Putting a valuation on a company may seem fairly straightforward on the surface. However, for most prospective buyers or sellers, it can be one of the most difficult aspects of buying or selling a business.
For potential buyers, knowing how to value a company and purchasing it at or below its value can mean the difference between turning a profit or reporting a loss. For sellers, it can be difficult to appropriately value a company that you’ve spent years pouring your blood, sweat, and tears into.
Fortunately, we have some tips that can make it a bit easier for you to calculate a fair value for the business in question.
Different Ways to Value a Business
As the adage goes, “there are multiple ways to skin a cat.” When it comes to valuing a business, there are several different ways of approach. Depending on the type of business you’re looking to value, you may use a few different methods to ultimately arrive at your valuation. Below are the three most popular methods for valuing a business.
How to Value a Company Based on Income
This method determines what a business is worth based on the amount of money it generates for the owner. There are three different ways to determine the worth of a business using income-based valuation.
Discounted Cash Flow (DCF)
This method evaluates the businesses net cash flow, the required investments to maintain that cash flow, and the potential sale price of the business to arrive at a valuation. With a DCF valuation, the company is valued based on the amount of income it can generate over a period of time.
Capitalization of Earnings
This method evaluates how likely it is that the business will generate a profit over time. To arrive at a valuation with the capitalization of earnings method, the business’ projected earnings are divided by the cap rate. This type of valuation is popular for real estate related businesses.
Multiple of Discretionary Earnings
This method is most popular when evaluating small businesses. To arrive at a valuation, this method takes the discretionary earnings of the business (your pre-tax earnings, plus salary, depreciation, and expenses) and multiplies it by a number between 0-4. The multiplier is determined by several factors, such as the health of the business, growth potential, whether or not it owns or leases property and more.
How to Value a Company Based on Assets
This method determines the worth of a business based on the assets it owns, which could include anything from equipment and real estate to patents and web properties. There are two basic schools of thought when it comes to asset-based valuations.
This method places a value on a business by comparing its assets to its liabilities. All of the company’s tangible and intangible assets are valued individually and then added together. The same is done for the business's liabilities. Then, the liabilities are subtracted from the assets, and the difference left over is the value of the business.
Capitalized Excess Earnings
With this method, all of the tangible assets owned by the business are added together, along with any earnings the business has that aren’t related to its tangible assets. This is also referred to as the US Treasury method, and it’s been used since the 1920’s to value businesses.
How to Value a Company Based on The Market
This valuation method is wildly different from the methods we’ve already discussed. The first two methods determine value based on the businesses earnings or assets, while this method determines value based on what the market is likely to pay for the business.
This method relies on market research to determine what similar businesses have sold for recently, and it can be particularly useful for businesses that have value that can’t necessarily be explained on a balance sheet, or businesses with a strong and established brand name.
Preparing a Company for Sale
There are several steps a business owner can take to prepare the business for sale that can improve the appearance of the business and make it more attractive to prospective buyers.
Get Your Books in Order
One of the biggest deal killers when it comes to small business acquisitions is poor bookkeeping. It’s important that the books are neat and orderly, and they back up the story you’re telling to prospective buyers.
It’s also a good idea to pay down any debt the business currently has on the books, as it’s an easy way to maximize the sale price of the business.
Update Promotional Materials
If you were selling your home, there are some steps you’d take before you put it on the market. Perhaps you’d put down a new coat of paint, clean up any clutter in the yard, and fix that loose handrail on the deck. If you’re selling your business, you’ll want to do the same things, albeit in a different way.
Make sure that your promotional materials, such as your website and sales materials are properly updated and don’t appear dated. Consider increasing your advertising spend to increase your market share before selling the business. These types of changes can have a major impact on your ability to maximize the sale price of the business.
Consider Professional Assistance
Many small businesses are guilty of overvaluing their business. The current owners have an emotional attachment to the business and feel as if they’re the only one who could ever run the business properly. They overvalue the time they’ve put into the business, and they consider that time spent as part of the valuation for the business.
If you’re having a hard time removing your heart from the equation, it may be best to seek outside help from a firm that specializes in valuing businesses. This will allow you to remove yourself from the equation, and it will also lend credibility to your asking price since an independent arbiter is the one arriving at a valuation.
Get Buy-In From Key Accounts and Employees
Many businesses would be lost without the contributions of their key employees. Other businesses rely on their largest accounts or key suppliers to keep the business on track and profitable. In many cases, a change in ownership can greatly disrupt the existing relationships of the business.
To maximize the sale of the business, it can be helpful to get letters of intent from the key parties that keep your business running smoothly. That way, the prospective buyer feels confident that things are going to continue running smoothly after the transition to new ownership.
Consider Paying More in Taxes
Come tax season; most business owners spend countless hours looking for every possible deduction they can take on their taxes. Many business owners even apply their personal expenses to their business taxes to further reduce their liability. This has a major short-term benefit since it can greatly reduce the tax liability of the business on that year’s taxes so that they owe less to Uncle Sam.
But, since many valuation methods place a value on a business based on the net income the company reports, all of those deductions can come back to haunt you when it’s time to sell. By reporting more of your business income on taxes, you’ll be providing prospective buyers with a much clearer picture of how much your business is worth.
The Bottom Line
When it comes to how to value a business, many professionals will tell you that it’s as much of an art as it is a science. While many business owners will be able to evaluate their business’ worth based on facts carefully, some business owners may have difficulty placing a dollar figure on their company. In this case, it may be prudent to seek professional help in evaluating the worth of the business.