As a business owner, you may be asked to calculate the fair market value of your business, known as your business’s valuation. The circumstances that warrant a small business valuation process include:
- Refinancing a loan
- Planning to bring on additional shareholders or partial owners
- Looking to sell your business
Personal legal proceedings can also require a valuation—a divorce, for instance, may require a thorough accounting of your business assets.
There are various ways to calculate business valuations. The approach you use will depend on factors like your industry, the reason for the valuation, and the health of your business. Small businesses, corporations, and venture-capital-funded startups may each tap different formulas.
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What is a business valuation?
A business valuation is a measure of how much your business is worth. Finding the valuation involves gathering and analyzing business information such as assets (tangible things the business owns, like bank accounts and equipment) and liabilities (taxes, payroll, debt).
Business valuations are conducted by certified business appraisal professionals using one of several types of valuation, depending on the business industry and/or business entity. The appraiser reviews documents such as past financial statements, future financial projections, and payroll.
Some of the criteria for calculating business valuation are objective and tangible. Others, such as the company’s reputation or trademarks, are more subjective—but these are still valid considerations when calculating a company’s worth.
When do I need a business valuation?
There are certain situations, such as a merger or buying an existing business, where it can be especially important to know the value of a business. Circumstances commonly requiring a valuation include:
- When your stakeholders change. Anyone with a stake or potential stake in a corporation, such as new shareholders or possible investors, will want to know the value of a business.
- If you want to sell. If you’re looking to sell your business or merge with another, your potential buyers or partners will obviously want to know your business’ value.
- To price options for equity compensation. If you’re a young startup company and offer compensation packages that include equity and/or stock options, you’ll need your business valuation to price those options.
- For financing. Bankers and creditors will need to know your business valuation for loans or refinancing. Potential investors will need a solid grasp of the intrinsic value of your company before they decide to back you. Some loans don’t need a business validation, but will depend on other factors such as sales revenue history.
- For tax reporting purposes. The government may need to know the value of your business if it changes ownership. For example, If you sell your business below market value, the Internal Revenue Service (IRS) may charge you a gift tax according to its own valuation of your business. You may also need a business valuation to file an estate tax return or bequeath your business as a gift.
- For personal reasons. If you’re going through a divorce, a business valuation is often necessary to fairly divvy up marital assets—any property acquired during the course of the marriage. If a couple disagrees on the fair value of a business belonging to one or both of them, their attorneys may enlist a business appraiser to calculate a valuation both parties can agree on. Small business owners planning their estates will also need their valuation to decide how to fairly allocate their assets after death.
What are the different approaches to business valuation?
There are various business valuation methods that small business owners use to arrive at a business valuation. Some methods, for example, estimate a company’s economic value based on a forecast of the company’s future cash flows.
Others determine value based on market ups and downs, and comparisons of sales of similar companies. A healthy business may use a different valuation method than a business in bad repair.
Income-based approaches to the valuation process are most common, and estimate a business’s value based on the income the business is expected to generate over time.
This process is meant to help stakeholders and investors assess the risk of future investments or expenditures by projecting how much money the business may make in the future, not just how much they make now.
There are three main types of income-based valuations:
- Discounted cash flow method (DCF). This method projects a company’s future cash flow and then “discounts” that amount by taking into consideration inflation and business uncertainty to come up with a current value. The discounted cash flow method works well for newer businesses that may not be profitable yet, but have potential for high future earnings.
- Leveraged buyout analysis (LBO). Similar to the discounted cash flow method, an leveraged buyout approach considers cash flows and applies a discount rate to arrive at a company value. However, the goal of an LBO analysis is not to determine a company’s present value, but rather its internal rate of return (IRR)—that is, the profit a potential buyer can expect to earn.
- Capitalization of cash flow method. This process considers a company’s cash flows, annual rate of return, and expected value to determine its future profitability. But unlike the discounted cash flow method, this number isn’t adjusted to account for a future economic environment. Instead, the capitalization of cash flow valuation method assumes a company’s future worth will more closely mirror what it’s done in the past. That’s why it’s often used for more longstanding businesses with stable profits.
Similar to a market analysis in real estate, a market-based business valuation process determines a company’s value based on “comps”—i.e., the business valuations of comparable companies. To use this method, the person doing the valuation will look at purchases and sales of comparable companies or other assets in the same industry. Discounts are then made based on differences between the two—for example, location or size.
This method can be useful for fast-growing companies who want to get a better idea of their worth or for companies that are looking to be sold.
Methods of valuation under this umbrella base your company’s value on your tangible assets, including equipment, property, inventory, as well as intangible assets, such as software, licenses, patents, and intellectual property (IP). There are different asset-based methods, but with any of them, you’ll need to tally up the estimated worth of everything you own, including depreciating business assets, such as equipment.
If you are considering closing up shop, you may decide to use an asset-based approach to valuation. That’s because it gives you an idea of how much you and other investors or owners would get if you sold off all the company assets.
For example, you might calculate your liquidation value—the value your business assets would represent if you were to go out of business and sell everything off today at fair market prices. You might also calculate your book value, or net asset value, which is a tally of the assets and liabilities on your balance sheet.
Hiring a business valuation professional
Determining the value of your business is a complex endeavor—but you don’t have to do it alone. There are various types of professionals who are adept at valuation for small businesses and able to provide an objective estimate of your present or maximum value.
- Certified public accountant (CPA): In addition to their accounting prowess, many CPAs carry an additional Accredited in Business Valuation (ABV) certification, which requires specialized training in calculating business valuations.
- Accredited senior appraiser (ASA): The American Society of Appraisers offers an accredited senior appraiser (ASA) designation. ASAs must fulfill rigorous educational requirements and have five years of verified full time experience performing appraisals.
- Chartered business valuator (CBV): For Canadian businesses, a Chartered Business Valuator provides the same business valuation services as the other professionals on this list.
Don’t be afraid to ask a specialist for help—figuring out your business valuation can be tricky. But with the right information and expert assistance, you can get it right.
Business valuation FAQ
How much is a business worth with $1 million in sales?
What are the 5 methods of company valuation?
- Discounted cash flow analysis (DCF)
- Asset-based valuation
- Comparable company analysis
- Precedent transactions analysis
- Leveraged buyout analysis