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How To Place An Accurate Value On A Small Business That You Plan To Buy Or Sell

How To Place An Accurate Value On A Small Business That You Plan To Buy Or Sell

Buying or selling a small business certainly comes with plenty of questions and crucial decisions. One of these important matters centers around the price that you are willing to either pay or accept depending on your side of the transaction. In essence, the selling price needs to be acceptable for both the buyer and seller. If the two parties simply cannot agree on the selling price, chances are high that the deal will not close. The good news is that there are many solid methods to determine the valuation of a business.

The amount that said business is valued at may very well vary depending on the method that is utilized. That is why it is so important that both buyers and sellers are not only aware of, but have at minimum a basic comprehension of these methods. Think of it in the following manner. You always want to compare apples with apples instead of comparing apples with oranges. That way the buyer and seller will be on the same page. Once you have a realistic idea of how much the business is worth, it is always a smart idea to consult with a professional business broker or business appraiser.

That way you will be sure that you are buying or selling the business at a realistic and fair price. In addition, if you own a small business there are a few reasons that you should have an up-to-date business valuation beyond selling the company. For example, you may very well need debt or equity financing for expansion, or cash flow issues. Potential financiers or investors will want to see that the organization has sufficient worth. Another example is adding shareholders or one or more shareholders may ask for a buyout.

In this case, the share value will need to be determined before the transaction or transactions can be conducted.

Regardless of the reason, the value of a business depends on a plethora of factors including the organization's balance sheet, the current state of the economy, and the strength of the competition to name a few. If similar small businesses within the area have recently sold, the value of the business that you are planning to buy or sell will be determined in large part to the selling prices of those companies. That being stated, it is important for you to know what are business valuation methods and what it means.

 

What Exactly Is A Small Business Valuation?

Before we explore the various details about the types of small business valuations methods, it is important that you understand what a small business valuation actually is. For example, all business valuation methods are ways in which to determine how much a company is currently worth. The values of the equipment, inventory, property, liquid assets and any other item of value that the company owns are included in these calculations. The management structure, projected earnings, revenue, and share price to name a few are other factors that may be utilized.

There certainly are many small business valuations methods available, however, the best valuation approach typically depends on why the valuation is needed, the size of the business, the industry, and other factors. For example, the majority of small private firms are sold as asset sales, while the majority of middle-market transactions are based on the sale of equity. In essence, these scenarios would require different approaches to business valuation.

The Four Standard Business Valuation Methods

Although professional business brokers and appraisers utilize a vast variety of valuation methods, some are certainly better than others depending on your exact situation. That being stated, there are four standard methods that are most widely used across all types of businesses and industries alike. In essence, they are considered to be the standards in the realm of business valuation methods. It is a good idea for both buyers and sellers to be familiar with all four.

1. The Asset-Based Business Valuation Method

Basically speaking, the asset-based business valuation methods are utilized in order to calculate or total up all the investments in a particular business. The asset-based valuations can be performed on either a going concern or on a liquidation basis. In essence, the asset approaches place a fair market value on what a business actually owns. This includes equipment, real estate, patents, or digital accounts such as specific URLs. Anything that a business can turn around and sell in as-is condition is generally considered an asset. There are actually two common methods of valuing a business based on its assets. They are as follows.

 

    • The Asset Accumulation Approach
      For this method, an organization compiles a list of all of its tangible and intangible assets and compares them directly to all of the company's liabilities. The difference is considered to be the business's assets. In essence, it is the amount of money that would be leftover if a company sold off all of its equipment, intellectual property, and real estate/physical location. This method is also referred to as the liquidation asset-based approach. The bottom line is that it determines the nest cash that would be received if all assets were sold and the liabilities are paid off in full.

    • The Capitalized Excess Earnings Approach
      This asset valuation method adds together the value of the tangible business assets with excess earnings. In essence, the excess earnings are considered to be the business earnings that are not derived from tangible assets. This method is also referred to as a going concern asset-based approach, which lists the company's net balance sheet value of its assets and then subtracts the value of its liabilities.

      Utilizing the asset-based approaches to value a sole proprietorship is a bit more difficult. In a corporation, all of the assets are owned by the business and are typically included in the sale of the business. On the other hand, the assets in a sole proprietorship are in the name of the current business owner. Separating the assets from business and personal use can be tricky to say the least. For example, a sole proprietor in a home improvement business may use various pieces of equipment for both business use and personal use. The potential buyer of the company will need to differentiate the assets that the owner intends to keep or sell as part of the business.

 

2. The Earning Value-Based Business Valuation Method

Earning value methods are based on the basic principle that an organization's ultimate value is in its ability to produce future earnings and its capacity to accumulate wealth. One of the most common types of earning value approaches is known as the capitalizing of past earnings method. This method involves a valuator who determines a level of expected cash flow that is based on a company's prior earnings. This information is then normalized for unusual expenses or revenue and multiplied by a capitalization factor. This capitalization factor can tell you what rate of return the average buyer would expect on the investment, in addition to the level of risk.

Another type of earning value approach is called discounted future earnings. This method determines an average of the trend of potential earnings in the future instead of an average of past earnings. The average is then divided by the capitalization factor. It is important to note that the valuation of any type of sole proprietorship in relation to prior earnings can be challenging, as loyalty from customers often comes with an association with the business owner. Existing customers often expect the new owner to deliver the same quality of products or services than the previous owner.

 

3. The Market Value-Based Business Valuation Method

In the market value approach, the value of a company is established by comparing the business to other similar businesses that have recently sold.

While this method can be rather useful, there has to be an ample number of similar businesses sold in order to obtain great results. It can be especially difficult to assign a value to a sole proprietorship as they are individually owned and locating public information on past sales is not always easy. In today's day and age, the earning value method is no doubt one of the most popular business valuation methods.

That being stated, the vast majority of businesses find success when combining this method with other business valuation approaches. In fact, professional business appraisals often include different market valuation methods, such as the comparative transaction method and the guideline publicly traded company method. Each of these valuation methods requires the comparison of the subject business to other businesses sold recently in the same or a similar industry.

For privately owned firms, transactions that involve small capitalization public companies are generally used as evidence of business value. Determining the fair market value of a business typically requires the utilization of valuation firms that are derived from comparable business sales. If non-competition clauses are involved in the agreements for a sale of a business, know that these can affect valuation.

 

4. The Return On Investment Based Business Valuation Method

The return on investment, or ROI method for short, is a rather quick and easy way for both buyers and sellers to calculate the value of a business. That being stated, it should only be utilized for initial conversations. The methods listed above are far more accurate and detailed when it comes down to actual negotiations regarding the actual sales price. However, the ROI method does answer a primary concern. When you are considering investing in something, it is important to have a grasp on your return on that investment.

For example, if you purchase a stock in a publicly-traded company you certainly want a return, but what is considered a good return? It ultimately depends on the market, which is why business valuation, in general, can be so subjective. In order to see the ROI-based method in action, let's take a look at the television show "The Profit." Believe it or not, you can actually learn a great deal about business valuation from watching this show. That is if you are paying careful attention. One of the main discussions that the host of the show has with the business owners is how much money he is willing to invest for a particular percentage of ownership in their companies.

In essence, he is putting a value on the business at this point. The math is actually rather simple when calculating the value of a business based on the ROI method. Simply divide the amount of money desired by the percentage offered. It equals a business evaluation of 100%. For example, you are buying a business and offer $500,000 for 50% of the business. That means you are valuing the business at $1,000,000. The bottom line here is that you have just performed a business valuation right on the spot.

However, as mentioned above, you may want to back these numbers by utilizing the other three (3) business valuation methods. If you are utilizing the ROI approach in order to seek buyers, you will absolutely need to convince them of the valuation in order to even start an initial conversation. You can begin by having answers to the following questions.

  • How long will it take to recover my original investment?
  • After that, when I look at my share of the expected net income, compared with my investment, what does my return look like?
  • Is that number realistic? Ambitious? Conservative?
  • Does it make me want to invest in this company?

The answers to all of these questions will help to provide a far more accurate ROI-based business valuation.

Which Business Valuation Is Best For Buyers And Sellers?

Whether you are buying or selling a small business, a large business, a new business, or an established business, you are likely to find the best approach is contained within these three business valuation methods. Each one offers a different view in which drives the values of a business. Therefore, no one method is better than another. However, you will want to consider a few vital factors when choosing between the different options. If you are buying or selling a young company, market-based and asset-based valuation methods do not make much sense.

This leaves an income-based valuation method with one of the best options being the discounted cash flow method. For example, if you are buying or selling an established company that usually generates steady income streams, there will likely be ample business sale data to make an accurate market value assessment. An excellent choice for companies that have stable and recurring earnings is the multiple of discretionary earnings method. If you are buying or selling a business in the wholesale, retail, or service industry, compatible business sales are likely plentiful. In this case, market-based business valuation methods can work incredibly well.

 

Numerous Buyers And Sellers Utilize All Four Standard Business Valuation Methods

Most buyers and sellers use a comprehensive approach to valuation, which draws from each of, the areas listed above. The reason for considering valuation is that every business has different a business model. A physical business built around customers coming to a brick-and-mortar store is going to have a very different valuation process when compared to a business that mainly operates online and has more intangible assets than tangible ones. Business buyers and sellers who can easily discuss the difference between the income streams, asset valuations and comparative sales prices of other companies that have recently sold are at a tremendous advantage.

For example, buyers typically appreciate it when the seller has a detailed comprehension of the daily operating process of their company. In essence, it provides the buyers with far more trust in the seller's side of the valuation. This can very well lead to the buyers being more willing to paying a fair market price for the organization.

 

Learn More About The Business Valuation Methods

If you decide to purchase or sell a business, it is incredibly important to have a solid understanding of exactly what the organization is worth from a monetary standpoint. There are different types of business valuation methods in order to help you determine an accurate amount. Some buyers and sellers choose to utilize one of these methods based on their specific wants and needs. On the other hand, others choose to utilize a combination of these methods in order to obtain the most reliable results.

With results from at least two business valuation approaches, you can stand by your decision in a confident manner. Please contact us today in order to learn more about the various business valuation methods, or for assistance with the business valuation process. We look forward to working with you.