At a certain point, every businessperson needs to know what his company is worth. While it might sound simple, accurate business valuation is quite complex. No prospective buyer is going to take your word for how well your company is doing. When you claim your business is profitable and has great potential, you need to back up those statements with numbers and documentation.
Whether you are considering purchasing an existing business, selling your business, looking to attract investors or thinking about going public, here is a look at how to approach the process of valuing your business.
Reasons for Valuing
Two common reasons for needing a business valuation is because you want to sell your business, or someone has made an offer to purchase it. However, other financial circumstances might require it, like a divorce, disagreement about the value of an estate, or a problem with gift taxation.
When you need to figure out what your business is worth, three common approaches for calculating the value of your business are:
- Asset-based
- Income-based
- Market-based
Each model is appropriate in specific circumstances.
Asset Approach
With this model, you calculate the net value of all the assets your business owns, taking into account depreciation, and the result is your firm’s value. Assets include land, buildings, equipment, inventory, copyrights and trademarks, customer lists, and improvements to the physical structure. The owner’s discretionary cash for a single year called the owner benefit, is also included in the total asset figure.
This method should also account for liabilities, such as outstanding loan balances and accounts payable. These liabilities should be deducted from total assets to yield a net asset value.
Prospects love assets like these because they are built-in insurance. If cash flow slows down after he buys, he can sell assets to bring in money.
This is the sensible method for retail and manufacturing firms, which are considered asset-heavy. It is usually not the best one to use for a small business.
Income Approach
With the income approach, which is also called capitalization of income, you focus your attention on cash flow and the return on investment. For example, if your business has revenue of a million dollars and $750,000 in expenses, you will have an income of $250,000. However, businesses are typically not valued based on a single year of income, but their ability to produce continued earnings in future years.
The capitalization method uses a capitalization rate and anticipated earnings to value the business. Different industries typically use different standard capitalization rates as a basis for valuation. However, the capitalization rate for your business might be lower or greater than the industry average based on a number of key financial and operational factors. These include things such as business growth, competitive environment, management team and an earnings history.
The capitalization rate eventually used for your business will be used as an earnings multiplier. As an example, a capitalization rate of 33% will yield a three-times earnings valuation, and a rate of 50% will yield a two-times earnings value.
Market Approach
This method is much like what realtors use when tempting buyers to purchase a home. The realtor shows prospects comparisons of what similar homes in particular neighborhoods have sold for in the recent past. Similarly, with a market approach for your business, you use sales figures based on industry averages as a multiplier. This makes it the most subjective of the three approaches.
The challenge with this method is that it is easy to over or underestimate the value. A prime example is the internet company with an inflated value, selling for many times its estimated gross revenue before they have made a penny in profit.
Documenting Your Work
Most every prospect interested in your company will expect proper documentation. When they have an accountant or lawyer perform due diligence before deciding to buy or invest, they will want to check the numbers that tell the financial story of of your business. They want to review at least the following:
- Basic financial reports
- Sales reports
- Personnel organization charts
- Job descriptions
- Production reports
- Manuals that cover plant and office operations
Naturally, the more complete your company’s documentation is, the higher your prospect’s comfort level will be. By the same token, if you do not have a complete set of books, it sets up danger flags to potential buyers.. This is not reassuring to someone who wants to buy a moneymaking concern.
In summary, figuring out how much your business is worth is one that makes the most of a prospect’s perception of the business. It is not a mere number-crunching exercise. In fact, experts consider it more art than science.
A sensible prospect will use professionals to help him determine the value of your business. That can mean employing the expertise of an appraiser, broker, accountant or lawyer, or all of them. It is important that you, as the owner, sit down with them and go over your financials and other documentation.
This gives you a chance to ask and answer questions, point out intangibles and help them get an accurate understanding of what makes your business so potentially valuable. It also lets you get a close-up view of how they arrived at the business value they did, making you more comfortable with the end valuation.
