Do you know much your business is worth? The value of your company is often irrelevant to day-to-day operations - but if you are considering selling the company, buying out a partner (or taking on new partners), applying for a loan, merging with another business, or developing your estate plan, you may need to know what your company is worth. Valuing a business requires objective analysis of past performance and subjective determinations about your industry, the economy, and future prospects for your company.
These are a few reasons why performing a business valuation may be necessary:
- You wish to sell the business - or receive an offer to sell the business
- You wish to apply for a loan, take on new partners, or seek venture capital or angel investors
- A shareholder in the company wishes to liquidate his or her position
- You are setting up your estate plan and wish to determine the value of all your assets, so you can distribute them equitably between your beneficiaries
- You wish to merge with another company
If these or other situations may require you to determine the value of your business, you can use a variety of valuation techniques. Here are a few basic valuation guidelines.
If your business is:
- Well established, has a solid position in the market, has enjoyed stable earnings, and continued performance is not dependent upon specific members of the management team: Value should be eight to ten times current profits.
- Established, has a good market position, faces some competitive pressures, earnings have varied in recent years, management team is a factor in continued performance: Value should be five to seven times current profits.
- Established, has no real competitive advantages, faces heavy competition, owns few capital assets, and is heavily dependent on management skills and profile: Value should be two to four times current profits.
- Small, with one to five employees, providing personal or professional services: Value should be one to at most two times current profits.
Then you can use one of two basic valuation approaches: Value of assets and value of income.
- Asset valuation assumes the business has assets that could be sold. Asset valuation techniques include adjusted book value and asset valuation. (More on those techniques below.)
- Income valuation assumes the value of a business is based on the future value a buyer can receive from purchasing the business. Income valuations are the most commonly used valuation technique and are used for businesses that are assumed to be stable and capable of staying in business for the foreseeable future. Income valuation techniques include the capitalized earnings approach, discounted cash flow approach, multiple of earnings, etc.
If you hire an appraiser, the appraiser typically has discretion over which valuation method is used. Most appraisers will perform multiple valuation calculations using different techniques, comparing the results to create a "blended" value. Financial statements and accounting records are analyzed and compared with other companies in the same industry.
There is a wide variety of valuation techniques and formulas to determine the value of your business. Here are a few of the more common approaches:
- Adjusted Book Value. Value is determined by subtracting liabilities from assets.
- Asset Valuation. Value is determined by calculating the value of facilities and improvements, equipment, and inventory. Cash can also be included as an asset.
- Capitalized Earnings Approach. Value is based on the rate of return investors expect. Relatively standard formulas are used: In low-risk businesses, investors typically expect eight to ten percent returns. Small businesses are typically assumed to have a twenty-five percent rate of return (for investor purposes.) For example, if you own a small business with earnings of $25,000, using the capitalized earnings approach the value would be estimated at $100,000.
- Cash Flow. Value is based on the cash flow of the business, factored by the amount of a loan a lender would provide based on cash flow. The value of the business is the amount of the loan that would be approved using standard business loan parameters.
- Debt Assumption. Value is based on how much debt a business could incur and still be able to function by using cash flow to pay debt obligations. This method often results in the highest business valuation.
- Discounted Cash Flow. Value is based on the time value of money; in simple terms, the fact that dollars received today are worth more than dollars received at some point in the future. The goal is to discount projected earnings to account for inflation and risk.
- Earnings Multiple. Value is determined by calculating a multiple of cash flow. This is arguably the most common business valuation method. The multiple used varies depending on the industry. Manufacturing businesses tend to use a multiple of five to seven times earnings; consumer product businesses tend to use a multiple of eight to ten times earnings.
- Market Valuation. Value is based on average sales figures within particular industries. For example, a market valuation factor for restaurants could be 65% of annual gross sales.
- Balance Sheet. Value is based on the value of current assets.
- Intangible Assets. Value is based on intangible assets that are nonetheless valuable to potential buyers. A large, long-term customer base could be considered an intangible asset; if that is the case, the value is based on the cost (advertising, marketing, customer service, etc) to create a similar customer base from scratch.
Seem complicated? It can be. If you’re just curious about what the business is worth, you can use one of the techniques above. If accurately determining the value of your business is important - for instance, if you need a loan, are thinking about taking on partners, or are interested in selling the company - getting professional help is probably the best way to arrive at as accurate an estimate as possible.
But keep in mind the ultimate value of a business is its fair market value. Fair market value is what a ready, willing, and able buyer is willing to pay a willing seller, assuming each party is fully informed and is under no pressure to take action; that is the true definition of fair market value according to the IRS.