The Basics of Business Valuation

The Basics of Business Valuation

If you own a business, chances are that your business represents more than the sum of its line items to you.  It is a personal or family legacy; a testament to something you’ve spent a good chunk of your waking hours building.  Still, a variety of circumstances can trigger the need to place a concrete value on your business.  Whether you are engaged in business succession planning, tax and estate planning, transferring ownership, raising additional capital, or applying for a small business loan, many events in a small business owner’s lifetime require some way of estimating the company’s concrete value.  If one of these triggering events occur, you need to feel assured that your business is accurately valued no matter the life cycle.

The difficulty of assigning a value to private companies and small businesses is reflected in federal tax regulations:

Where selling prices or bid and asked prices are unavailable, fair market value is to be determined by taking the following factors into consideration:

the company’s net worth, prospective earning power and dividend-paying capacity, and other relevant factors.

Some of the “other relevant factors”…are:  The good will of the business; the economic outlook in the particular industry; the company’s position in the industry and its management; the degree of control of the business represented by the block of stock to be valued; and the values of securities of corporations engaged in the same or similar lines of business which are listed on a stock exchange.  However, the weight to be accorded such comparisons or any other evidentiary factors considered in the determination of a value depends upon the facts of each case.

Even the IRS agrees there is no secret formula for determining the fair market value of a closely held company whose shares are not traded on a public market, where do you begin?

Choosing the Appropriate Valuation Method:  What Do You Want to Know?

Different valuation methods tend to answer specific questions about the health of a business.  The first step in the valuation process is often knowing what questions you want the valuation to answer about your business.  The following common methods of valuation are best suited to answer different questions about your business:

1.  What Does My Company Own?  The Asset-Driven Approach 

The asset-driven approach to valuation determines the value of a company based on the value of its tangible assets after subtracting its liabilities.  This approach is commonly used by nonoperating companies such as holding companies in all their forms, startups, or other companies with unpredictable or unstable earnings.

When determining whether an asset-driven approach makes sense for you and your business, keep in mind that assets include not just tangible assets such as real estate, equipment, and inventory, but also (and sometimes even more importantly) intangible assets like intellectual property, customer goodwill, and brand recognition.  While these “intangible assets” might not show up on a balance sheet, they most certainly impact a company’s profitability and long-term growth potential, and are therefore, an essential element to understanding your business’s actual value.

2.  What Are the Historical Benefits of Ownership?  The SDE Approach 

Another common method of business valuation is to calculate seller’s discretionary earnings or “SDE”.  SDE stresses the health of a business’s profitability and cash flow and is often utilized by companies that deal in services, as opposed to goods.  SDE emphasizes income statements and includes whatever revenue your business actually generates.

Simplified, an SDE calculation starts with your pretax, pre-interest earnings, which are then added to any purchases that aren’t essential to operations, such as vehicles or travel, that you report as business expenses.  Employee outings, charitable donations, unusual one-time purchases and your own salary and benefits can also all be included in your SDE.  SDE is a common method used by many small business owners since small-business owners often expense personal benefits.

Prospective buyers will surely want to have a good handle on SDE before entering in earnest into negotiations to purchase your business, especially if your business is a “small” business.  SDE is the pulse of the small business.

3.  What Have Businesses Like Mine Already Sold for Under Similar Conditions?  The Market-Based Approach 

The market-based approach to valuation seems self-explanatory—similar businesses are worth similar amounts in similar geographic areas, right?  However, since there is no Zillow for closely held businesses, getting a handle on the market can be more difficult than it may seem, especially if your business is successful because you’ve been able to separate from the pack.  Your ability to gather market data to inform you valuation is context specific and depends on your industry, location, and size.

Use Business Valuation to Reach Your Goals

Understanding your business’s valuation impact on your goals is considerably more important than the valuation itself.  There are many tools and free calculators available online, and many professional valuation services that can provide you with in-depth valuation services. Putting the data provided by those services in context requires knowledgeable and experienced counsel.  If you need help starting the valuation process, understanding your valuation, or if you have any other business planning needs, please contact our office today!