Whatever stage an operating business is in, there is often a need to put a value on the business. Whether you are applying for a small business loan, seeking an investment partnership, or planning to sell your business, understanding how to value the total worth of the business will be beneficial for raising funds or accurately pricing the business to find the right buyer.
A business valuation represents a company’s total worth. Entrepreneurs looking to buy an existing business should also be familiar with valuations, and feel comfortable estimating value independently of the business owner or broker’s asking price.
Valuing a business is both a science and an art in determining a fair market value. It can be a daunting and emotional process. There are a lot of valuation techniques that can be used, but there are some tried and true common valuation methods sellers and buyers-owners should follow.
1. Get the financial records in order — Having dependable financial reporting is crucial for the financial analysis required for calculating an accurate value. Business income tax returns, financial statements such as profit and loss statements and a balance sheet, a business asset list, and licenses and other proprietary information are key pieces to the valuation puzzle.
2. Cash Flow is King — Prospective buyers will need to assess how much cash is available to provide them with a desired rate of return on their investment and/or provide them a salary. This valuation method is commonly known as seller discretionary earnings (SDE). SDE is like EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), but also adds back the owner’s salary and benefits and other discretionary personal expenses such as vehicles and travel. This calculation provides a good baseline for future cash flows. Understanding SDE and providing an accurate accounting of what cash flow the business actually generates is essential for providing accurate valuations and establishing the market price for the business.
3. Understand industry trends and multiples — Familiarity with the industry is crucial for both buyers and sellers. A thorough understanding of an industry’s trends can help you determine an accurate fair market valuation that also reflects the current market. A multiple of the aforementioned SDE business valuation method values the business according to industry standards. Various industries have different multiples. The multiple for any given industry will vary based on industry trends, external factors, geography, the company’s size, and the level of risk associated with a management change. Different multiples will provide a range of values. The higher the multiple, the more the business is worth.
4. Consult a Business Valuation Professional – Valuing a business can be a complicated task. It is both an art and a science. Do not hesitate to consult with a qualified professional that provides business valuation services. Financial and legal professionals will help you wade through the business valuation process and methods of valuation, research industry trends, conduct the financial modeling, and maybe most importantly, take some emotion out of the process and provide an objective assessment of value.
5. Be flexible — Ultimately, no matter the approach to valuation, a business is worth how much someone is willing to pay for it. You may need to compromise on your number if the market doesn’t support it. If you need the capital to survive or have other extenuating circumstances such as divorce proceedings, then you cannot afford to be inflexible with your valuation.
Buying or selling a business can be stressful and confusing. Parties are never quite sure if they’re getting the benefit of the bargain. Understanding the foundational steps for proper business valuation methods is an excellent start to ensure that you are performing your best due diligence.
About the Author: Tom Bell, MBA has over 25 years of commercial and business banking and financial consulting experience as a lending manager for one of the Midwest’s larger regional lenders. He handles all aspects of business finance, restructuring, audits, business sales and lending. Should you need assistance in with business valuation, or have any further questions about business financial matters in general, contact Tom Bell, MBA, who is a key financial advisor at Soble Law, real estate and finance attorneys. Tom can be reached at firstname.lastname@example.org.