A Valuation Metric Just for Small Businesses: Valuing a small business, like a mom-and-pop restaurant, requires a different approach than what you’d use for a large corporation. Traditional valuation methods, such as discounted cash flow analysis or price-to-earnings multiples from publicly traded companies, are often too complex and irrelevant for small businesses. Instead, valuation advisors turn to a more suitable metric: Seller’s Discretionary Cash Flow (SDCF).
Why SDCF Works for Small Businesses
Public market data doesn’t capture the unique characteristics of small businesses, which often serve as a steady source of income for their owners. Small business owners value being bosses, employing family members, and passing on a legacy. They also enjoy discretionary perks like business trips, company cars, and season tickets. In return, they build “sweat equity” in their ventures. SDCF reflects these unique elements, making it a more meaningful metric for small businesses.
Calculating Seller’s Discretionary Cash Flow
To estimate your small business’s value using SDCF, start with earnings before taxes and then adjust for:
- Non-operating income and expenses
- Unusual or nonrecurring income and expenses
- Depreciation and amortization expense
- Interest income and expense
- One owner’s total compensation
- Above (or below) market rates paid to or received from related parties
- Discretionary expenses
Identify and disclose all discretionary expenditures relevant to a potential buyer, such as business-related meals. Document all benefits for the owner and employees to show potential buyers the available benefits and their approximate annual costs.
Comparing to Similar Businesses
Once you have calculated SDCF, compare your business to similar companies in your industry with comparable size, financial performance, and geographic locations recently sold. Calculate the SDCF-to-value multiple for each comparable transaction to understand what your business might be worth in the current marketplace.
Recognizing Dual Elements of Value
SDCF multiples derive value from all the cash flows available to an individual business owner. This method captures an owner’s return on investment and reasonable annual compensation, which are valuable to small business owners. Small business buyers focus on sufficient income for their livelihoods, similar to dividend returns for stock investors. Sellers are interested in how buyers perceive their businesses as investments, similar to stock appreciation.
Why Professional Valuation Matters
Small businesses can be challenging to value because they don’t fit traditional valuation models. Valuation professionals view SDCF as a meaningful metric for both buyers and sellers of small businesses. It’s often preferred over more sophisticated methods like discounted cash flow techniques and stock pricing multiples.
Partner with Patten and Company
Whether buying or selling a small business, partnering with a qualified and experienced valuation advisor is crucial. At Patten and Company LLC, our CPAs can assist you in capturing and presenting the correct financial data to calculate a reasonable value estimate. Let us help you navigate the complexities of business valuation with expertise and precision.
Contact Patten and Company today to discuss how we can assist with your business valuation needs and ensure you get the most accurate and beneficial assessment for your small business.
