be expected to do so in the future.
Discounted Cash Flow
Discounted cash flow (DCF) uses future cash flow to establish a present-day value for a company. To use the DCF method for a valuation, you would first project your annual cash flow for a given period of time, usually three or five years. The period of time will vary depending on the stage of the business and how long it will take to mature. Next, apply a discount rate such as 5% or 10% that represents the return you would receive if the same dollars were used for a different investment or were earning interest.
The current value of the business is the total cash flow over the given period, less the discounted amount.
Enterprise Value and Multiple
An enterprise multiple is a type of business valuation that’s most commonly used in publicly held company mergers and acquisitions. First, the enterprise value is calculated by taking a company’s market capitalization, adding debt, and subtracting the cash on its books. Then, the enterprise multiple is determined by taking the enterprise value and dividing it by EBITDA (earnings before interest, taxes, depreciation, and amortization).
Getting Your Business Ready for a Valuation
Before you start applying any formula to determine your business valuation, you’ll want to explore ways that you can improve your balance sheet.
A profitable company always commands a higher valuation than one that is losing money. Remember that selling your business for a price higher than the value of your assets has tax advantages because the amount you receive over asset value can be recorded as goodwill. Goodwill is subject to capital gains taxes which is a lower rate than equipment, furnishings, and other assets are taxed.
Some of the ways you might improve the profitability of your business are:
Recast Financial Statements
For many private companies, financial recordkeeping aims to show as little profit as possible to reduce tax liability. But suppose you are getting ready to sell your business, raise capital, or take on new shareholders. In that case, you’ll want to remove expenses like vehicle leases, club memberships, and travel that reduce your company’s profitability.
Consider using the seller’s discretionary earnings (SDE) method of accounting if you’re not already doing so. SDE is considered a standard accounting metric for owner-operated, private companies because it only shows buyers necessary business expenses, not the discretionary items that are specific to the seller and might not be needed by a new owner.
Similarly, if your business moved, or you renovated your facility some years back, clearing those expenses from your financial statements will improve your profitability.
Lower Expenses
Reducing expenses has a direct impact on your bottom line. Take a close look at items like your cost of goods, supplies, marketing, and other operating expenses to determine whether you can reduce costs. However, use caution in reviewing your payroll expenses.
While cutting staff can improve your bottom line, you’ll want to make sure that your business has the human resources it needs to function effectively.
Explore New Revenue Streams
If your business is still showing losses, it might be time to revisit the income side of your balance sheet.
- Can you add products or services to increase revenue?
- Dust off your business plan. Does it include ideas for business development that you never got around to implementing?
- Consider ways to expand your customer base. Consumer businesses might add subscription services to encourage repeat purchases. Business-to-business companies might offer promotional prices to new customers.
Look Beyond the Financial Statements
While it’s likely that potential buyers will apply at least one, if not several, business valuation methods before deciding to make an acquisition, it’s important to remember that the value of a business is determined by more than its balance sheet.
No matter the valuation method used, other factors also carry weight in a business valuation, including:
- Intellectual property
- Industry trends and projected growth rates
- Competitive environment
- Intangible assets such as a company’s reputation
- Business location
- Building lease
Perhaps most important for a potential buyer are the reasons the business is losing money and the amount of time and money it will take to turn losses into profits.
The Reasons Behind the Losses Affect Valuations
Not all losses are created equal, nor are they treated equally when valuing a business.
In most cases, the valuation for a business that’s losing money will include a discount. This adjustment accounts for differences between the market rate of return for similar companies or the cost of capital compared to the company’s returns. But the discount amount can vary greatly depending on the reasons the business is losing money.
For example, losses from temporary business disruptions, such as weather events, won’t weigh as heavily on the business valuation as losses due to falling demand for products and services. Factors that can be easily turned around should not greatly impact your business’s value.
Establishing the value of a business that’s losing money is essentially determining its worth. Look for the hidden value in your business and ways to streamline operations, optimize products, and establish additional revenue streams. Valuing a business is a multi-layered process and will often combine one or more valuation methods. To get started, try using the BizBuySell BizWorth Calculator, which will generate an industry multiple based on the financials of comparable businesses in our database.