Whether it's a local bakery, a medical practice or a tech startup in its early stages, determining the value of a business is important for several reasons, including developing an appropriate business succession strategy. However, unlike publicly traded companies with readily available market data, valuing a private business can be a complex task.

Business owners generally aren’t experts at business valuation and often overvalue their business relative to what the market would reflect. Without a professional objective valuation, a business owner’s subjective view of his or her business’s worth can lead to unrealistic expectations and disappointment.

It’s important to know a business’s value even in advance of a planned succession event, and potentially early in a business’s life – the more you know about your business’s financials, market position, assets and liabilities and the other factors that play into an ultimate value, the earlier and more easily you can adjust if one or more of those factors heads in the wrong direction. And knowing an objective value through the course of your company’s lifecycle can help set your and your successor owners’ expectations appropriately.

Various professionals may be able to offer an opinion of value – your CPA, your company’s Chief Financial Officer, a business broker, for example. Other professionals (such as insurance professionals) can help value individual parts of your business. But using a licensed appraiser is often considered the most reliable option for formal valuations – not only will a licensed appraiser address different methods of valuing a business to determine which is most appropriate, but that appraiser may also be able to offer opinions of value for different purposes. If you plan to sell your business, you’ll want to get the highest price possible. But if before a sale you want to transfer ownership of part or all of the business to family members, especially in the form of a gift, you might want a lower valuation. A licensed appraiser should be adept at providing a value consistent with your stated goals for the valuation. However, please remember that it is important to consult with tax advisors or legal professionals to ensure that the valuation complies with applicable tax laws and regulations.

Understanding the basics of business valuation can help you think about your options as you get closer to succession and can help inform your choice of professional to help you determine your company’s value.

Fundamentals of valuation

The primary factors that go into the valuation of a business are:

• Financial performance: The business's revenue, expenses, profit margins and cash flow, both currently and historically. Has the company been growing consistently? Is the company profitable? What are realistic projections?
• Market position: The business's position within its industry and geography and the competitive landscape. Factors such as market share, customer base, potential for expansion, relative pricing and pricing power and brand reputation, among others, influence value.
• Assets and liabilities: Including tangible assets like equipment, inventory and property, as well as intangible assets such as intellectual property and goodwill. These add to the business’s value. Liabilities, including debts and obligations, detract from the overall value.
• Growth potential: What is the business's potential for future growth, innovation and expansion? A positive trajectory can significantly impact the value, but projections are inherently uncertain. Consider consulting with professionals to assess realistic growth scenarios for your business.

Business valuation: methodology

Business valuation is as much an art as a science. There are a number of different ways to value a business. The three most common valuation methods are the asset approach, the income approach and the market approach. Many appraisers will review one, two or all three for a particular business and either select one or weigh two or more if more than one can be applicable. A thorough appraisal will take you through the background of the business, the background of the industry in which the business operates, and then details about one or more of these methods, why it was they were selected, and ultimately arrive at a conclusion of value.

Asset approach

The asset approach arrives at a business’s value based on a business’s balance sheet as of the valuation date. This approach uses the fundamental equation associated with the balance sheet of assets = liabilities + equity.

The asset approach consists of two methods: the book value of equity (BVE) method and the adjusted book value of equity (ABVE) method.

The BVE method is the most straightforward way of valuing the business because it simply looks at the equity on the balance sheet. This method is not used frequently since it does not consider the fair market value of the business’s assets and liabilities. This usually would lead to the business being significantly undervalued.

The ABVE method solves for this discrepancy. Under the ABVE method, the liabilities and equity on the balance sheet are adjusted to fair market value. This adjustment to liabilities and equity results in a more accurate estimate of the value of the business.

The asset approach does not consider the business’s ability to generate profits from its assets, because this approach looks at strictly what’s available on the business’s balance sheet. Most businesses use their tangible and intangible assets to generate a profit. By not considering these profits, the asset approach can undervalue a company that generates large profits. As a result, the asset approach is generally only used for businesses where a large portion of the value is attached to the business’s fixed assets and not its ability to generate profits, such as a real estate holding company.

Income approach

The income approach arrives at the business’s value by analyzing a company’s free cash flow and then discounting or capitalizing it. A business’s free cash flow is how much cash the business has after paying its operating expenses and maintaining its capital expenditures.

Does the business generate net cash after paying for the cost of goods sold; after paying to maintain its property, plant and equipment; after paying salaries and administrative expenses and after paying any debt service or other outstanding liabilities?

The income approach also looks at the discount or capitalization rate, which is a measure of risk and return. The discount rate can either be the weighted average cost of capital (WACC) or the cost of equity (COE).

The discount rate is usually expressed as a percentage. The higher the discount rate, the lower the current value will be, and a riskier business will generally have a high discount rate.

There are two ways to apply the income approach to arrive at a value: the capitalization of earnings method and the discounted cash flow method.

The capitalization of earnings method values a business based on its future free cash flows with the expectation that cash flow will grow at a rate of about 3%–5%. The free cash flow is then divided by a capitalization rate. Generally, this method is reserved for mature businesses, where the free cash flow is a good indication of the subject business’s future performance.

The discounted cash flow method values a business based on its projected free cash flows discounted by the appropriate discount rate. This method is used where historical free cash flow is not a good indication of the business’s future performance. The discounted cash flow method can be used for all types of businesses where there is a possibility of increased free cash flow over time. The discounted cash flow method adds up the present value of all future cash flows, plus the terminal value of the enterprise, to arrive at a present value.

Market approach

The market approach arrives at a business’s value by comparing a company to other similar companies, either publicly traded or based on prior private sales. This approach assumes that a similar business will sell for a similar multiple of earnings as other businesses in a similar industry and of a similar size.

While the market approach can provide valuable insights, finding comparable businesses to the one being valued is often challenging, particularly for private companies. A licensed appraiser might help identify suitable comparisons and adjust for differences.

The most common multiple that’s used in this approach is a comparison to earnings before interest, taxes, depreciation and amortization (EBITDA). You may occasionally see a different multiple being used, such as a revenue multiple or a gross profit multiple; however, because these look at top line earnings and disregard a business’s ability to manage direct and indirect costs, this can result in an overvaluation of the business. Whatever the chosen multiple is, it is then multiplied by the corresponding financial metric (e.g., business’s EBITDA x EBITDA multiple) to arrive at the value. The key to arriving at a good estimate of value under the market approach is to use appropriate comparable businesses that are similar in size and structure.

Uses for a business valuation

In prior papers in this series, we addressed some of the risks and mitigants for business owners in different stages of the company’s lifecycle. Valuation can play a role in all of them.

As you’re starting out, and particularly if you seek capital to help your business grow, knowing whether to borrow money (issue debt) or sell equity can be an important decision. Early-stage debt often comes with equity to compensate lenders for the risk of lending to a young business. Issuing equity requires you to know how much your company is worth so you know how much of the company you’re parting with. 10% of a company with a value of $250,000 ($25,000) is the same amount of money as 2.5% of a company with a value of $1 million – but if you valued your company at $250,000 you’d be selling four times as much equity as if you valued it at $1 million. Note that valuations for equity sales can be complex and subject to negotiation, depending on market conditions and business specifics.

Professional guidance is essential when determining the best course of action for selling equity.

As your company grows and you take on partners, knowing the value of the company can help as you think about risk management. Do you need to insure real estate or other tangible assets? Do you need key person insurance to fund a buy-sell agreement?

While the value for buy-sell agreement purposes isn’t necessarily the same as the fair-market value, it can be helpful to know if those values are far apart – too much disparity could lead to unnecessary complexity and possibly litigation if the time comes that one owner or the business has to buy a deceased owner’s interest from his or her family. In buy-sell agreements it is important to consult legal and financial advisors to ensure that all parties agree on valuation methods and expectations.

As your business matures and you look to succession planning, valuation becomes critical. Does the business have value outside of your involvement? Can its management and employees carry on the business without you? Will a new owner – whether a family member or an outside third party – be able to retain key personnel and continue to grow the business? If your transition relies on the new owners paying you over time based on the cash flow from the business, those questions can be key in determining how much you’ll want to take as a down payment, how much interest you’ll charge, and so forth – and knowing the base value will help both parties determine the feasibility of the transition.

On the personal side, will the transition of the business give you enough (either cash flow over time or a lump sum from a sale) to allow you to accomplish your financial goals, whatever they are? Having a financial plan that shows you the likelihood of you achieving your goals at various prices for your business can give you a good sense of how much you need to sell the business for – and can inform your timing, if the business today won’t support that valuation.

Valuation supports a number of important business decisions throughout the life of a company. Having a professional valuation, refreshed periodically, can help you make better-informed decisions as your company grows and as you approach a succession decision. And a better-informed decision is usually a better decision.

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