It's a question every entrepreneur asks themselves at one time or another. What's my business worth? They see similar businesses offered for sale and wonder how the seller arrived at that price.

Sometimes, it's more idle curiosity than anything else – sort of a "how-am-I-doing" kind of gut check. But often, the question needs to be answered in a formal way. The owner has decided to sell. Perhaps there's a serious tax or litigation dispute. Maybe a partner wants out. Or a divorce looms, and a value has to be put on the business as part of a split of the couple's assets.

That’s when most entrepreneurs who need to put a figure on their businesses will quickly find it's not an easy matter — and definitely not an exact science.

Unlike a publicly-traded company, where the market gives its minute-by-minute opinion of a company's worth through its stock price, the valuation picture for smaller, privately-held companies is a lot less transparent.

There are many valuation methods out there. Some valuations are arrived at based on the book value of the business – assets minus liabilities at its most basic. Some businesses sell for a fraction of book value because they’re being liquidated.

But let’s assume the business is a going concern. The current owner wants to sell and retire. So what’s the business really worth?

No MLS for small biz

Value isn’t an easy thing to figure out. For one thing, there’s not a lot of comparable, publicly available information for very small businesses. There’s no complete, MLS-like database on previous sales transactions, for example. This is where experienced business brokers really earn their pay.

First off, a good business valuation means gathering information … and lots of it.

First, the evaluator needs to take a look at the industry the business is part of. Is the industry changing rapidly? Is it booming or declining? Is it easy for competitors to enter the market?

How does the business interact with the industry? What’s its market share? How good are the relationships with its customers, suppliers and bankers? Is the company's building or facilities also for sale, or just the business itself?

But it’s the books that will ultimately tell much of the story. Corporate financial statements – and that includes tax returns — will reveal what the company brings in and what it pays out. Buyers should ask for five years of statements to see how the business has developed.

In the hands of a professional, the examination of the wider industry (the macro) and the corporate financial records (the micro) will allow the valuation process to enter high gear.

Discounting the future

In some ways, the process of business valuation seems a bit like fortune telling because it involves looking far into the future.

“Business value at a point in time represents the future profits,” says Farley Cohen, a principal at Cohen Hamilton Steger & Co., a Toronto-based business valuation firm.

“If I buy the business, what do I get? Although we use the past as a guideline to help us do that, we’re really trying … to estimate what the future’s going to look like.”

Cohen says a business valuator usually first comes up with estimates of future profits or cash flows. Then the valuator might either capitalize the value – applying a certain multiple of annual profits to arrive at a present value – or the valuator might take the estimated future cash flow projections and then discount them to today.

Why discount? Future cash flows are typically discounted to reflect the time value of money and the risks that future growth projections might not materialize.

Picking the appropriate multiplier or discount rate depends on the risk inherent in the industry and in the particular business.

Finding a business valuator

If arriving at an appropriate earnings multiple or discounting future cash flows appear to be tasks that aren’t for amateurs, you’d be right. In Canada, more than 1,400 people – Farley Cohen among them -- have the letters CBV after their name. That designation stands for Chartered Business Valuator.

You can find a CBV through the Canadian Institute of Chartered Business Valuators. Most are accountants and all have advanced training in business valuation.

Be warned that their services don't come cheaply. Even a straightforward valuation report will typically cost thousands of dollars. But when you’re talking about a transaction in the hundreds of thousands or millions of dollars, it can be money well spent.

Business brokers who specialize in the sale and purchase of commercial and industrial businesses also perform pre-sale valuations. Because of the amount of work involved in coming up with a valuation and eventual sale, many brokers charge a retainer up front that will be credited to the client once the deal goes through. Commissions will typically run to 10 per cent on the first million dollars, with declining percentages on amounts above that.

The best business brokers and valuators provide the seller with confidentiality. "When we evaluate a business and put together an information package that can be marketed, we never mention the seller's name or location until we've qualified the prospective buyer," says Mike Hammer, a business broker with Toronto-based Canadian Business Counsellors. "At that point, we filter inquiries to ensure they're a good fit."

‘Normalizing’ the picture

When someone wants to buy a business, they inevitably want to know how profitable it is. This isn’t as obvious as looking at the bottom line.

If the valuation method uses a multiple of net earnings, you need to be sure about what exactly “net” means.

Some people do a multiple of ‘net before owner’s salary', because it’s a smaller business. Some people put personal expenses through their businesses. So you need to adjust the net earnings to make sure you’re comparing apples to apples.

Normalizing the earnings adjusts for any revenue or expense items that may be out of the ordinary.

You’ll see many businesses priced at, say, three to five times normalized EBIT (earnings before interest and taxes). But that’s a very rough guide – a rule of thumb, as it’s called – that can easily trip up the unwary.

Rules of thumb

You may have heard about even more specific rules of thumbs when it comes to arriving at the price for a small business.

Some who make their living selling businesses regard these almost as gospel. There are even handbooks out there with guidelines that suggest certain business-specific rules of thumb for some retail or small businesses.

Here are some examples:

• Hair salon – One times adjusted annual earnings.
• Dental practice — 50 to 60 per cent of annual gross revenue.
• Book store – 15 per cent of annual sales-plus-inventory.
• Coin laundries – 20 times monthly gross revenue.

This can give business owners a rough idea about the value of their business, but the pros advise against using rules of thumb as the only determinant.

"We use rules of thumb only as a secondary approach," says Cohen. "If the rule is one times revenue and two businesses have the same revenue but one makes money and the other doesn't, the rule of thumb would suggest those businesses are worth the same amount. But clearly, the business that makes money would be worth more."

Some brokers shy away from rules of thumb entirely. "I don't use them, don't trust them, don't like them," says Stewart Baker, president of Saint Andrews, N.B.-based CBI Business Brokers. "Rules of thumb are averages and no business is average …each is unique," he says.

Baker points out that there can be regional differences in valuing small businesses. "Many businesses in the Maritimes own their own real estate," he points out. So a separate real estate appraisal may need to be part of the valuation equation.

Some types of professional businesses, like accountants and financial advisers, sell a book of business – i.e. their client accounts and the ongoing fees and commission those accounts will generate. Sometimes, there's a payment over one, two or three years, depending on how many clients stay.

In the case of a very small retail business, it will be too expensive to do an independent business valuation and many business brokers don't do small deals. Commercial real estate brokers are one option here. Some real estate brokers specialize in certain kinds of retail business transactions, like car washes, restaurants, or gas stations. That kind of experience can be useful in arriving at how one business stacks up against another in a given market.

The importance of goodwill

It's important to establish the value of the intangible assets of the business – especially goodwill. That's an amount that's over and above the fair value of a company's net assets. It takes into account such things as the staff's knowledge, the good relationships with their customers and suppliers, its position in the marketplace and the reputation of the business in the community.

"If a prospective buyer says 'I don't pay for goodwill,' then I say go to a liquidator," says Mike Hammer of Canadian Business Counsellors. In other words, if a business is healthy and making money, chances are it's worth more than the sum of its net assets.

In the end, arriving at a suggested selling price is as much an art as a science. As for arriving at that final price, it can be delicate matter.

"Quite often we find that people think their business is worth more than we think it is," Farley Cohen says. He points out that buyers tend to focus on risks, worrying about whether profit margins will go down, for instance, or that they might lose a major customer, while vendors think mostly about growth and higher profits."

In all but the smallest transactions, buyers and sellers typically have each done their own valuations. Squaring those can be a challenge. Typically, each side will spell out how they arrived at their own valuation. In the end, the process is often emotional … and intensely personal.

"You can't take people out of the equation," says Mike Hammer. "The fit and chemistry [between buyer and seller] is important. The sellers want to monetize their assets but they don't want to sell their business to an incompetent."

But if the will is there on both sides, the deal can usually get done. Just don't expect it to be a quick process, or an easy one.

So if you're thinking of selling and your go-between's method of coming up with a price consists of simply asking, “How much do you want?,” the pros say it might be an idea to find someone else if you want to get a fair price.