Most owners have an opinion about what their business is worth. Maybe your estimate is based on what a competitor sold for, what you'd need to retire comfortably or simply a gut feeling developed through years of hard work and experience. The problem is that buyers, investors and the courts may not perceive your operations the same way as you do. In fact, it's common to discover after a professional valuation that your business is worth more or less than you expected.
Even if a sale isn't on the horizon, understanding the factors that drive value can help you evaluate growth opportunities, prepare for unexpected events and build a stronger business over the long run.
Business valuations are often associated with mergers and acquisitions (M&As) and retirement planning. Those are certainly common reasons to obtain a valuation, but they're far from the only ones. Knowing what your business is worth can also be helpful when:
And life doesn't always follow a carefully planned timetable. An unsolicited purchase offer, a disagreement with another owner, a divorce, the disability of a key person or other unexpected events can quickly turn business value from an academic question to an urgent one. By understanding the approximate value of your business interest before those situations arise, you'll be better positioned to respond and avoid making important decisions under pressure.
The term "value" can have several different meanings. However, fair market value often serves as the starting point. Under federal tax guidance, this term is defined as "the price at which property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts."
In other words, it's a transaction-based price that considers the perspectives of both hypothetical buyers and sellers. It assumes the subject business interest would be given adequate time to sell, and both parties are well informed about the business and the market in which it operates.
However, when evaluating fair market value, buyers and sellers may perceive the same facts differently. Business owners (sellers) know their operations better than anyone else. They understand their customers, employees, competitors and markets. They know what makes the business successful and what keeps them awake at night. But familiarity can sometimes make it difficult to view your business the way an outsider would.
When it's time to sell, prospective buyers won't pay for your retirement goals or the sacrifices you've made along the way. They'll evaluate your business based on the future economic benefits they believe it can generate and the risks they'll assume.
Important: Fair market value isn't the only standard of value that could apply when valuing your business. But it can be a useful metric for evaluating how potential buyers may generally perceive your business. The appropriate standard may vary depending on the purpose of your valuation and applicable requirements.
Qualified business valuation professionals combine management's understanding of the business with objective financial analysis, industry research and market-based evidence to arrive at a supportable estimate of value. Just as important, they view the business through the eyes of a hypothetical buyer or investor.
Valuation professionals also evaluate whether your business's historical financial results accurately reflect ongoing operations. For example, they may adjust earnings for nonrecurring expenses, excess owner compensation or other items that a hypothetical buyer would view differently.
An independent valuation can provide credibility when presenting value conclusions to lenders, investors, courts, tax authorities or potential buyers. When valuing a business for tax or litigation purposes, a qualified valuation professional's opinion typically carries more weight than an owner's personal opinion.
Valuation professionals typically consider the following three approaches when valuing a private business:
1. Cost (or asset) approach. Under this approach, a business's value is based on its assets and liabilities. For example, a valuation professional might revalue the amounts shown on a business's balance sheet from historical cost to market value. This approach is often more appropriate for holding companies and others that rely heavily on tangible assets, such as inventory, equipment and real estate.
However, not all assets and liabilities appear on the balance sheet. Examples of items that may impact value even if they aren't recognized on the financials include customer lists, patents, trademarks and goodwill, as well as pending litigation and warranty obligations.
2. Market approach. This technique uses pricing multiples from sales of comparable (or guideline) businesses. Guideline data may come from either public stock prices or public or private M&A transactions.
Based on the principle of substitution, this approach is only as reliable as the underlying comparables. Valuation professionals apply various selection criteria — such as industry, size, performance and transaction date — to obtain a sufficient sample of meaningful comparables. However, it can sometimes be difficult to find a meaningful sample of comparables, especially for businesses that specialize in a particular industry niche.
3. Income approach. Under this technique, valuation professionals discount future earnings forecasts to present value. Discount rates — or capitalization rates when capitalizing a single representative period's earnings — are based on the business's risk. All else being equal, high-risk businesses are assigned a higher rate, which equates to a lower value (and vice versa).
No single valuation method is appropriate in every circumstance. Depending on the nature of the business, the purpose of the valuation and the availability of reliable data, a valuation professional may rely more heavily on one approach than another. Professional judgment is required to determine which methods are most relevant and how to reconcile the results.
Valuation professionals also consider a basic question: What are the future economic benefits of owning this business, and what risks come with those benefits? That's where business owners are often surprised.
Many assume value is driven primarily by assets, revenue, profits or growth. Those factors certainly matter. But valuation professionals also evaluate whether future economic benefits are sustainable over the long term.
For example, two businesses with similar financial results may have very different values if one relies heavily on a single customer, supplier or owner. Likewise, a business with a strong management team, recurring revenue streams and well-documented operating procedures may be worth more than a faster-growing competitor with less predictable results. In other words, value depends not only on what your business earns today, but also on how confident a buyer would be that those earnings can continue tomorrow.
Value drivers vary from one business to the next, and some may not become apparent until a formal valuation. Examples of factors that can enhance value include:
On the other hand, certain characteristics may increase risk and reduce value. Common examples include excessive reliance on a single customer, supplier, key employee or owner. Weak internal controls, limited management depth and the absence of a succession plan can also negatively affect value.
One of the most frequent valuation surprises involves owner dependence. Many entrepreneurs have spent years building businesses around their expertise, relationships and leadership. While those contributions are often central to success, they can also create risk to a prospective buyer. If your business would struggle without you at the helm, a buyer may question whether it can maintain future results after a transition in ownership.
Many business owners think of a valuation as a one-time exercise that's needed only when it's time to sell. However, a valuation isn't just about putting a price tag on your business. It can reveal strengths that enhance value and risks that may be holding you back. Contact your financial advisor to discuss whether a formal valuation could help you better understand your business's long-term opportunities and challenges.
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