What Are Business Valuation Methods?
Before delving into what makes each valuation method different, we must first establish what they have in common. All business valuation methods have the same purpose: to determine the current worth of your business. They accomplish this through calculations that can involve your business’s assets, like equipment, inventory, and property, along with financial data like revenue, profitability, and projected earnings.
But different industries measure their success in different ways. Even the most successful restaurants, for example, have notoriously low profit margins. Plenty of businesses also don’t own property or expensive equipment. And you can’t disregard location. It costs so much money to operate in certain cities that simply staying open for several years could increase worth.
Then, you have to consider the reason for doing these calculations in the first place. If you’re selling your business, the buyer will likely gain much more than just tangible assets. There’s the brand name’s value, the number of existing customers, and the inherited partnerships with your most loyal suppliers. But some of these factors likely wouldn’t come into play when establishing partner ownership percentages or applying for small business loans.
As you can see, determining the best valuation method for your business can get pretty complicated. That’s why certain situations, like buying an existing business, undoubtedly call for business valuation professionals’ expertise.
Yes, these services can cost several thousand dollars. But you won’t have to worry about possibly using the wrong valuation method. And if you do use the wrong method, you stand to lose much more than the cost of good help.
Which Business Valuation Methods Are Most Popular?
Most businesses use one of the following three methods to determine their value. Each option incorporates its own criteria. Still, it’s not uncommon for the same company to use multiple methods at different stages of its development. Thus, all entrepreneurs should know how to calculate each method under the right circumstances:
1. Market Value Business Valuation Method
Instead of assets or financial data, this method derives your business’s value from other companies’ final selling prices in your industry and general location. This arguably makes the market method the most subjective option. It prevents you from overvaluing the company and coming up with an unrealistic figure.
You cannot accurately apply the market method, however, without proper data on local competitors. sole proprietors should probably choose another method because, unlike LLCs and corporations, they cannot access data on other sole proprietors simply by visiting an online database.
The market method also doesn’t involve as many exact, indisputable numbers as other methods. Two people could have different opinions about what makes your business more or less valuable than your competitors. For example, an increase in monthly rent doesn’t always mean the neighborhood has officially become the new hot spot for small businesses.
In other words, you might have to do some negotiating before both parties agree. Smart investors and buyers will not accept an initial offer based on your opinion or other indeterminable factors.
For that reason, many entrepreneurs only use market valuation to compare it to the other two methods. If the other two results don’t even enter the same ballpark as the first, it’s time to reconsider their criteria.
2. Asset-Based Business Valuation Methods
The two main asset-based valuation methods derive value from your business’s assets and projected worth in the coming years. Both methods incorporate your total net asset value and your total liabilities, which you can find on your balance sheet. Subtracting the latter from the former will produce your business’s current total equity.
Now, let’s explain the differences between the two methods: Going-Concern and Liquidation Value.
Going Concern
“Going-Concern” is just another name for the balance sheet-based formula mentioned above: assets minus liabilities. However, businesses that will not be liquidated and do not plan on selling off any of their assets soon should only use this method. To clarify, the Going Concern method is not meant for businesses with short lifespans. These businesses should instead use the Liquidation Value approach:
Liquidation Value
Assets are usually sold for lower prices than their current market value. So, rather than just using the data on your balance sheet, the Liquidation Value puts your net total assets at a lower number. Therefore, the total value you come up with will be significantly lower than what you would get with the Going Concern approach.
Remember, you wouldn’t use the Liquidation Value approach unless the business has breathed its last breath. In this case, you would want to sell the business as quickly as possible. The Liquidation Value approach makes it easier to do that by competitively pricing your total assets.
3. Earnings-Based Business Valuation Methods
These three methods derive value from arguably the most practical factor: financial data. This includes cash flow, revenue, profitability, etc. Most earnings-based valuation methods use current data to make projections, making them ideal for financially stable and consistent businesses. However, successful young companies may benefit from Earning-Based valuation methods if they can essentially guarantee that their current numbers will only increase year after year.
Discounted Cash Flow (DCF)
The DCF method (also known as the “income” method) bases its value entirely on cash flow. It takes the business’s current and projected cash flow to create an adjusted, or “discounted” cash flow that ultimately determines the final value.
Capitalization of Earnings
Like DCF, this method places the most emphasis on the business’s future financial health. But instead of projections for cash flow, Capitalization of Earnings bases the value on projections for profitability. These projections’ accuracy stems from the incorporation of metrics like current cash flow, the new owner’s expected annual ROI (return on investment), and the businesses’ logistical value in the coming years.
Times Revenue Method
This method (a.k.a. the “Multiples of Earnings” method) uses a multiple of the business’s current revenue to determine its maximum value. The chosen multiple depends on various factors, like industry, other companies’ financial health in the area, and the general economic climate. So, while one business’s value might be half of its current revenue, another business might be valued at twice its current revenue.
4. ROI-Based Business Valuation Methods
The ROI-based business valuation method (a.k.a. the “Shark Tank” method) revolves around convincing investors to buy stock in your company. Rather than deriving value purely from assets or hard data, this method derives value from the company’s current and projected overall success. In other words, the ROI-Based valuation method ultimately allows you to propose valuations that your current cash flow or profitability might not fully support.
Business owners who use this method typically intend only to sell percentages of their businesses. So, when speaking to investors, they usually won’t announce the business’s total value. Instead, they will reveal the prospective investor’s stake (yes, like on Shark Tank). The investor then uses this percentage to calculate the value of 100% of the business.
For example, let’s say the business owner offers an investor 25% of their business in exchange for $300,000. The investor would then do some simple math to arrive at a total valuation of $1.2 million.
If you’ve watched Shark Tank, you know that the sharks immediately start writing on their notepads whenever an entrepreneur presents an offer. Are they simply just writing down what the entrepreneur just told them? Nope: they are calculating the business’s total valuation. Once they have that written down, they can see if this valuation still makes sense after the entrepreneur throws some more numbers at them (revenue, profit margin, etc.).
How Do You Choose The Right Business Valuation Method?
Choosing the right valuation method for your business requires the consideration of myriad factors. On top of basics like industry and revenue, you must also account for your business’s size, growth rate, and financial stability. No two companies will match up in every one of these areas. Thus, you cannot automatically choose the method used by your closest competitors.
The number of factors involved in this process should explain why it usually makes sense to look into business valuation professionals. Very few business owners have the time to lay out every potential factor and, based on these criteria, figure out which method to use.
How To Explain Your Chosen Valuation Method
Investors and buyers will want to know which valuation method you used to arrive at your proposed price. So, you’ll have to explain why your chosen method makes sense for your business and what kind of math is involved.
Remember: your business valuation professional chose the right method for you after reviewing large swaths of data. Investors and buyers may ask for these figures (profit margins, asset value, etc.). It doesn’t look good if you don’t know them off the top of your head.
Business owners are accustomed to skirting the truth now and then. In this case, however, you must answer all questions with the utmost honesty, especially if you are selling your business. The buyer’s team will eventually examine your financial statements. Admitting your flaws early on poses much less risk than the buyer unearthing something contradictory to your initial claims.
What Else Do You Need To Sell Your Business?
Now that you know your business’s valuation, you can move on to gathering the other resources required for selling your business. The buyer’s accountant and lawyer will have a ton of paperwork to review. It’s your job to get those documents in order and make sure they all check out. These documents must support your proposed valuation and prove that your business has no hidden issues that would dissuade the buyer.
Before letting the seller’s team examine your documents, you should ask the seller to sign a confidentiality or nondisclosure agreement. This confirms that the seller will not publicize any private information that gets uncovered during this process.
Here are the most important documents to have on-hand before selling your business:
Business Licenses and Permits
Every business needs some licenses or permits. The buyer’s team will likely want to examine these documents first. If your business is missing or has not renewed a necessary license or permit, you are technically breaking the law. Common examples include health permits, environmental permits, fire department permits, and sellers’ licenses for liquor, firearms, or gasoline products.
Organizational Documents
If your business is an LLC or corporation, you must prove that you are registered with the state. LLCs must have articles of organization, whereas corporations must have articles of incorporation. Like the previous section, an LLC or corporation without these documents is breaking the law.
Certificate of Good Standing
The buyer may request this document from your secretary of state to prove that your business has paid taxes, filed required documents, and complied with all other state-mandated regulations.
Contracts and Leases
This refers to business partnerships as well as unowned assets like physical location, equipment, etc. You may have leases that will expire very soon or contracts with somewhat unfair terms. In this case, the new owner would have to negotiate new terms and add one more thing to their already massive list of new duties.
The buyer will also want to look at your contracts to see if your business obtains most of its products or revenue from one client. What would happen if that client went out of business?
Lastly, check if the individual or company that drafted your current contracts and leases has no issue transferring them from your name to the new owners.
Business Financials
In addition to financial statements, this refers to tax returns, sales records, accounts receivables, accounts payables, and debt disclosures. Many businesses appear successful when, in reality, they just got lucky not too long ago. The buyer’s accountant will test the legitimacy of your business’s success by examining three years’ worth of financial statements.
These documents will also denote whether your business’s profitability has increased or decreased. Businesses that have increased or maintained the same profitability level for at least three years will most likely continue this path.
Closing The Deal
Once the two parties have agreed on a price, and the buyer has financing in place, the final step is yet another document checklist. The final sale cannot take place without the following paperwork:
Bill of Sale
This document officially makes the buyer the new owner of the business’s assets.
Purchase Price
This is the final purchase price, with all assets and expenses included.
Lease
If the buyer is taking over an existing lease or has negotiated a new one, this confirms that your former landlord is aware of the sale.
Vehicle Ownership
Is a vehicle among the buyer’s new assets? If so, he or she register as the new owner with the DMV.
Intellectual Property
This refers to transferring all patents, trademarks, and copyrights to the new owner’s name.
Non-Compete Agreement
This legally prohibits you (the seller) from opening up a competing business.
Employee Agreement
If you plan to stay on board as an employee, this document shows that both parties agree.
IRS Form 8594
Also known as an Asset Acquisition Statement, this document lists all the assets the buyer has acquired along with their value. Having all this information in one place comes in handy when new owners of existing businesses do their tax returns.
Bulk Sale Laws
“Bulk sales” or “bulk transfers” refer to transferring large amounts of assets, most notably inventory. Federal bulk sales laws typically only apply to businesses in bankruptcy. State bulk sales laws prevent businesses from doing bulk transfers solely to avoid state sales taxes.
Is the new owner inheriting a large amount of inventory? Depending on your state, the new owner may have to obtain special certification to prove that you are not transferring over the inventory solely to avoid paying taxes on it.
Yes, This Could Take a While
You may think you’re ready to let go of your business. But being ready for the process of letting go of your business is a whole other story. For some businesses, this process can take well over an entire year. Working with the buyer’s team (people you’ve never met) for this long can be emotionally draining. And that’s even if you’re sure you are selling to the right person.
In summary, do not sell your business if you are not feeling 100% for any reason. Lacking the energy and focus required for the selling process increases the risk of careless decisions. When it comes to life-changing moments like this, even the tiniest bit of doubt can leave you unhappy for a very long time.
United Capital Source has been helping small business owners find the working capital they need to grow their businesses since 2011. Your business is our only business!
