A business valuation is an in-depth analysis of the market value of your business. Valuations are performed using a range of business data. A valuation performed by an experienced, credentialed valuation professional provides an impartial view into your business providing valuable insights for many business strategies and needs.
Why Would a Business Owner Need a Business Valuation?
There are several reasons why a business owner would need to know the value of a company. Here are a few common scenarios:
- Mergers and Acquisitions—When you are considering a merger or the acquisition of another business, you want to put yourself in the best negotiating position possible. A valuation of your business or the business you may acquire provides invaluable insight into the true value of the business.
- Business Exit Planning —There are many benefits to having your business valued well in advance of a potential sale or exit. Determining your business’s value now will help you with future transition planning. An early valuation can also help you determine if there are ways to increase the value of your business and implement these strategies far before you reach the point of exit.
- Tax Purposes/Estate Tax Planning—A proper business valuation may reduce tax liabilities, especially those related to gift and estate tax planning.
- Litigation—Many businesses will experience some type of litigation over the course of their lifespan. Some litigation requires a valuation, especially those involving business damages or matrimonial disputes.
- Securing Financing—Whether you own a small business or a large company, business growth often requires financing. Providing a clear and credible indication of the value of your business to banks or potential investors can position you well for a better borrowing rate and a more significant investment.
- Identifying Areas for Improvement—Business valuations aren’t just for determining the monetary value of your company. Valuations can help identify areas of improvement within your business. From determining financial performance to evaluating business strategy gaps between you and the competition, valuations can help you identify weaknesses and inefficiencies.
Business Valuation Methods
Dangers of a Rule of Thumb Approach
If you go to your favorite search engine and type in “business valuation methods”, you will run into numerous valuation techniques. Let me tell you that not all of these techniques are created equal. Especially methods that rely on rules of thumb, which refer to generalized, non-transparent, and sometimes outdated industry guidelines to arrive at a business value. These methods are unable to accurately reflect your company’s own unique attributes, which can include a range of factors, like degree of recurring revenue, profitability/margins, rate of annual growth, new accounts and services, transitions in the business, depth and experience of the management team, a niche industry focus, certain intangible assets and intellectual property, etc.
To arrive at an accurate valuation, a business owner needs to make sure the company’s unique attributes are captured to separate their business from similar companies – or risk leaving cash on the table.
Common Rules of Thumb
- Multiplier approaches use a generalized multiplier based on financial metrics like trailing twelve-month (TTM) revenue and EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) with the assumption that all businesses within an industry sell for similar multiples of these metrics. This is a dangerous assumption leading to inaccurate valuation results.
- Revenue multiples use a company’s revenue and generalized multipliers ranging from 1x to 3x to arrive at an accurate valuation. A business using a revenue multiple attempts to choose the right multiplier falling between 1 and 3 based on a few general industry guidelines.
- Gross profit multiples estimate a company’s value by multiplying gross profit by a generalized multiple (typically 2-4x gross profit). Just like revenue multiples, a business will try to determine the right value to multiply by using general industry standards.
Here’s an example of how a business owner of Company A would calculate their company’s worth using a market-based approach. Company A’s owner researches or finds out from peers in the industry that similar companies sell for a multiple of 4x to 5x EBITDA. Company A’s owner uses this multiplier with their company’s own EBITDA to arrive at a valuation. However, this method fails to account for Company A’s unique business traits.
Rather than using one of these generic valuation processes, I’d suggest seeking out a licensed valuation expert to determine a trustworthy company valuation. Generally, experienced professionals use a combination of principles from each of these methods combined with unique business factors that separate the company from similar businesses in the industry.
Credible Valuation Approaches and Methods Used by Experienced Valuation Professionals
- Income approaches—Income approaches use current and projected cash flow to determine value. Generally, this is done by dividing future cash flow by a discounted cash flow (DCF) rate.
- Market approaches—While a market approach utilizes comparable business transactions as part of the valuation process, this approach also considers unique business factors and variables.
- Asset-based approaches—An asset valuation methodology uses the net asset value of a business to determine its worth. The formula is essentially total company asset value – total company liabilities. An asset-based approach is rarely used for an operating business that is cash flow positive.
A business appraiser will use metrics and factors like the following to determine a business’s value:
- Financial statements—historical balance sheets, income statements and cash flows as well as projected future financial outlook
- Recent historical and future rates of growth and operating profit margins
- Liabilities
- Market conditions and position
- Strength of customer base and concentration
- Intellectual property and other intangible assets
- Recurring revenue
- Volatility of earnings
- Expertise of management team
- Product and/or service diversifications
The Dangers of an Inaccurate Valuation
Failing to have an accurate picture of your company’s value can cause strategic mistakes, and potentially, financial loss. From higher than necessary interest rates to receiving low acquisition offers from potential buyers, you could easily leave money on the table. I cannot emphasize enough the value of a thorough business valuation with a professional who routinely values companies like yours.
If you aren’t sure where to start when valuing your business, we have a blog post explaining the valuation process. Our valuation team is also ready to answer any valuation questions you might have. Contact them below.
