Business Valuation Methods
Do you know how much your company is worth?
Well, whether you are aware or not, a business owner can find themselves in a number of circumstances where knowing this information can assist in accomplishing certain goals.
- A business owner passes away suddenly and leaves a family behind. The family isn’t sure if they want to sell the business or not. They need to have an idea of its value, however sad and unfortunate the situation, to see if selling is a good idea.
- An entrepreneur is looking for funding from investors. The investors will want to know what the company is worth and if they can expect to receive a return on their investment. You make it to Shark Tank, for example, and need to establish the percentage of your company you’re willing to give up in exchange for a given amount of funding.
- A business owner wants to sell their business and needs to know how to set the price.
These are just three examples. Other reasons for valuing a business may include when a business is used as collateral or if shares of the business are issued as a form of compensation, among others.
These scenarios can befall any business owner, and entrepreneurs should be prepared and know what they bring to the table before they are asked.
A valuation is a way to invest in one’s financial security, said Kevin Jennings, president of Jennings Business Valuation, Inc.
“You know where you stand with your most important asset. Many business owners use a rule of thumb or rely on sales they know about. (For example,) a friend sold a business for two times revenue, three times earnings before interest, tax, depreciation and amortization (EBITDA). But this is anecdotal and not an absolute measure to rely on. It’s really important to know what your company is worth to you as the owner,” he said.
To learn more about business valuations, the three different valuation methods, why a business should establish its value and which method fits what type of business, continue reading.
What is business valuation?
Let’s start with the definition. A business valuation is the determination of the value of a business. It answers the question, “What is my company worth?” Determining a valuation is a four-step approach that includes:
- Planning and preparation
- Adjusting financial statements
- Choosing and applying a valuation method
- Reaching a valuation conclusion
Planning and preparation
The first step of finding out how much your company is worth is to understand the purpose of the valuation. Once you know the “why,” you can then prepare the necessary documentation and additional information about your business.
“The first step in any part of the process is really going to be to understand the business, because a valuation needs context to be meaningful,” said Hunter Clark, vice president of Valuation Services for the global advisory firm Duff & Phelps, which has 3,500 employees throughout 28 countries and serves clients in valuation, investigations, cyber security, disputes, corporate finance and regulatory matters.
So will your business be valued on a going concern basis, over a set term or period of time, or perhaps on a liquidation basis?
A business being valued under a going concern basis assumes that the business will continue to operate into perpetuity, even after it is sold. This is the most common assumption for an operating business. The valuation serves as a price marker, with the business ultimately going to the highest and best-fit bidder.
However, in a liquidation scenario, the assets of the business will be used to settle the obligations or liabilities of the entity, sometimes referred to as a “fire sale” if the liquidation is performed under distress. If a business is unable to service its debt, and its creditors take receivership of the business, they will often choose to liquidate the assets of the business to recover as much value as possible if they believe that will yield more value than trying to continue to operate the business.
A valuation under a liquidation scenario is usually lower because the seller is often in distress. The drive to settle the company’s obligations may place the seller under time restrictions, meaning they might not have enough time to find all suitable buyers, and ultimately, the buyer who is willing to pay the highest price for the assets. Additionally, if the potential buyers know the seller is in a distressed situation, they could have more negotiating leverage to pay a lower price, and they may also know they have fewer competing bids if the seller is under time constraints.
Knowing the premise for your valuation will allow you or a valuation expert to approach the number-crunching with the appropriate considerations.
Do you find yourself in a liquidation scenario, or should your business be valued assuming a going concern?
After identifying whether your business valuation will be of a going concern or a liquidation basis, the next part of this process will be to assemble the necessary documentation and support.
Documentation will tell your business’s valuation story. These documents should include financial statements, tax returns, operating procedures, business and marketing plans, a customer list, and any other key documents needed to learn more about the business’s finances and operations.
Adjusting financial statements
Second, you should adjust key financial statements such as the income statement, balance sheet and statement of cash flow. These adjustments should reflect an accurate amount for compensation for yourself and your team, the true value of rented items and the removal of any outlier or one-time expenses. While you might adjust these numbers to decrease the amount in taxable income, your valuation should rely on values that illustrate your business’s true profitability.
Choosing and applying a valuation method
Third, choose a valuation method.
There are three main approaches for estimating the value of a business, with each approach having its own merits for determining a business’s value:
- Market approach
- Asset approach
- Income approach
We’ll take a more in-depth look at these three valuation methods below.
Reaching a valuation conclusion
A business can conduct a valuation using its own team and resources or by working with a valuation expert. Software such as ValuAdder and BizEquity can also provide online valuation services.
Results should be accurate and simple to substantiate. No one approach for valuation — income, market or asset-based — will be definitive. Different methods should be checked against one another for accuracy to reach a conclusion.
A conclusion can also be reached by doing a valuation using various methods and then assigning a weighted value to the results based on the relative importance of the method to the overall valuation.
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Why should you establish your business’s value?
Knowing what a business is worth, as subjective as the figure can be, gives a business owner a foundation to rest on. It is a way to be prepared for any number of situations that can occur.
Here is a bulleted list of different situations where a business valuation will be needed:
- Knowing the worth of what is possibly your most valuable asset
- Estate tax reporting
- Determining compensation
- Buy-sell agreements
- Corporate stock options
- Use of the business as collateral
- Marriage divorce
- Business divorce
- Litigation (i.e. bankruptcy or shareholder disputes)
Methods for establishing the worth of your business
As explained above, there are three main methods for establishing the worth of your business:
A market-based valuation compares a business to other similar companies. Business A, for example, can look at the certain metrics of Business B, a company conducting comparable operations that is similar in size, geography and structure, to gauge its own value. This method can be challenging to apply for smaller businesses (such as a small sole proprietorship) because of the lack of readily available public information. This is because most publicly traded companies and transactions with publicly announced transaction value and financial metrics are typically larger in size.
The market approach will work well for businesses in industries in which operations are typically consistent (such as service or distribution businesses with consistent profitability and growth across the industry) or markets in which there is a lot of publicly available information about comparable companies. “If you wanted to value a business, you can look at what similar businesses have sold for and what they’re trading for,” Clark said.
Market-based valuations can also be useful for valuing businesses that are not yet profitable, as a revenue multiple can often be used to estimate value in these situations.
Market-based approaches can be useful by capturing market sentiment and industry-wide expectations within the market.
An asset-based valuation relies on the net worth of a business’s assets. There are several methods in which an asset-based valuation can be applied. One method takes the difference of total asset value and non-debt liabilities to arrive at an estimate for the business value. Another method takes the total value of tangible assets and intangible value such as goodwill. Goodwill can be comprised of the business’s “going concern” value, as well as the ability to develop new services or build on its current customer base.
The asset-based approach can be used on businesses based on a professional practice (such as medicine, law, accounting, etc.), and for forced liquidations.
The income approach calculates a business’s earning ability. (The income approach indicates the value of a business based on the value of the cash flow that a business can be expected to generate in the future.) If you estimate that Company A will generate $25 million over the course of 10 years, how much is this income worth today, taking into account inflation, the time value of money, opportunity cost and the risk of the investment?
The income approach can be a useful valuation tool, as it allows you to capture company-specific characteristics in the forecast, as well as the discount factor. The income approach can be used on a new company, such as a startup, to ascertain a company’s value based on the profit it will generate in future years.
Which method is right for you?
Each business has a unique situation. Here are different types of businesses and valuation methods that fit.
What type of valuation might work for a startup? Startups are new companies and therefore have little to no financial history. So rather than looking backward, startups will require a valuation method that looks forward, one that determines the value of its future earnings. An income-based valuation is the answer.
What type of valuation might work for a small business? Depending on the industry, a small business will likely be able to find information from similar companies that have sold. A market approach is the answer.
What type of valuation might work for a professional practice? If your physician, accountant, lawyer or dentist has his or her own practice, you likely return time and time again because of the trust this particular person has built with you. He or she has created goodwill with you and other clients. This valuation method will require one that takes this intangible asset into consideration. The answer is the asset approach.
The bottom line
For a business owner that wants to be prepared for the various scenarios that will come his or her way, knowing how much a business is worth is an important milestone. Adequate research is key to properly establishing your business’s worth.
Knowing this number is one way a business owner can be proactive and have a stronger sense of financial identity as a business operates from day to day.
Consult a qualified valuation professional, or work with valuation software to put a price on what could be your most valuable asset.
Jennings has one piece of advice for businesses in need of a valuation, and that is to keep an open mind.
“We all have an idea of what our business is worth. But there are really multiple values: what it’s worth to you as the owner, what you can sell it for (which is a wide range), and what its value is for transitioning ownership to others. The valuation result is not an absolute number, and valuation is not a science; it’s an opinion,” Jennings said.