Written By Geoff Burns
Business Valuations are often considered important only if you are looking to buy or sell. But, business owners and investors can use business valuations to secure better terms for loans, find new funding sources, investigate franchising and many other opportunities. Whether you are are a business owner, investor, or just interested in the process, lets look at the three most common ways to determine the value of the business.
All the asset methods do is summarize the value of the company assets. We can think of this in two different ways. First, simply take the balance sheet and add up all of the assets. (You can read more about the balance sheet in my previous article, here.) Subtract the total liabilities and now you have the equity, or what is commonly called, the “Book Value.” This is a crude, but effective, simple approach to get a base-line idea as to the value of the business.
A second way, and equally as crude, is to evaluate the sale price of all assets. In this approach, there is less emphasis on the “book value,” and more emphasis on what the actual cash position would be if all assets were sold to pay off all the liabilities. Think of it as a “real world” application and not just “on paper.”
Earning Value Methods
These methods are predicated upon the concept that the real value of a business is its future ability to produce revenue. One way to utilize this method is by assessing the past earnings and cash flow. Typically a professional (not a business owner), will evaluate the financial history of the business and take into consideration unusual income spikes or expenses through a process called, “normalization.” Once the normalized cash flows are determined, the number is multiplied by a “Capitalization Factor.” This is just a fancy way of picking an appropriate value to scale up the earnings potential based on several, reasonable factors which could influence the future earning potential and risk.
Another way to use this method is to look forward at predicted earnings without regard to prior earnings, and reduce the calculated value. In this method, instead of looking at previous earnings and increasing the number by the “Capitalization Factor,” the future earnings are reduced by the “Capitalization Factor” in order to scale back the potentially inflated future earnings estimate.
Market Value Methods
The methods used in determining Market Value is similar to that of the housing market. When looking at real estate, agents and brokers look at similar properties that have recently sold in the area. For business valuation purposes, the process compares similar businesses that have sold in the same or related industry. One of the key drawbacks is lack of available comparable data. In niche businesses, it can be especially difficult to assess as there aren’t enough similar businesses with which to compare.
Which Method is Best?
Unfortunately, there is no “one size fits all” answer. Sole proprietorships are privately owned and the details of private sales are not often public record. This adds to the difficulty of the Market Value Method. Earning Value methods are probably the most popular method. The reality is that using a combination of several methods is likely to be the best, and most reasonable way to determine the business value.
Legally binding agreements can come into play when determining the value of a business for sale. Non-disclosure agreements and Non-Compete Clauses among others are common place in the transition from owner to buyer. If you are only looking to position your business for better rates on traditional loans, these agreements may not be significant or even necessary, but for businesses looking to sell, they can play a critical role in determining a final price.
Seek Professional Help
Something we all should do, right? Business owners and investors should also heed this advice. Never rely on your own valuation. Find a professional appraiser or other third party that can objectively determine your business value. Often in business valuations both the buyer and the seller will hire a professional and then compare the two valuations to determine a fair price.
Regardless of the reason you are seeking a business valuation, your result can only be as good as the data used to calculate the value. Bad numbers make for bad valuations. This can cheat the seller, the buyer, or even make a business ineligible for a loan. The best way to ensure accurate numbers is to work with a professional bookkeeper who can ensure that your financial records are in order and can provide custom reports to show the true financial picture of the business. I see businesses that need lots of clean up before they are ready for valuations. Good bookkeepers are difficult to find, but a great one will be your asset and ally. Before engaging in business valuation, make sure your books are clean, up to date, and accurate. You can read about some other problems with bad bookkeeping, here. It is never too late, or too soon, to get your books in order.