As a business owner, you may be asked to calculate the value of your business, known as your business’ valuation. The circumstances that warrant a valuation are myriad:
- 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 valuations, and 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.
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).
Valuations are conducted by certified appraisers 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 are very tangible, while 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 might 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 company. 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 see the company’s valuation.
- If you want to sell. If you sell your business, merge with another, or are acquired, everyone who’s part of the transaction will need 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.
- For tax 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 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. 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 methods of valuation that business owners use to arrive at a business valuation. Some methods, for example, estimate a company’s value based on a forecast of the company’s future cash flow.
Others determine value based on market ups and downs, and comparisons of sales of similar companies. A healthy business may use a different method of valuation than a business in bad repair.
Income-based approaches are the most commonly used approach and estimate a business’ 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 two 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. This method works well for newer businesses that may not be profitable yet but have high future earning potential.
- Capitalization of cash flow method. This process considers the company’s cash flow, annual rate of return, and expected value to determine its future profitability. But unlike the DCF method, that number isn’t discounted. This 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 the comparative analysis that you might do if you’re in the real estate market, a market-based approach determines a company’s value based on “comps”— the 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 business assets, including equipment, property, inventory, and intangible, nonphysical business 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 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.
Determining the value of your business is a complex endeavor—but you don’t have to do it alone. In the United States, CPAs who carry an Accredited in Business Valuation (ABV) designation specialize in analyzing the value of businesses.
Appraisers with an Accredited Senior Appraiser (ASA) designation are also qualified and highly skilled at performing business valuations. Don’t be afraid to ask a specialist for help—figuring out your business valuation can be tricky. But with information and help, you can get it right.