Value is calculated. Price is negotiated.
That’s one of the most important things to remember about the process of business valuation.
Business valuation is a topic that goes deep and wide. There are a lot of questions and a lot to learn.
We did the digging for you and created the second in our series of “Ultimate Guides”.
(The first in the series: The Ultimate Guide to EBITDA)
After engaging with the information below, we hope you come out on the other side with a good understanding of why value is calculated and price is negotiated.
1. Why would I go through the business valuation process?
As a merger & acquisition firm, we mainly utilize business valuation as a vital component of the process to buy or sell a business. But there are many other reasons a business owner may undergo the business valuation process. Here are 25 reasons from Melisa Silverman and another 50 from Edward Mendlowitz.
Many of the reasons deal with planning for an owner’s exit from the business. But business valuation is also useful for guiding the management and growth of a business.
“Valuation can and should be used as a powerful driver of how you manage your business. The purpose of this estimated value is to track the effectiveness of your strategic decision-making process and to provide you with the ability to track performance in terms of estimated change in value, not just in revenue.” –Quickbooks
“The reasons for a business valuation all revolve around a common theme: helping the business owner objectively analyze his business and future business decisions in a whole new light as a buyer would.” –Generational Equity
2. What methods are used to value a business?
There are three main ways to value a business and within those three, different versions.
Chart from Barnes Wendling CPAs
How is each method of valuation calculated?
The videos below walk through simple calculations and examples of each type of valuation approach.
This article from ValuAdder provides a written explanation of each method’s calculation.
Which method of valuation is best?
There are multiple methods of valuation because not every company is built the same way. The valuation method that is best depends on the type of business that is being valued.
1. The income approach “may best suit a company that has a history of earnings but few tangible assets, such as an engineering firm.”
2. The market approach “may favor a younger company with little sales and no significant earnings in a ‘hot sector’ such as a technology company.”
3. The asset approach is “most appropriate when valuing a mature, capital-intensive company with steady sales and marginal profitability in a competitive industry.”
For an interesting comparison on how different parts of the industry use different valuation methods, look at these charts below from the 2016 Pepperdine University Private Capital Markets Report.
|DVS Group Insight
There will never be an end-all, be-all number for a business. The number will be different depending on the buyer. There will always be a bell curve for a company’s valuation. A certain percentage of the buyer pool will fall in this valuation range, another percentage will land here and at the high end, you have small percentage of the buyer pool willing to pay that amount for the business. This is important to remember to keep expectations in check. Ask yourself, “What’s the probability of getting a certain valuation and what is the buyer population at the different valuations?”
As an example, we worked with a business in a tightly regulated industry looking to sell. Because of its niche nature, there was a small buyer pool and thus, only one buyer at the high end of the valuation curve. We were able to find that buyer and complete the deal. It ended up being a great win-win situation. But what if that high-end buyer wasn’t ready to make a deal? The step down to the next buyer hurts a lot with a 50% drop in value.
3. How does the business valuation process work?
Business valuation begins by seeking a third-party appraiser. Using a third-party appraiser is prudent and allows for a non-biased view of the business.
“Business owners should not do their own business valuation. This is too much like asking a mother how talented her child is. Neither the business owner nor the mother has the necessary distance to step back and answer the question objectively.” –The Balance
There are a lot of factors to consider when choosing who to complete your business valuation. These articles give advice on how to prioritize those factors and pick the best valuation firm for your business.
Selecting a Business Appraiser (Mercer Capital) – Includes points to consider for business owners, attorneys and accountants
Business Valuations: When and How To Choose a Business Valuation Company (Nationwide Valuations) – Provides nine questions to ask a business appraiser to be sure they fit SBA lending requirements
Beware When Choosing Business Valuation Firms, the Obvious is Typically Not the Best (American Fortune) – Shares a somewhat different side of the story
This article includes a chart that details the primary requirements of each type of business valuation credential. If you’re looking for a more academic approach to the business valuation industry, check out this article that analyzes the Five Forces of the industry.
How much does business valuation cost?
Business valuation is not free. It can hurt a bit to spend thousands of dollars to get a valuation that doesn’t match your expectations. The level of expertise you need and thus, the amount of cash you’ll have to expend will depend on the purpose of your valuation.
A business valuation could fall in the range of $2,000 to $30,000. The price is based on factors such as:
1. Type of Engagement
2. Industry of the business
3. Size of the business
4. Age of the business
5. Volatility of both the business and the industry
6. Condition of the financial records
The article from Napier Business Advisors that walks through these considerations includes an example of how the cost for a business valuation may be calculated.
What steps need to be taken and what information needs to be provided for a business valuation?
The process of business valuation requires effort and energy from the business owner. Business valuation professionals follow a specific course of action and seek out information on many facets of the business. The articles below flesh out what the process looks like and what information is needed.
|DVS Group Insight
After you get a valuation, take it to your banker. Because that number doesn’t matter to a financial buyer if they can’t get the funding to make it happen. You could have the prettiest numbers in the world but then you learn really quick that you’re sitting in that top 3% of valuation and you’ve got very, very few buyers and they can’t get bank financing to make a deal.
Five steps to establish your business worth (ValuAdder) – Focuses on valuation method applied and use of financial statements
More to Business Valuation than Meets the Eye (Davis/Chambers Business Valuation) – Examines the non-financial aspects of business valuation
What Information is Needed for a Business Valuation? (The Balance) – Provides a list of 26 pieces of information required to put together a business valuation
4. Do I have to use a third-party appraiser? How can I estimate business value on my own?
There are many online business valuation calculators. Here’s a list of five of the most used. These can be helpful to gain a sense of input needed and see what a potential valuation may be. But take the valuation with a grain of salt and know that it cannot be used in lieu of a formal valuation.
As these calculators indicate, there are many factors that impact a business valuation. These articles look more closely at what these factors are and exactly how they impact valuation.
Factors to Consider When Valuing a Closely Held Company (Exit Strategies) – Explains the IRS ruling on business valuation
Top 5 Factors That Determine the Value of Your Business (Business Transition Academy) – Looks at three internal and two external factors impacting valuation
Seven Things That Determine the Value of a Business (Business Development Solutions) – Dives into financial considerations of business valuation
5. How do I improve my business valuation?
The improvement of business valuation is an essential component of a discipline called Exit Planning. There are multiple organizations that focus exclusively on Exit Planning- like Business Enterprise Institute (BEI) and Exit Planning Institute (EPI). These organizations provide resources to teach financial advisors how to guide business owners to a successful exit.
The founder of BEI, John Brown, wrote a series of articles on growing business value on Forbes.
1. Next-Level Management: The Mother of All Value Drivers
2. Operating Systems That Enhance the Transferable Value of Your Company
3. Your Company’s Growth Strategy: Another Element in Transferable Business Value
4. Six Ways to Increase the Value of Your Business
Here are some insights about growth in business value from other industry experts:
4 Ways to Increase Your Company Value by David Lonsdale, Allegiance Capital
Here Are 10 Ways To Boost Your Company’s Value Even In A Bad Market by Rick Andrade, Diamond Capital Partners
Ten Steps to Improve Business Value by Marc Borrelli, Corporate Finance Associates
This post covered a lot of information. Here are some of the key points:
1. There are many reasons to conduct a business valuation- to prepare for a sale and to direct strategy.
2. The three main methods of valuation are based on a business’ assets, its income or the market. The best method to use depends on the need.
3. The business valuation process begins with selecting an appraiser and understanding their costs. An appraiser will require numerous documents and pieces of information to create their valuation.
4. Online business valuation calculators are available to provide an estimate of business valuation.
5. Business valuation can be improved by focusing on the right elements for growth.
This video does a great job of summarizing many of the things covered here.
What about “Value is calculated. Price is negotiated”?
Hopefully, you now have a better understanding of valuation as a calculated process. It often does not take the buyer into account. Price is determined (usually with valuation as a main consideration) through negotiation between buyer and seller. These negotiations weigh heavily on the value that the buyer sees. Valuation is crucial but it cannot be meaningfully examined without a thoughtful consideration of the buyer pool.
If there are questions you have about business valuation or other M&A topics, please give us a call or shoot us an email. We always welcome complimentary and confidential conversations.
|P.S. Business valuation is certainly important in an M&A deal but it is not the ultimate factor of success. We have a saying around our office, “You can get your price or you can get your terms.” A sentiment echoed by the recent Axial Forum article, Owners: Stop Obsessing Over Valuation.
Deal structure and terms are just as important to future financial well-being as the calculated value of the business. Don’t forget to consider things like seller financing or picking the right bank for SBA financing. Each piece of the puzzle is vital for a successful deal.