Creating value for yourself is fundamental to the success of any small business. Unfortunately, too many small business owners don't seem to understand the value of what they own and sometimes look at the wrong things when defining it. They typically overstate the value of their business. They think about how "good" the business has been to them over the years and use that as a proxy for its value.

Creating value is about what your business is worth to someone else, not to you. Whether you plan to pass the business on to the next generation or sell it, building value means thinking in terms of turning your business into an investment. How much expertise and experience does the next owner need to keep the business successful? If it's really an investment, very little. Know who might be interested in buying your business, and why, even if it is an event that will happen ten years down the road. Whether you intend to sell the business is irrelevant. Its the thought process that's important to building value.

Keep two things in mind when it comes to the value of a small business. First, value and profitability are not the same. In fact, while a valuable company produces profits, profits are not always an indicator of value. The "quality" of a companys earnings is important to its value; if those earnings can't be consistently realized in the future, for whatever reason, why would you expect them to add to the value of the company?

Second, there is a big difference between the owners' compensation and the value of their business. Let's say a business earns $150,000 a year and that's what the owner pays himself. You cannot then say that the business is worth some multiple of that number. If I were buying a business I would first deduct the market cost of replacing the current owner and then use whatever earnings are left to come up with a value for the business. Why would I want to pay the seller a multiple of what I would then have to pay someone else to do his job? Or, if I were going to do his job myself, why would I say that my time isn't worth anything at all?

There are several fundamental ways to value a company and it's beyond the scope of this review to go into great detail about them here. The most simplistic way to value a business is to simply apply an industry multiple to sales, or earnings - for example 2x sales, or 5x earnings. While there is usually a lot that goes into calculating these multiples, they are often based on what other similar companies have sold for and don't necessarily reflect the value of a particular company. You can also look at either the market value or the liquidation value of assets. But, probably the best way to determine the value of your business is to determine the "free cash flow" the business will throw off in the future - in other words, the earnings of the company after reasonable compensation is paid to the owner. That's the real value of a business and looking at cash flow lets you determine what the return on your investment would be.

Building the value of a business is a long term, strategic process that should start on day one and then be integrated into everything you do. It doesn't just happen. You have to make it happen over a long period of time by understanding what makes your company valuable to the marketplace and then consciously building that value into the business. Starting the process a year or two before you're ready to sell isn't a formula for success. It's just too hard to increase the value of a company in a short period of time.

If I were selling my company to you, I'd want to be able to say, "It has long term value, because" of things like:

- We identified these specific markets that were underserved and here's what we did to capitalize.

- The length of time our customers stay with us has increased over time; here are the numbers and here's why.

- We've made a conscious effort to increase the average profitability of our customers; here are the numbers and here's how we did it.

- We know we add value for our customers by doing these things; and we know because we ask them and here's what they say.

- Our margins never go below these levels, because we do these things.

When you can deal with issues like these for a potential buyer, you know why the business you own is valuable. When you can explain to someone else why the investment he is making is good for him, you understand the value of what you have. Building that value, however, is a long-term process and you need to make decisions about how to do it long before the end-game for you business is in sight.