Business Valuation: A Strategic Business Tool
How to Prepare and What to Expect
How much is your business worth? It may be worth more than you think, or much less than you hope. In any event, guesswork won’t answer the question. A business valuation will.
A business valuation can serve many purposes, and business owners should have a clear goal in mind when engaging a valuation professional. They also should be prepared to provide a large amount of information about their business – beyond the financials – to help reach the best conclusion about the company’s value.
Why Obtain a Business Valuation?
Business owners often seek valuations when they are considering selling their companies, but there are many other reasons to get a valuation. If one partner wants to exit the business before other partners do, a valuation can help establish the buyout price. If a business owner is in the process of divorce, a valuation is usually necessary to determine an equitable division of assets. And when owners need to prioritize capital spending and business improvements, obtaining a valuation can help determine which expenditures would add the most value to the company.
Estate planning presents other reasons to obtain a business valuation. Whether the business will be succeeded to the next generation of family owners, or sold as part of the estate, its value as a piece of the owner’s estate is an important factor.
What is a Business Valuation?
At its most basic level, a business valuation is a process of determining the value of a business. There are three approaches to valuation, and all three should be considered as part of a comprehensive valuation process:
- Market approach. This approach considers the company’s value in relation to similar businesses in the marketplace. The two methods most commonly appropriate to use within the market approach are the guideline public company method and the transaction method. The guideline public company method uses pricing multiples for publicly traded companies that operate in similar industry(s) to the company being valued. The transaction method involves compiling a list of prior sales of businesses in the same or similar industry as the company being valued and using available pricing multiples to determine a value. This method is most commonly used for smaller, privately held entities.
- Income approach. The income approach involves looking at a company’s net income and financial data. Historical data and forward-looking projections are utilized to establish whether a company’s financial performance is stable or heading toward an upward or downward trajectory. The same methodology is frequently applied to cash flow. After determining a company’s benefit stream, either a discount or capitalization rate is applied resulting in an estimate of value.
- Asset approach. The adjusted book value method measures all assets and liabilities to their current fair market values. To get a complete picture of a company’s net asset value, appraisals should be done on real estate and certain equipment. A company’s adjusted book value will also include assets that may not be reflected on their historical balance sheet, such as customer lists, prospect lists, written business processes, patents, and goodwill.
When preparing a Conclusion of Value, all three approaches must be considered. The resulting values are triangulated to determine a final estimate of value.
But different companies have different circumstances, and different industries lend themselves more to one type of approach than another. Consequently, a valuation professional must determine how much weight to give to each value. Sometimes equal weight is given to all three, and other times one methodology will be disregarded, with the value determined by the other two. For instance, the asset approach generally doesn’t make sense for a service-oriented business, since the value is in the services the business provides and not its equipment. But for a family farm, the asset approach will most likely rule because of the high value of land, which is often higher than the income being produced from it.
How to Prepare for a Business Valuation
To produce a comprehensive business valuation that is more than numbers – a valuation that tells the story of your business – a valuation professional will want to speak with you and your key managers to learn about your business and what makes it operate efficiently.
The valuation professional also will learn about your industry, your customer base, how you do business and whether you are operating in a high-risk or low-risk environment.
Before you call a valuation professional:
- Have a working idea of where you see your business in five years. Will you be running it, or are you looking to exit in that timeframe?
- Make sure your financials are in order and your books are clean. Get any personal items such as loans and car leases off the balance sheet. Make sure all adjustments are made and the reporting is consistent.
- Check the accuracy of your operating agreements and other legal documents and bring them up to date.
- Be prepared to walk through the strengths and weaknesses of your business with candor.
The documentation the valuation professional will need includes:
- Financial statements
- Tax returns
- Operating agreements
- Buy-sell agreements
- Governing documents
- Customer lists
The documentation list may seem overwhelming, but it helps establish important information and intangible factors that impact valuation, such as risk.
The final estimate of value of a closely held business will often require discounts to be applied to the triangulated approaches discussed above. Common reasons for the value of a closely held business to be discounted include:
- Lack of marketability. If your business is a specialty manufacturer in a smaller city, you will likely not be able to sell it as quickly as you would if it were publicly traded and listed for sale in major markets. It may take some time to sell. The application of a marketability discount reflects the decreased liquidity of a closely held business in comparison to shares of stock of publicly traded company.
- Lack of control. If you are a minority owner of a business, you generally have no authority to make decisions on behalf of the company. The person who owns a controlling interest has authority over the decision making. When you want to sell your non-controlling interest, a buyer will take that into account and expect a discounted price. The amount of the discount will depend on several factors, including the industry and the type of business.
Demand for Valuations High
The demand for business valuations spiked during the COVID-19 pandemic and is continuing unabated in all industries as the Baby Boom generation exits the marketplace and transitions their businesses to younger family members or third-party buyers. Consequently, the merger and acquisition market is at an all-time high.
If you are looking to exit your business or make other major changes in the next five to seven years, getting a baseline business valuation now can help you optimize the value of your business when the time comes. Contact your Adams Brown advisor today for a consultation.