Proactive business owners always have an eye on the future. And part of that preparedness means knowing what the company is currently worth and doing everything possible to maximize that price. Operating in a sale-ready state can be worthwhile, for example, if the business receives an unsolicited purchase offer—or if an owner unexpectedly dies and the company must repurchase that owner's interest.
The market value of your business may have changed during the pandemic. Some companies may be worth more today thanks to emerging business opportunities, but others could be worth much less because of higher costs, rising interest rates and increased operating risks. So, it's smart to review the basics of how to value a business.
Reasons to Value a Business
A variety of circumstances may trigger the need for a business valuation. These include when an owner applies for a personal loan, retires, files for divorce or buys out another owner. Valuations are also typically relevant in succession planning, mergers and acquisitions, and when management needs to borrow money to finance the company's operations or growth. Understanding different business valuation methods can help in these situations.
Unfortunately, the value of a business isn't listed on the face of its balance sheet. And there aren't any reliable valuation formulas that apply to every business. In fact, oversimplified "rules of thumb" tend to be ambiguous and overlook distinctive operating characteristics—such as nonoperating assets, exclusivity contracts, or in-process research and development—that differentiate the subject company from its competition. These factors are critical when considering how to approach a company valuation.
Rules of thumb also may become outdated over time or as market conditions change. Valuations are valid only as of a specific date and for a specific purpose.
Standard of Value
The term "value" can have several different meanings. Perhaps the most commonly used starting point for business valuations is fair market value. Essentially, this is the price the "universe" of potential buyers and sellers would agree on for a business interest. Fair market value assumes no compulsion to buy or sell and reasonable knowledge of all relevant facts.
Another common standard of value is fair value. In an accounting context, it's similar to fair market value except that it's an exit (rather than an entry) price and, therefore, excludes transaction costs. Moreover, fair value considers only the market participants active in the principal (or most advantageous) market.
Accountants use this term when, for financial reporting purposes, they value assets and liabilities, such as asset retirement obligations, long-lived assets and goodwill. For instance, some distressed companies may have reported goodwill impairment during the pandemic. This occurs when the fair value of acquired goodwill is lower than the amount shown on the balance sheet. These write-offs usually foreshadow financial problems.
There's also strategic (or investment) value. This refers to the perceived value to a specific investor. A business seeking to increase market share, for example, might pay a premium to acquire a competitor. Strategic value depends on an investor's individual requirements and expectations.
3 Approaches
Valuation professionals typically consider the following three approaches when valuing a private business:
Important: Although the cost approach starts with a company's financial statements, some assets and liabilities may not appear on its balance sheet. Examples include internally generated trademarks, customer lists, patents and goodwill. On the liability side, examples include pending lawsuits and warranty claims.
Selection criteria for comparables might include:
It can be difficult to find a meaningful sample of comparables for some companies—especially those that specialize in a particular industry niche. Understanding the nuances of business valuation methods can help overcome these challenges.
The income approach may be difficult for laypeople to understand. Sophisticated buyers and sellers are more likely to use this approach. It's often the preferred method for start-ups and companies with significant intangible value.
Key Value Drivers
Value drivers vary by individual company, industry and the needs of a specific buyer. But owners who know their company’s hidden gems and distinctive benefits may be able to defend their asking prices—and even negotiate premiums when it's time to sell.
Value drivers are the characteristics likely to either reduce the risk associated with owning the business or enhance the prospect that the company will grow significantly in the future. Common examples include:
Less obvious value drivers are operating systems capable of improving or sustaining cash flows, well-maintained facilities, effective financial controls, and fraud prevention initiatives. Likewise, a solid, diversified customer base and an established workforce can be valuable assets in today's uncertain markets.
Yet another value driver is the company's percentage of recurring revenue—in other words, the percentage of revenue that can be reasonably expected to occur in the future based on past trends and existing relationships. It may include customers under purchasing contracts. Because of its reliability, recurring revenue has an inherently higher value to buyers than one-time revenue.
On the flip side, certain attributes can increase risk and drive value lower. For example, a buyer may discount the asking price of a business that depends heavily on the personal skills of a key owner or relies on one large customer or supplier for more than 10% of its revenue or materials. Likewise, a company may be less attractive to potential buyers if it lacks a solid succession plan or a management team that's committed to grow the business after a sale.
Are You Ready for Potential Buyers?
If you're contemplating selling your business, you'll need an estimate of how much it's worth to set an asking price. Then you'll need to successfully convey that value proposition to potential buyers. A comprehensive offer package can be an effective tool. It should include the following documents:
We Can Help
While you may have a general idea of what your business is worth, do-it-yourself valuations can be perilous. A valuation professional can provide an objective estimate that you can take to the negotiating table, the bank, a courtroom—or anywhere you need it. Leveraging expert knowledge in business valuation can provide the most accurate and beneficial assessment for your company.
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