"Your valuation's ridiculous; I'm out." How many times have we heard those words from one of the Dragons in the Den? For many SMEs, understanding the market value of their business is the last thing on their mind. However, such knowledge is critical for any owner seeking not only to attract but also to maximise external investment in their business. So how do you do this? There are three main schools of thought:

What's the value of your assets?
The most simple of valuation methods, this technique values your business based on its assets less its liabilities at a point in time. This is often used for companies which are asset-rich, such as property and investment businesses. The valuation is usually based on the balance sheet and then adjusted to reflect current market values and specific business circumstances. It is not uncommon to use a third-party valuer to perform this.

How much cash will your business generate?
The maths behind this method is a bit tricky, but in essence it values your business based on its expected future cash flows. Commonly used among institutional investors, cash flows will be estimated based on either historical performance or a business plan and then these will be discounted to take into account both inflation and also the perceived risk to the investor.

What are your trading profits?
Probably the most common method used, an investor will look at your current annual profit before tax and adjust it to add back depreciation (the cost of business assets, spread across their useful business life) and interest charges. This is better known as EBITDA (Earnings Before Interest, Tax & Depreciation). This figure will then be multiplied by a factor based on your industry (calculated from other historical sales) and also the speed of growth of your business and future earnings potential. This multiple can range from 1 to 20 or more. In the current market, however, multiples of 4 to 8 are realistic for most businesses.

So, that's the theory. However, in my experience, most investors adopt a market-based approach which would typically be to negotiate a valuation taking into account not just the points above, but several other key factors which are not captured by mathematical formulae, such as:

The market - Are many people looking to invest in your sector or your business right now and what average profit multiples have been achieved?
Your Product/Service - Is it new, unique, on trend or in demand?
Over and above the financials what are you really selling? – Consider factors such as your customer base, business expertise, intellectual property, speed to market?
How risky is the investment - To what extent is your business plan proven?
Previous investment levels - If someone invests £100k for a 10% stake, that immediately values the business at £1m. Any further investment, and therefore valuation, should reflect what's subsequently changed in the company (either good or bad).
Control - The amount of equity given away in an investment round needs to be tempered with future investment down the line. If you give too much away too early, you'll find there's not much left for you by the time you get to round three or four.
Gut feel - Both trust and personal rapport play a huge role in any negotiation.

In essence, the value of your business is simply the price you are willing to sell it at and the price someone else is willing to pay. However, by considering some of the factors above you’ll go into meetings with potential investors neither setting yourself up for a Dragon’s Den-style fall nor selling yourself short.