Business valuationFrom Wikipedia, the free encyclopedia

Business valuation is a processed set of procedures used to estimate the economic value of an owner’s interest in a business. Valuation is used by financial market participants to determine the price they are willing to pay or receive to perfect a sale of a business. In addition to estimating the selling price of a business, the same valuation tools are often used by business appraisers to resolve disputes related to estate and gift taxation, divorce litigation, allocate business purchase price among business assets, establish a formula for estimating the value of partners' ownership interest for buy-sell agreements, and many other business and legal purposes.

Why Do You Need a Business Valuation?

Your local assessors office has a record of what your house is worth. The popular automotive Blue Book tells you what your car is worth. Articles in Consumer Reports provide the pricing data you need to negotiate the best deals on everything from a refrigerator to a set of golf clubs. And articles in personal finance magazines counsel you on how to compare the cost of mutual funds and even where to find the best college education values. So, why is it that most small business owners in the country don’t know what their business is worth–and often don’t know how to find out?

Interestingly, we insure our homes and our cars based on their value, and even get our jewelry appraised. Yet, when it comes to valuing our small businesses, most business owners pass the buck. Across all industries, the response to the question, “Do you have a business valuation?” generally is, “No, because I’m not ready to sell”.

Yet, when you think about it, knowing what your home, your car, your investments, and even that diamond necklace are worth in advance of deciding whether to put them up for sale certainly helps you to better manage those assets and make big-picture financial decisions. For

example, if your home is already valued at the high end of the houses in your neighborhood, it might not be wise to invest in a half-million-dollar renovation. Or, if you calculate that you have more than enough cash to fund your retirement, you may be ready to consider some gifting strategies.

Similarly, a business valuation can help you improve the way you manage your business. The bottom line is that while most business owners start down the valuation road only when they begin contemplating the big sale, there are many reasons why a business valuation is good business. A business valuation can help you achieve the following:

Strengthen your credibility. An independent, outside valuation builds everyone’s confidence, from your employees to lenders to future buyers. If you want to expand significantly by building a new facility or attracting top employees, your business valuation will help both lenders and job candidates to evaluate your business.

Keep employees motivated. Some incentive programs, whether they are cash- or stock-based, may be tied in some way to the growth of the business’s value. Demonstrating the company’s current value to your employees, how you will measure growth, and how their rewards will be determined will give them incentive to outperform.

Track your goals. Maybe you’re planning to buy a new office building, launch a new product, add staff, or expand internationally. Whatever your goals, you need a way to measure your progress and how your efforts impact the value of your business. A valuation gives you a starting point.

Determine when you can retire. Small business owners often have an inflated sense of the value of their company. If you are counting on income from the sale of your business to support you in retirement, the sooner you determine whether your estimate of your company’s worth is realistic, the better.

Expedite sales and acquisitions. Think about real estate sales in your hometown. Fairly priced properties move more quickly, right?

The same is true for sales of small businesses. If you have a firm idea of what your business is worth, you are more inclined to price it attractively for interested buyers. On the flip side, you may wish to merge with or acquire another company. Having an up-to-date business valuation can allow you to move faster to take advantage of these opportunities.

Inform estate planning. In many cases, the value of a business represents a sizable percentage of your net worth, so working on an estate plan is impossible without an accurate valuation. A valuation is particularly important if you have children who wish to continue to be involved with your business.

Protect your family. If something happened to you, a business valuation could help your family deal with the potential sale or dissolution of the business. Knowing the value of your business could also be important in divorce proceedings or if you wanted to buy out a partner and bring in one of your children.

The value of the business consists of not just the Price (i.e., the amount to be paid for the business) but also the associated Terms and the Deal Structure. Different values for a business can exist because of different operating assumptions, deal structures, payment terms, etc., not due to use of different valuation methods.

A few of the value drivers are:1) Future Performance                                                    5) Deal Structure2) Financial Leverage                                                      6) Asset Type3) Financial Return Expectation                                       7) Exit Strategy4) Cash Flow, Not Profits

Five steps to establish your business worthBusiness valuation is a process that follows a number of key steps starting with the definition of the task at hand and leading to the business value conclusion. The five steps are:

1. Planning and preparation

2. Adjusting the financial statements

3. Choosing the business valuation methods

4. Applying the selected valuation methods

5. Reaching the business value conclusion

Let's examine in more detail what happens at each step.

Step 1: Planning and preparation

Just as running a successful business takes planning and disciplined effort, effective business valuation requires organization and attention to detail. The two key starting points toward establishing your business worth are:

determining why you need business valuation

assembling all the required information.

It may seem surprising at first that the valuation results are influenced by your need for business valuation. Isn't business value absolute? Not really. Business valuation is a process of measuring business worth. And this process depends on two key elements: how you measure business value and under what circumstances.

In formal terms, these elements are known as the standard of valueand the premise of value.

Business value depends on how and why it's measured

A few examples will illustrate this important point.

Let's say you want to sell your business. Business has been good, with revenues and profits growing each year. You plan to market the business until a suitable buyer is found. You want to pick the best offer and are not in a hurry to sell.

In this situation your standard of value is the so-called fair market value. Your premise of value is a business sale of 100% ownership interest, on a going concern basis. In other words, you plan to sell your business to the highest and most suited bidder and it will continue running under the new ownership.

Next let's imagine that you own a small business that has developed a product of great interest to a large public corporation. They already approached you offering to buy you out. They have some great plans for your product and want to sell it internationally. These people are even prepared to offer you some of their publicly traded stock. As your CPA tells you this can significantly lower your taxable gain on the business sale.

In this scenario you have a synergistic buyer who is applying the so-called investment standard of measuring your business value. Such buyers are often willing to pay a premium for a business because they can realize some unique advantages through a business purchase.

Now consider a situation where the business owners need to settle a large bill with one of the business' creditors who is tired of waiting. There is not enough cash in the bank to cover the amount, so businessassets need to be sold quickly.

This is the case where the so-called forced liquidation premise of value may apply - business owners don't have enough time to look for a suitable buyer and may have to resort to a quick auction sale.

Once you know how and under what conditions you will measure your business worth, it is time to gather the relevant data that impacts the business value. This data may include the business financial statements, operational procedures, marketing and business plans, customer and vendor information, and staff records.

Business facts affect business value

Here are a few examples of how information about the quality of operation affects the business value.

Well-documented financial statements and tax returns are essential to demonstrate the business earning power.

Steady, above industry norm earnings tend to translate into higher business value.

Detailed written business operating procedures make it easy to understand how the business works, who does what, and what skills are required.

Since it is easier to take over a well-organized business, there is higher business buyer interest and competition among them tends to increase the business selling price.

A good marketing plan provides the essential inputs into the future business earnings projections. And accurate earnings projections are key to establishing the business value based on its income.

A look at the customer list quickly shows where the business gets its revenues. Businesses that do not rely on a few large customers for most of their business sales tend to command a higher selling price.

Let's say that the business enjoys an exclusive distribution agreement with a major vendor, a key competitive advantage. If this agreement can be transferred to the business buyer, the business selling price is likely to be higher.

Skilled and motivated staff is essential to business success. Not surprisingly, if experienced long-term employees stay with the business after the sale, the selling price is likely to reflect it.

Some of the information will provide immediate and useful parameters to determine the business value. Other parts of this data, notably the company's historical financial statements, require adjustments to prepare inputs for the business valuation methods. We discuss the financial statements adjustment process in the following sections.

Step 2: Adjusting the historical financial statements

Business valuation is largely an economic analysis exercise. Not surprisingly, the company financial information provides key inputs into the process. The two main financial statements you need for business valuation are the income statement and the balance sheet. To do a proper job of valuing a small business, you should have 3-5 years of historic income statements and balance sheets available.

Many small business owners manage their businesses to reduce taxable income. Yet when it comes to valuing the business, an accurate demonstration of the full business earning potential is essential.

Since business owners have considerable discretion in how they use the business assets as well as what income and expenses they recognize, the company historical financial statements may need to be recast or adjusted.

The idea is to construct an accurate relationship between the required business assets, expenses and the levels of business income these assets are capable of producing. In general, both the balance sheet and the income statement require recasting in order to generate inputs for use in business valuation. Here are the most common adjustments:

Recasting the Income Statement .

Recasting the Balance Sheet .

Step 3: Choosing the business valuation methods

Once your data is prepared, it is time to choose the business valuation procedures. Since there are a number of well-established methods to determine business value, it is a good idea to use several of them to cross-check your results.

All known business valuation methods fall under one or more of these fundamental approaches:

Asset approach

Market approach

Income approach

Tools to Value a Business

Find out more   »

The set of methods you choose to determine your business value depends upon a number of factors. Here are some key points to consider:

The complexity and value of the company's asset base.

Availability of the comparative business sale data from the market.

Business earnings history.

Availability of reliable business earnings projections into the future.

Availability of data on the business cost of capital, both debt and equity.

Choosing the asset based business valuation methods

Determining the value of an asset-rich company may justify the cost and complexity of the asset-based valuation methods, such as theasset accumulation method. In addition to valuing the individual business assets and liabilities, the method can be helpful when allocating the business purchase price across the individual business assets, as part of the asset purchase agreement.

However, the method requires considerable skill in individual asset andliability valuation which often makes its application costly and time consuming.

Business Value = Assets + Business Goodwill

See Example   »

How the market based business valuation methods work

Market based business valuation methods focus on estimating business value by examining the business sale transaction data available from the actual market place. There are two types of transaction data that can be used:

Guideline transactions involving similar public companies.

Comparative transactions involving private companies that closely resemble the subject business.

The advantage of using the public guideline company data is that it is plentiful and readily available. However, you need to be careful when selecting such data to make an "apples to apples" comparison to a private company.

In contrast, reviewing business sales of similar private companies provides an excellent and direct way to estimate the business value. The challenge is gathering sufficient data for a meaningful comparison.

Regardless of which market-based method you choose, the calculations rely on a set of so-called pricing multiples that let you estimate the business worth in comparison to some measure of the business economic performance. Typical pricing multiples used in small business valuation include:

Selling price to revenue.

Selling price to business earnings such as net income, SDCF,EBITDA, or net cash flow.

Each pricing multiple is a ratio of the likely business selling price divided by the respective economic performance value. So, for instance, the selling price to revenue multiple is calculated by dividing the business selling price by business revenue.

To estimate your business value, you can use one or more of these pricing multiples. For example, take the selling price to revenue pricing multiple and multiply it by the business annual revenue. The result is the business selling price estimate.

Valuation multiple formulas

More sophisticated market based business valuation methods, such as the Market Comps in ValuAdder, use business pricing rules that make an intelligent choice of which pricing multiplies to apply when valuing a business. In addition, the Market Comps let you account for key business attributes automatically:

Business revenue or profits

Inventory

FF&E

Tangible asset base

Valuing a Business based on Market Comps

See Example   »

The income based business valuation

Income based business valuation methods determine business worth based on the business earning power. Business valuation experts widely consider these methods to be the most accurate. All income-based business valuation methods rely on either discounting orcapitalization of some measure of business earnings.

The discounting methods, such as the ValuAdder Discounted Cash Flow, produce very accurate results by letting you specify the details of the expected business income stream over time. The Discounted Cash Flow method is an excellent choice for valuing a young or rapidly growing company whose earnings vary considerably.

Alternatively, the so-called direct capitalization methods, such as theValuAdder Multiple of Discretionary Earnings, determine your business worth based on the business earnings and a carefully constructedcapitalization rate. The Multiple of Discretionary Earnings method is an outstanding choice for valuing small established companies with consistent earnings and growth rates.

How to Value a Business as Multiple of Earnings

See Example   »

Step 4: Number crunching: applying the selected business valuation methods

With the relevant data assembled and your choices of the business valuation methods made, calculating your business value should produce accurate and easily justifiable results.

One reason to use several business valuation methods is to cross-check your assumptions. For example, if one business valuation method produces surprisingly different results, you could review the inputs and consider if anything has been overlooked.

ValuAdder business valuation software helps you focus on the big picture of determining the business value by automating complex calculations and letting you easily adjust and capture your assumptions while running multiple what-if valuation scenarios.

Step 5: Reaching the business value conclusion

Finally, with the results from the selected valuation methods available, you can make the decision of what the business is worth. This is called the business value synthesis. Since no one valuation method provides the definitive answer, you may decide to use several results from the various methods to form your opinion of what the business is worth.

Since the various business valuation methods you have chosen may produce somewhat different results, concluding the business value requires that these differences be reconciled.

Business valuation experts generally use a weighting scheme to derive the business value conclusion. The weights assigned to the results of the business valuation methods serve to rank their relative importance in reaching the business value estimate.

Here is an example of using such a weighting scheme:

Approach Valuation Method Value Weight Weighted

Value

Market Comparative business sales $1,000,000 25% $250,000

Income Discounted Cash Flow $1,200,000 25% $300,000

IncomeMultiple of Discretionary Earnings

$1,350,000 30% $405,000

Asset Asset Accumulation $950,000 20% $190,000

The business value is just the sum of the weighted values which in this case equals $1,145,000.

While there are no hard and fast rules to determine the weights, many business valuation experts use a number of guidelines when selecting the weights for their business value conclusion:

The Discounted Cash Flow method results are weighted heavier in the following situations:

Reliable business earnings projections exist.

Future business income is expected to differ substantially from the past.

Business has a high intangible asset base, such as internally developed products and services.

100% of the business ownership interest is being valued.

The Multiple of Discretionary Earnings method gets higher weights when:

Business income prospects are consistent with past performance.

Income growth rate forecast is thought reliable.

Market based valuation results are weighted heavier whenever:

Relevant comparative business sale data is available.

Minority  (non-controlling) business ownership interest is being valued.

Selling price justification is very important.

The asset based valuation results are emphasized in the weighting scheme when:

Business is exceptionally asset-rich.

Detailed business asset value data is available.

How To Value A Business

By Richard Parker, President of The Business For Sale Buyer Resource Center™ and author ofHow To Buy A Good Business At A Great Price©

Accurately valuing a small business is often the most challenging part of the process for prospective business buyers. However, it doesn't have to be an overwhelming or difficult undertaking. Above all, you should realize that valuation is an art, not a science. As a buyer, always keep in mind that the "Asking Price" is NOT the purchase price. Quite often it does not even remotely represent what the business is truly worth.

Naturally, a buyer's valuation is usually quite different from what the seller believes their business is worth. Sellers are emotionally attached to their businesses. They usually factor their years of hard work into their calculation. Unfortunately, this has no business whatsoever being in the equation.

The challenge for you, the buyer, is to formulate a valuation that is accurate, and will prove to provide you with an acceptable return on your investment.

There are several ways to calculate the value of a business:

Asset Valuations: Calculates the value of all of the assets of a business and arrives at the appropriate price.

Liquidation Value: Determines the value of the company's assets if it were forced to sell all of them in a short period of time (usually less than 12 months).

Income Capitalization: Future income is calculated based upon historical data and a variety of assumptions.

Income Multiple: The net income (profit/owner's benefit/seller's cash flow) of a business is subject to a certain multiple to arrive at a selling price.

Rules Of Thumb: The selling price of other "like" businesses is used as a multiple of cash flow or a percentage of revenue.

Let's look at each to determine what's best for your purchase:

Asset-based valuations do not work for small business purchases. Assets are used to generate revenue and nothing more. If a business is "asset rich" but doesn't make much money, how valuable is the business altogether? Conversely, if a business has limited assets, such as computers and office equipment, but makes a ton of money, isn't it worth more?

Income Capitalization is generally applicable to large businesses and most often uses a factor that is far too arbitrary.

The "Rule of Thumb" method may be too general since it's hard to find any two businesses that are exactly the same. Valuation must be done based upon what you, as the buyer, can reasonably expect to generate in your pocket, so long as the business's future is representative of the past historical financial data. Notwithstanding this, the "Rules of Thumb" methodology is an good place to start but is a bit too broad to consider by itself.

The Multiple Method is clearly the way to go. You have probably heard of businesses selling at "x times earnings." However, this can be quite subjective. When buying a small business, every buyer wants to know how much money he or she can expect to make from the business. Therefore, the most effective number to use as the basis of your calculation is what is known as the total "Owner Benefits."

The Owner Benefits amount is the total dollars that you can expect to extract or have available from the business based upon what the business has generated in the past. The beauty is that unlike other methods (i.e. Income Cap), it does not attempt to predict the future. Nobody can do that. Owner Benefit is not cash flow! It is, however, sometimes referred to as Seller's Discretionary Cash Flow (SDCF).

The theory behind the Owner Benefit number is to take the business's profits plus the owner's salary and benefits and then to add back the non-cash expenses. History has shown that this methodology, while not bulletproof, is the most effective way to establish the valuation basis of a

small business. Then, a multiple, based upon a variety of factors, is applied to this number and a valuation is established.

The Owner Benefit formula to use is:

Pre-Tax Profit + Owner's Salary + Additional Owner Perks + Interest + Depreciation less Allocation for Capital Expenditures