Business Valuations: A Quick Guide
As a small business owner, you’re in a unique position. Your most valuable asset isn’t likely to be your home, vehicle, or retirement accounts…Instead, there’s a good chance that your small business is your most valuable asset.
However, calculating what your business is worth is a lot harder than logging into your retirement account’s online website or checking your home’s value online. After all, your business has plenty of moving parts regarding its financial accounts (like assets and liabilities).
To find out the value of your business, you’ll need to perform a business valuation.
What is a Business Valuation?
Business valuation is the process of discovering how much your entire company is worth in terms of economic value (your business’s value based on how much benefits one might gain from owning it).
Think of a business valuation like a home appraisal.
In a home appraisal, an appraiser looks over your entire property and evaluates numerous different parts of the home. They also might look at similar homes that were recently sold to help. From there, the appraiser can determine approximately how
It works much the same in a business valuation. The business’s assets, liabilities, and equity are all explored in more detail — along with examining similar companies that were recently sold — to calculate the approximate value of the business.
Why Do You Need a Business Valuation?
Here are a few of the top reasons to get a business valuation.
Selling Your Business (Or Buying Another One)
Selling your business? You need to know how much it’s worth to do that, of course. That’s what a business valuation is for.
Or, perhaps you’re buying a business or acquiring one for your existing company. Once again, you’ll need a business valuation of that other business — although the seller will likely handle that for you.
Exit Strategy Planning
As much as you might love your business, you’ll no longer run it at some point. You need an exit strategy.
Now, you don’t have to sell your business — you can pass it down to your heirs or someone else if you’d like, or you could even let it pass with you.
However, you don’t know what the future holds. It’s helpful to get a business valuation to see where you stand and evaluate your exit options.
Yet, if you do plan on selling in the future, you’ll want to raise your businesses’ value to maximize payout. You’ll need to know your business’s current value to approximate the growth required to hit that goal.
Bringing on Investors
Investors ask for a lot of information before putting money into your company to maximize their chances of earning solid returns.
One piece of information you have to know is your business’s value because you need to know how much a share is worth. You can’t issue equity without a business valuation (more on this later).
Debt is your other option for raising capital, but you might need a business valuation for this, too. Banks often want to see a valuation alongside other relevant information and documentation before handing you a loan.
Business Valuation Methods
There are three main types of approaches to valuation:
- Cost Approaches
- Market Approaches
- Discounted Cash Flows Approaches
Let’s look at each in more detail.
Cost approaches essentially calculate what it would take to build or replace the asset in question — in this case, your business.
There are several types, but the simplest are asset-based approaches.
Going concern (a company that is expected to continue operating indefinitely) asset-based approaches involve looking at the balance sheet, summing the value of all assets, and subtracting liabilities from that total. It’s called a going concern approach because the company isn’t expected to liquidate and sell the assets.
Speaking of liquidating, liquidation-based approaches are similar, but also consider what you can sell assets for.
For example, if your assets totaled $10,000 on the balance sheet, but you could only sell them for $7,000, then you’d use $7,000 as your asset total in your calculation.
Now, these types of approaches are helpful for real estate transactions, but they’re not used very often for business valuations.
Market approaches are used quite often in the industry due to simplicity. All you do is compare your company to several similar businesses that recently sold. With enough data, you can calculate an approximate value for your business.
Of course, this method falls short if you can’t find more than a few businesses similar to yours that sold recently.
Income-based approaches emphasize a firm’s ability to produce income in the future. After all, generating profits is the goal in business.
The most common income-based approach is the discounted cash flows method (DCF), which calculates business value as the present value of its total future cash flows.
This method is the most detailed and rigorous (and may require Excel modeling) but can often be the most accurate. It involves projecting the firm’s cash flows up to 10 years into the future, calculating what’s known as a terminal value, then discounting these two values to the present day.
DCF is tough to perform on your own if you aren’t a finance whiz. Fortunately, you can hire external business valuation specialists to handle your valuation.
Where Can I Go to Find a Qualified Business Valuation Specialist?
A range of different professionals can provide you with business valuations:
- Business advisors
- Business brokers
- Certified Public Accountants (CPAs) specializing in business valuations
- Mergers & acquisitions specialists (for larger businesses)
Perhaps the best choice for most people will be to hire someone with the Accredited in Business Valuation (ABV) certification.
The American Institute of Certified Public Accountants (AICPA) awards the ABV to qualified CPAs and non-CPA business professionals who meet rigorous eligibility requirements (including significant education and work experience) and pass the ABV exam.
Professionals with the ABV designation are experts in appraising businesses, so it might be worth investing in one. If you have a CPA with an ABV already, then your best choice may be to rely on them.
Considerations For Equity Funding: 409(a) Valuations
If you plan on issuing equity to investors, you need a special type of valuation laid out in Internal Revenue Code 409(a) called a 409(a) valuation. This valuation assesses the fair market value (FMV) of your firm’s common stock.
Why do you need one of these over another valuation method?
Without this valuation, your shareholders could face ordinary income taxation on stock options and a 20% penalty tax. 409(a) valuations provide you with “safe harbor,” helping your employee-shareholders take advantage of their equity.
The easiest way to get an adequate 409(a) valuation is to hire one of the professionals listed earlier, as long as they are an independent third-party. They’ll use a proven valuation method to calculate your firm’s FMV.
You’ll also need to refresh your 409(a) valuation every 12 months or after a “material” event occurs (such as raising a new round of venture capital funding).
The Bottom Line
Business valuations play several vital roles, from raising capital to helping with exit planning and more. Finding your business’s valuation on your own can be tricky, though, but business valuation professionals can take it off your hands. In fact, it's best if you hire someone else.