How a Business is Valued
Determining what your business is worth is maybe the most difficult task entrepreneurs face when deciding to sell their businesses. Usually, entrepreneurs have calculated the value of their business based upon how much money the business makes in a given year. When I give them the harsh reality, they're often pretty shocked. Valuing a business is as much an art as it is a science, and no two appraisers will assess the same business at the same price, much less even using the same method. Even still, neither appraiser may be wrong in their assessment. At the end of the day, the value of a business is worth what someone else is willing to pay for it, and what someone is willing to sell it for. However, there are some ways to estimate that amount.
On October 30, 2015, I presented a talk on how businesses are valued at CLE Alabama's Business Law Conference. The conference consisted of business law attorneys from around the state, and was live streamed over the internet across the world. The above video is a recording from my presentation. While I encourage you to watch the video, I'll provide a quick summary.
Check Your Books
The first step before ever considering selling your business is to get your books in order. Accurate financial records are the most critical component of a successful business transfer. If your books are not thorough and accurate, there is no one that is going to take a risk on your business.
Most businesses only have their accountants compile their financial records in order to file tax returns. Compiling the records means that an accountant takes no responsibility for the accuracy of the records, they're simply passing it on. In a business transaction, this is a red flag.
Financial records should at least be reviewed by an accountant, meaning the math has been checked and things aren't grossly inaccurate, but ideally the records should be audited, meaning that an individual has gone through the books to ensure that every line item is accurate. An audit may not make sense for extremely low-value acquisitions, but they are a requirement for most purchases.
Determine Your Purpose
Next, you need to clarify why you're seeking a business valuation. Valuations will vary widely depending on if the same business is a continuing operation or if the business is being sold for scrap. Businesses that are a "going concern" (meaning that they will continue to operate after the sale) are generally valued the highest, whereas businesses that need to shed assets to pay creditors are going to be valued least. The reasons for a business seeking a valuation need to be clearly stated and understood, because they could swing the final number by a large amount.
Remove the Chaff
Unless you are selling a publicly traded company, you probably do not have to follow GAAP (General Accepted Accounting Principles) very closely. While the IRS provides a bare minimum for how items should be reported, GAAP is a higher standard that is required of most all accounting procedures. However, even still, you can have items that are reported accurately that still have nothing to do with a business's main concern.
The next step in the process is to remove all non-operating incomes and expenses from the equation. Most purchasers will only acquire specific assets within a business, so they will only be concerned with how your core business operates. If it's not a core concern, they won't be interested, and they will remove anything not related to that concern from the valuation. For instance, if you own a meat packing plant, but you happen to sublease to a cheese packer, that might be great for your bank account balance, but to any potential investor, you're still a meat packer and that other income is irrelevant.
Apply a Method
Generally, there are 3 methods for assessing a business, the income method, the asset method, and the market method.
The income method attempts to predict what money will be left over after everyone, including other investors, have been paid. The method then calculates what that number will be each year in the future, and then discounts those future cash flows. While this method could be the most accurate theoretically, it practicality breaks down over longer time periods because the future revenues become increasingly uncertain. This method works best with very predictable cash flows, so it is used often in commercial real estate valuations.
The asset method attempts to assign a fair market value, independently, to each and every asset and liability of the business in order to determine the "book value" of the business. After the values are assigned, the value is based on assets minus liabilities. While most often used in accounting and tax reporting, this system fails to be able to accurately value the business as a going concern, so it's generally a baseline valuation given to estimate the absolute lowest possible value of a business.
The market method ends up being one of the most common methods for valuing closely held companies in practice. The market method takes some metric in the business, such as earnings, dividends, or sometimes even gross revenue, and then applies a multiple to that metric to determine the business's value. Often called valuation by multiples, the market method is attractive in that it is easy to understand and intuitive, but it struggles because of its reliance on comparing the business with other business, which can be difficult or impossible given the type of business.
Ultimately, valuing a business will likely involve a combination of many methods to determine an actual value to the business. Regardless, there is not, and never will be, one authoritative method for determining a business value, and it's always a very fact-intensive exercise.
If you are considering selling your business, we can help value your business, shop for potential investors, and facilitate the transfer, all while advising you to ensure the best possible valuation for your business. Simply complete the form to the left of the page or give us a call at 205.545.7278!