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 valuing 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.
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.
Rules of thumb also may become outdated over time or as market conditions change.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.
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.
Valuation professionals typically consider the following three approaches when valuing a private business:
1. Cost (or asset-based) approach. Under this approach, the value of a business is the difference between its assets and liabilities. For instance, a valuation professional might revalue the amounts shown on a company's balance sheet from historic cost to market value. However, this approach is difficult to use on companies with significant intangible value. It's typically reserved for holding companies and others that rely exclusively on hard assets, such as inventory and equipment.
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.
2. Market approach. This technique generates pricing multiples from sales of comparable (or guideline) companies. Here, value is a function of selling price and a financial metric, such as annual revenue; operating cash flow; or earnings before interest, taxes, depreciation and amortization (EBITDA). Public pricing data can be obtained from daily stock market quotes and Securities and Exchange Commission documents for controlling interests. Alternatively, private deal terms may be obtained from proprietary databases.
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.
3. Income approach. Under this technique, valuation professionals project cash flows and then discount them back to their net present value. Discount (or capitalization) rates are based on the company's risk. High-risk businesses are assigned a higher discount rate, which equates to a lower value (and vice versa).
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:
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