Estimating the Value of a Business

Rhonda plans to sell her retail business. Is there a formula she should use to figure the asking price?

QUESTION: Rhonda in Virginia plans to sell her retail business. Is there a formula she should use to figure the asking price?

ANSWER: Yes, Rhonda, there are really two formulas most often used in small business for valuing a small business. The minimum that your business is worth is called book value, and that is if you just closed the business and sold off your inventory, collected any bills that were due to you—any receivables—paid the payables and any bills you owed out and netted out the cash. In other words, how much after you sold off everything and collected everything would you have in your hand? That’s called book value, and your business is worth at least that because you can just close it and get that out of it.

The most your business is worth is somewhere between four and five times your net profit after you are paid as an employee—a reasonable wage for your employment. So if you’re not paying yourself a salary out of your business, then you would have to pay a manager to manage the business if you didn’t work there every day. Take that out, and whatever the net profit is of the business—taxable profit—after the basic wages are paid to operate the business and the other expenses are paid to operate the business, about four or five times that—that gives a 20 or 25% rate of return for an investor buying the business. That’s called a cap rate method of placing a valuation—a capitalization rate method of placing a valuation on the deal, and that’s what you want to get into.