In some of my recent blog posts, I discussed buy-sell agreements and the critical need for a well thought out business exit plan. These are two elements of a well-prepared entrepreneur, but there’s one thing you need to have before you can establish a buy-sell agreement or say that you’ve completed your business exit strategy: a thorough and accurate business valuation.
What is a Business Valuation?
A business valuation is, to put it into broadly applicable terms such as the definition used by Investopedia.com, “the process of determining the economic value of a business or company.”
Businesses can be valued using a range of different methods. Some of the basic approaches include:
In this valuation method, the business owner simply adds up the value of all business assets, both the tangible (vehicles, equipment, etc.) and the intangible (patents, rights, etc.). As noted in an Inc.com article about valuation, “asset-based valuations can over-simplify the process and neglect the value of the company’s earnings potential. That is why asset-based valuation is a common method for the sale of defunct businesses and liquidations, but not as common for thriving companies.”
Earnings Multiplier Valuation
Under this method of defining a business’ value, you base your valuation for your business on a multiple of your earnings potential. For example, you could take your earnings for the year and multiply it by 3 or 5 times to create a base value for the sale of your business. The specific multiple you use might vary quite a bit, so you’ll probably want to consult with a professional when using this method.
This business valuation technique is probably the most subjective of the ones presented here. Rather than basing your business’ value on the liquidation value of its assets or on a multiple of its earnings potential, you simply make a close comparison of your business to others in your industry and in similar markets and see what those other businesses have sold for recently. However, when working with this method, you should work with a professional, and keep in mind that this may be a subjective value, especially if yours is a unique or niche business without a lot of active competitors that have successfully sold.
Which valuation method should you use? That depends on a number of factors. For example, some industries tend to use a specific method while others might use a combination of methods. The firm providing your valuation may choose their methodology and have a good, rational reason for doing this.
Why You Need a Business Valuation
Quick question, if you had to sell your business tomorrow, do you know how much it’s actually worth?
If you have never had a formal or informal valuation done by a professional, you could end up leaving a lot of money on the table when you sell your company. Worse yet, you might pocket a number for your business that is far lower than you anticipated and find yourself scrambling to downsize your lifestyle in retirement. This is why having a valuation done by an independent professional may be the most important thing you do when planning to exit your business.
Overpricing your business can be bad because it chases away potential investors and other buyers who may have otherwise purchased your business if the purchase price was more in line with the market. An inflated price may also mean a long delay in getting your business sold and, more important, a delay to your retirement.
Underpricing your business can be just as bad because experienced investors know a great deal when they see one, and will not hesitate to snap up a business that is selling for significantly less than its actual value. This means that you could lose out on a large chunk of your business’ sale value, reducing the income you get for retirement and the money you leave your heirs.
Having a formal, documented business valuation is also useful for business continuation planning. For example, when you transfer ownership of your business to an heir or colleague for any reason (such as retirement, death, or disability), the value of the business needs accurately stated for tax reasons, and the valuation will probably serve as a useful basis for structuring this plan.
One important thing to keep in mind when you perform a business valuation is that the value you calculate probably won’t be equal to the price buyers will be willing to pay. Not surprising, buyers expect to pay a price that’s low enough to turn a profit sometime in the next few years.
For most owners, the sale of the business is the ultimate goal and the ultimate achievement. It is the key means of funding their retirement—just like a 401k or Social Security—just much bigger or it is the legacy they had planned (for decades) to leave their children or grandchildren. The business is the most important and valuable asset they have, so it is critical as you plan this important next step to have good grasp of the value of this asset, one that is documented, founded on fact, and determined using a proven methodology.