Are you Over-Valuing Your Sole-Proprietorship Business?

This week, I’ve written an article for Craft Industry Alliance on Tips to Prepare, Value and Sell your Craft Business. It’s a members-only article. If you aren’t already a member, the articles and forums on the site are well worth the annual fee. Sign up! Below is an expansion of an excerpt from the article.

The value of a business is usually estimated at 1.5 to 3 times the annual profit of the business, depending on a variety of factors. This figure, of course, is of great interest to anyone considering selling their business.

Let’s take a look at a concrete example. Laura is looking to sell her fitness studio. The studio brings in $1 million dollars annually, and the business spends $900k annually on equipment, rent and staff wages. The profit for the business is then $100k (income minus expenses equals profit). Laura could expect to sell her business for anywhere between $150 and $300k.

Selling a business as a sole proprietor

Now let’s shift scenarios. Let’s look at Allison as a freelance fitness instructor, running a sole-proprietorship. She earns $100k in annual income and spends $30k in expenses, including advertising and payments to her web developer and freelance graphic designer. She puts a profit of $70k on her tax forms. So, her business is worth anywhere from $105 to $210k, right?

No. This is an example of a classic over-valuation of a sole-proprietorship business.

So why are these two examples different? There’s a crucial difference between a business and a job, and many sole-proprietors forget to take into account their own labor. The profit of Allison’s business is only $70k a year assuming she is working for free. This is different from Laura’s business, which included employees (and her own labor) as expenses.

Conflating payment for your own labor as a business owner and profit of the business is a common mistake, but becomes particularly pronounced when you’re at the stage of valuing your business for sale. (This distinction is so rarely understood that it’s one of the main reasons the book Profit First has become so highly recommended in entrepreneurial circles.)

A more practical valuation of Allison’s business would be around $20-40k, depending on the number of hours she puts into her business. And don’t try to cheat the books by paying yourself $10/hour to make your company appear to have a larger profit. A future owner would need to replace your labor paying someone else a fair hourly rate: and for most professionals, that’s far above minimum wage.

Whether you’re in the process of selling your business or just considering it as a ‘maybe someday’ option, it’s important to distinguish between your income working in the business and the profit the business is netting.  And most entrepreneurs are taken a bit by surprise: attaining a healthy profit for your business most likely requires you to raise your prices and trim costs to gain a plump margin. Plan for it!