You may need a business valuation for many reasons. Regardless of the reason, you need an accurate and fair valuation. Most importantly, the valuation method must match your type of business and your reason for obtaining the valuation.
You should consult both legal and financial professionals before getting your valuation. Financial experts can figure out the right valuation theory to use. Consulting experienced corporate attorneys can ensure the valuation gets used correctly in your transaction.
Why Knowing Your Business Worth Is Important
Many transactions require business valuations, including:
- Selling businesses
- Taking out loans or issuing bonds
- Applying for credit
- Selling shares of stock or taking investments
- Adding or removing owners
- Conducting an initial public offering
You may even want to know your company's value just for your curiosity. An internal valuation can help you plan growth and set revenue targets.
When you acquire a business valuation, it must be:
- Useful for its purpose
For example, a lender may need to know the asset value of your business since it needs security against default. On the other hand, an investor might want to know your company's growth potential over the next five years.
Key Factors Influencing Business Value
Many factors go into a business valuation. And these factors will differ depending on why you need to know the value of your business.
1. Company Size
Company size is a proxy for market power and growth potential. You can measure the size of your business in several ways, such as:
- Gross sales
- Gross income
- Number of employees
- Number of locations
You should measure your company size compared to your competitors. Suppose that you have $1 million in sales. This might be small for some industries. But if your closest competitor only has $300,000 in sales, you have a large business for your industry.
Profitability and profit growth will play a significant role in your business valuation. Profitable businesses have a higher market value than unprofitable ones.
Profitability and the time you took to achieve it also say something about your management skills, market, and market position. Companies that achieve profitability quickly typically have excellent management, high demand for their products or services, and a market with room to grow.
3. Market Traction and Growth Rate
Market conditions also play a role in business valuation. A company can get a high valuation when it can capture a growing share of a stable market.
For example, suppose one business quickly captured 95% of the market with a trendy product before dropping to 50% market share. Another has gained 5% market share per year for 10 years to capture 50% market share. These businesses have radically different valuations even though they each have 50% of their markets.
4. Sustainable Competitive Advantage
Sustainability comes from many factors, including proprietary methods and products, intellectual property assets, and strong branding with a loyal customer base.
Companies with these characteristics can maintain a competitive advantage due to the exclusivity of their products and services. These companies often have trade secrets, patents, trademarks, and copyrights they can enforce against copycat products and services. As a result, they can command a higher valuation.
5. Future Growth Potential
Future growth is influenced by both your market and your company's market position.
Growing companies often have:
- A stable share of a growing market
- A growing share of a stable market
- A growing share of a growing market
In any of these situations, your company should be able to increase its revenue by simply continuing what it currently does. If you have additional products or services to bring to markets, you could further boost your growth.
Different Approaches to Business Valuation
Accountants and financial experts can determine the value of your business in many ways. These methods look at different aspects of your finances and are often used for different purposes. Some common business valuation methods include:
1. Market-Based Approach
The market-based approach works best for selling a business. This approach boils down to how much a willing buyer would pay for your business.
This method relies on market research. Often, the sale of comparable businesses, also known as comps, will help determine the range for the value of your business. Analysts will compare your company's revenue, assets, and liabilities to the comps to estimate the fair market value for your business.
Since this method relies on comps, it does not work well for small markets or businesses with unique products.
2. Income-Based Approach
The income-based approach works when you need a business valuation to sell your business. It can also persuade investors and lenders to give you money since you can show them an income statement as part of your valuation. This approach relies on your future revenue, net income, and cash flow to establish a present value for your business.
Accountants use two methods to determine a current value for your business based on projected revenue. In one method, called the discounted cash flow analysis, you take your company's projected cash flow and calculate its present value. This tells you how much those earnings are worth to a purchaser today.
The second method called the capitalization of earnings method, calculates the present value of future net earnings. You then divide this value by the capitalization rate, which is a number selected by the investor based on their desired return on investment and risk tolerance. Lower ROIs give lower values.
3. Asset-Based Approach
The asset-based approach is best suited for bankruptcy or sale. You can also use this approach for businesses that have a lot of business assets but not much revenue yet. In the asset method, you add up the fair market value of assets such as:
- Real estate
- Intellectual property
This business valuation determines the company's liquidation value if it were to end as a going concern. This method necessarily ignores future earnings and cash flows.
4 Essential Steps to Determining a Company’s Worth
You will need to do homework to get a well-supported, accurate, and fair valuation for your business. Four steps to take as you work with a professional business appraiser include:
1. Analyzing Key Financial Metrics
You need detailed financial performance data.
Your financial statements should include:
- Cash flow
- Annual sales
- Annual earnings
- Net profits
This information will give you a full picture of the current financial state of your business so you can calculate a fair market value using the market-based approach.
You or your business broker will need to find at least one comparable existing business to compare to your company. These similar companies need to be in the same industry or related industries, be at a similar point in their development, and have comparable financials.
Your current financial state will help you find comps and make the comparisons to arrive at a value.
You will also need to use this information to make some financial projections. Predicting future earnings and cash flow can be tricky. You will need to make several assumptions about your business and its market. Even safe assumptions, like assuming your past growth rate will continue into the foreseeable future, are still assumptions.
Once you project your future revenue, cash flow, and net profit, you can calculate the value of the business using income-based approaches.
Remember that both these methods require you to make additional assumptions, like the discount rate (essentially the prevailing interest rate) and capitalization rate (essentially the expected ROI of the purchaser). But you can adjust these assumptions based on the buyer. You should also expect potential buyers to double-check your work.
2. Assessing Market Conditions and Industry Trends
Your market valuation can depend on your market and industry.
Some market factors that could play into your company's value include:
- Market growth
- Standard industry multiple
- Average business expenses
This information will help you make projections for an income-based valuation. The nature of your industry will also provide support for the assumptions you make.
For example, if your industry has experienced 2% growth per year for the past 20 years, you can project 2% annual growth into the future with high confidence. But if you assume 5% growth going forward, prospective buyers will rightly question your numbers.
Your ability to get a favorable company valuation will also depend on broader economic conditions. If the economy is in the midst of a recession, you must assume limited business growth in the short term. As a result, you will get a much lower market multiple than you could during an economic expansion.
Even localized disruptions can affect your formal valuation. A slowdown in the mining industry will reduce the value of your mining equipment business.
3. Evaluating Tangible and Intangible Assets
To use the asset-based valuation method, you and your business broker must assess the value of your major intangible and tangible assets.
Tangible assets include anything you can touch, such as:
- Real estate
- Equipment and furniture
- Accounts receivable
You must also evaluate intangible assets like:
- Trade secrets
The methods used to assess the value of intellectual properties are similar to the methods for calculating a business value. Patents, trademarks, copyrights, and trade secrets have value because you can prevent competitors from knocking off your products, methods, artistic works, and brands.
You can also license others to make, reproduce, use, or sell your protected products.
The value of these intangible assets comes from:
- The cash flow you make from your products;
- The licensing fees you make from allowing others to make your products;
- The fair market value of the proprietary information to other small business owners;
- The value of preventing a competing business owner from making your products.
All businesses have assets. But when a business based on proprietary inventions, brands, and artistic works gets a valuation, the monetary value of the business is highly dependent on the value of its intangible assets.
4. Seeking Legal Help
An experienced corporate lawyer can assist you in determining what your business is worth. Lawyers have experience with business law and negotiations for sales, mergers, and liquidations. These prior cases can help a lawyer spot potential wrinkles in your company's estimated value.
For example, you might have contract liabilities that reduce your company's value or unregistered trademarks that could increase it. In this regard, a lawyer can also help you identify and protect assets that can increase your company's valuation.
How Often Should I Evaluate My Business’s Value?
You only need to get a valuation when you are involved in a transaction. The other party might make the transaction contingent on your company's valuation. Even if the transaction does not require a valuation, you should probably obtain a valuation so you and your corporate attorney can negotiate for a fair price.
But you may also want to evaluate your business even when you have no pending transactions. Some business owners simply want to know their company's worth to evaluate performance and set goals.
For very small businesses, you or your accountant can put together an informal valuation based on your annual financial records. This would not necessarily provide a verified value of a business. But it would give you a broad picture of where your business stands.
You can perform these valuations annually without too much additional cost since your accountant probably prepares annual reports for tax purposes. You can increase or decrease this frequency but keep in mind that you may incur some costs when you do so.
Get in Touch with Our Experienced Corporate Lawyers at Sequoia Legal Today!
A business valuation takes time and expertise. Depending on your proposed transaction, you might need a particular type of business valuation. By gathering the right financial data and hiring the right financial and legal advisors, you can get an accurate and fair valuation.
Sequoia Legal has extensive experience representing all sizes of businesses in transactions requiring a business valuation. Contact us to discuss your transaction and how we can help you assess the value of your business.