The Definitive Guide to Business Valuation
If you’re in business, odds are, you will require an accurate business valuation at some point in time. You may intend to sell your business, apply for a business loan, or search for investors. Partners may need a business valuation if a partner desires to sell his or her interest in the partnership to the other partners. Sometimes, a business valuation may be needed in a divorce action for property settlements.
In some cases, a business owner may want to go through the business valuation process with a Maryland business attorney to track the effectiveness of various business strategies or to prepare a business succession plan. Regardless of the reason for a business valuation, it can help to understand some of the basic information used during the business valuation process.
Methods for Valuing A Business
There are numerous methods for valuing a business. Most valuation methods use a combination of factors to determine the current value of the business, such as assets, revenue, debts, operating expenses, goodwill, market value, and projections. The business valuation method used for a specific company depends on several factors, such as the type of business being valued, the size of the business, and the reason for the valuation. Choosing the best valuation process to use is the first step in the business valuation process.
“The business valuation method used for a specific company depends on several factors, such as the type of business being valued, the size of the business, and the reason for the valuation.”
— Steve Thienel
Three main business valuation methods are commonly used by business owners, lenders, investors, brokers, and other industry professionals when calculating the value of a company.
Asset-Based Business Valuation Method
This approach to valuing a business is based on the value of all assets owned by the company less the total liabilities owed by the company. Usually, a company uses its current balance sheet to calculate an asset-based business valuation. However, there is one very important factor to consider when using the asset-based method for valuing a business. Does the company plan to continue operating, or is the company liquidating?
The value for a going concern (a business that intends to continue operating) is usually higher than the liquidation value. The reason because the liquidation value of an asset is typically lower than an asset that the company intends to keep because the liquidation value considers a quick sale. Additionally, assets may be sold individually in a liquidation sale, which can reduce the fair market value of the assets.
Income-Based Business Valuation Method
There are two basic ways to use income as a basis for a business valuation — capitalized earnings (historical or past earning records) and discounted cash flow (estimated future earnings).
The capitalized earnings method uses the company’s past earning records to determine the expected cash flow for the future. The process involves normalizing the past earnings for unusual expenses or revenue. The normalized cash flow is multiplied by a capitalization factor to arrive at the business value.
The discounted future earnings process uses a projected future earnings amount based on the current trends and other market values. The predicted future earnings total is divided by the capitalization factor to arrive at the business value.
The capitalization factor for a business is based on the rate of return a purchaser or investor might expect to receive for their investment given a reasonable risk that the expected cash flow might not be achieved. It is the inverse of the expected rate of return.
Market-Based Business Valuation Method
The market-based business valuation method is a subjective comparison of the business to similar companies sold recently (comparable sales) or companies publicly traded (current stock values). Using this method of valuing a company requires sufficient market data to arrive at a realistic value for the business.
If the company in question is a niche company, it may be difficult to locate comparable market data to prepare a business valuation. Likewise, small businesses and sole proprietors may not have access to market data to perform a market-based business valuation.
However, the market-based method may be a good starting point for a more detailed business valuation. It can also be a good starting point for negotiating the sale of a business when you have several unique factors that can convince a buyer that the value of your business is also based on unique and immeasurable factors. Unfortunately, an investor or lender will likely require more data and facts.
Therefore, if you lack sufficient market data or your company is unique, adopt the asset-based valuation method or the Income-Based valuation method.
“If you lack sufficient market data or your company is unique, adopt the asset-based valuation method or the Income-Based valuation method.”
— Steve Thienel
Choosing the Best Valuation Method for Your Business
There are numerous methods for valuing a business and completing a business valuation on your own could be complicated. It can be difficult for business owners, especially sole proprietors and family-owned businesses, to be objective about the value of their business. Using an asset-based valuation method can be good if you want to get a rough idea of what your business is worth if you need a loan, for estate planning, or to help with a business strategy.
However, it's helpful to consult with a Maryland business attorney before making any major decisions regarding the future of the business, such as selling or transferring your business. An accurate business valuation is the foundation of sound business planning and business strategies. If you do not invest the time and expense in determining the correct value for your business, moving forward with a specific business plan could cause a substantial loss of revenue or value.
Planning and Preparing for a Business Valuation
Once you choose the business valuation method best for your company and your needs, it is time to assemble the required documentation and information needed for the business valuation.
The documents and information needed to complete a business valuation depend on numerous factors, including the type of business and the valuation method. However, key reports and documents needed for most business valuation methods include:
Business Tax Returns and information regarding audits and IRS investigations
Income Statements, Profit & Loss Statements, and Balance Sheets
Payroll Records, including employment agreements, non-compete agreements, confidentiality agreements, employee benefit plans, etc.
Fixed Asset & Depreciation Reports
Inventory Records and Reports
Property Appraisals (i.e. real estate, office equipment, business equipment, etc.)
Corporate Records, including by-laws, Articles of Incorporation, operating agreements, shareholder records, minutes of board meetings, etc.
Lease Agreements
Loan Documents
Information for Pending or Recently Settled Litigation, including copies of complaints and settlement agreements
Investment Records
Business Plans
Contracts and Purchase Agreements
Projections and Forecasts
List of Business Advisors, such as accountants, bookkeepers, attorneys, financial advisors, consultants, etc.
List of Top Customers with the percentage of revenue generated by these customers
The above list is not an exhaustive list of the information that might be necessary to complete your business valuation. Most business appraisers want to review the business records for the past three to five years, so be prepared to gather extensive records for your company.
7 Tips for Valuing Your Business
Valuing a business can appear overwhelming, especially for owners that have never needed to prepare a business valuation. These tips cover some of the basic information a business owner might find helpful when beginning the business valuation process:
1. Research Your Industry
Learn as much as possible about your industry and your competitors. Understanding how your company compares with other companies in your industry can help you as you prepare for your business valuation. The marketplace and your place in it can be a significant factor in the value of your business, especially if you offer something other companies in your industry do not offer.
2. Accurately Calculate Your Company Assets And Liabilities
A significant factor used in any business valuation is the company assets and liabilities. If you have large or unique assets, consider hiring a professional appraiser to provide current fair market values for those assets. Do not forget to value your intangible assets. Intangible assets can be worth more than your tangible assets, depending on your business. Intangible assets, including copyrights, trademarks, intellectual property, trade secrets, customer lists, and reputation.
Liabilities include any debts and other obligations that your company owes to any party. Examples of liabilities include mortgages, vehicle payments, leases, loans, and general accounts payable. It does not include overhead, such as utilities, office supplies, and payroll.
3. Consider Your Talent
Your employees are an asset to your company. Depending on your industry, employees with specialized training, knowledge, education, or experiencing could be valuable, especially for a purchaser interested in continuing operations. Preparing detailed job descriptions for key employees and highlighting their talents can increase your intangible value.
4. Do Not Forget To Calculate Your SDE
SDE or Seller’s Discretionary Income can cause you to underestimate the value of your company. SDE refers to the expenses that entrepreneurs deduct from their taxable income.
Most business owners search for ways to lower their taxable income by taking as many deductions as allowed for expenses. However, by doing so, it can make a business appear less valuable if a potential investor, lender, or purchaser looks solely at the company’s tax return as the primary basis of the company’s value. The tax return and other financial statements may need to be adjusted to reflect the actual revenue for the company before the owner’s discretionary expenses were applied for tax purposes.
Examples of items that would be added to the net income reported on a business tax return might include:
Charitable donations
Nonessential business travel
Owner’s salary
Owner’s perks (i.e. cell phone costs, personal vehicle payments, etc.)
Nonessential employee positions (i.e. family members on the payroll for non-essential positions)
Home office expenses
One-time expenses that might not necessarily recur after the sale of the business
5. Prepare A Competitive Analysis
How do your products or services compare to your top competitors? Preparing a competitive analysis can demonstrate why your company is a better investment compared to any of your competitors. It also highlights the differences that attract consumers to your company instead of another company.
6. Clean Up Your Operations
You need to demonstrate to potential investors and purchasers that your business is running efficiently and effectively. A potential buyer or investor needs to feel as if they can make money. A business may look good on paper, but if the business cannot continue to operate effectively and efficiently, there will be little return on investment.
“A business may look good on paper, but if the business cannot continue to operate effectively and efficiently, there will be little return on investment. ”
— Steve Thienel
Put together a well-organized packet to present with your business valuation that includes detailed records related to your employees, leases, vendors, customers, compliance requirements, and suppliers. A potential buyer or investor likes to see lease agreements with renewal options and terms highlighted; employment contracts that are transferable; a history of compliance with safety, health, and other regulations; vendor and supplier contracts with favorable terms; and, a well-established, loyal client base.
Anything you can do to highlight demonstrating that your company is a well-organized, efficient stream of revenue improves your company’s value to potential investors and buyers.
7. Pay Off Debt
If a business owner can pay off company liabilities, it can help increase the business valuation. However, before paying off business debts, complete the business valuation. It is easier to determine whether paying off a particular debt will make a sufficient change in the value to justify the lump sum payment.
Contact a Maryland Business Attorney for Help
Choosing someone to help you prepare a business valuation can be confusing. Do you need a business broker or a CPA to help you? Would it be better to hire a business appraisal service or an M&A (Mergers & Acquisitions) Firm?
The answer is similar to the answer for which business valuation method is best for your company. The company or professional you choose to assist with your business valuation can depend on why you are valuing your business. For example, if you want to sell your business, you might want assistance from a business broker. However, if you need to value your business to obtain a loan from a bank, a CPA or business appraiser might be a better choice.
A Maryland business attorney may be the best choice of all. A business attorney understands all the reasons you may have for valuing your business. Besides providing the legal counsel you need during the valuation process, a business attorney can also help you identify the professionals you might need to assist with the business valuation, locate candidates, and review contracts to ensure you receive the services you need for a reasonable price. Contact Thienel Law today if you have questions about business valuations. Maryland business attorney Steve Thienel is dedicated to assisting clients in Maryland, Virginia, and throughout the DC Metro area.
