Put a price tag on your business: A guide to business valuation
If you want to sell all or part of your business, you need to have an idea of its value. This information will help you understand the different approaches to business valuation, but you may want to seek professional guidance and advice. Prospective investors will also assess its value when they consider your proposal.
The process of determining the value is called valuation. You and the buyer or investor need to determine what you feel is an appropriate business valuation because it will be the basis for negotiating:
- How much of your business the investor or buyer will purchase
- How much the buyer or investor will pay (the price of the business or of its shares)
- The return the buyer or investor can expect to earn
Ways of valuing a business
Valuation is not an exact science, and there are different ways of valuing a business. Each of these methods is based on different assumptions and financial information, which typically results in a different value for each method. For instance, you could base a valuation on the assets of a business (how much it owns) or by taking into account projected revenues or cash flows. Investors generally prefer methods based on cash flows. It's important to know about a variety of methods because they can be useful as benchmarks to check the validity of the value and the price you determine.
Earnings and cash flow-based methods:
- Discounted cash flow
- Going-concern value
- Book value
- Liquidation value
Discounted cash flow
From the investor's perspective, this is usually the most accurate and effective way to estimate a business' value because it is based on future cash flows. These cash flow figures reflect the amount of money that is estimated to come into the business and will ultimately determine the investor's return on investment. The discounted cash flow method is used to answer three critical questions:
- Value: How much is your business worth today, based on what it will earn in the future?
- Rate of return: What is the buyer's or investor's expected rate of return, given the amount invested and your business' financial projections?
- Equity share: How much equity will the buyer or investor receive for their investment?
The discounted-cash-flow method is often preferred because it can be more accurate than other methods. Its accuracy and complexity are due to the fact that it:
- Uses cash flows: It takes into account the projected ups and downs of revenue over a period of time.
- Discounts the cash flows: It adjusts the cash flows by a rate that is acceptable to the investor to account for risk and the time the investor must wait for a return.
How it works
In this method, cash flow predictions are discounted, or reduced, to adjust for the risk the investor faces and to make up for the fact that the investor could invest their money in something else.
Investors are looking to be compensated for their risk, and their benchmark rate — or "discount rate" — will adjust for the value of money over time. They will choose a discount rate and compare your proposal against that rate.
Advantages and disadvantages
The discounted cash flow method allows values to be estimated even when your cash flow is fluctuating. A start-up or new venture may expect to lose money in the first years and then make money in later years. These changes in cash flow are taken into account by the discounted cash flow method.
If you use this method, keep in mind that:
- Its accuracy depends on the accuracy of your cash flow projections. That is why your financial data and assumptions are critical.
- It is a complex process, so you may require professional guidance.
- It can give you detailed estimates, but it is important to remember that business valuation is not an exact science — your numbers will be based on assumptions and predictions of future performance.
Value: How much is your business worth today?
Let's say financiers are considering an investment in your business, but plan to take their money out in five years. To them, your business is worth today what it can earn during those five years, plus their share of the value of the business at the end of the five years. However, future cash flow numbers and the future value of the business are unknown. The discounted cash flow method applies adjustments or "discounts" to account for those unknowns.
Using this method, the value is the total of the cash flows, adjusted or discounted, plus the value remaining (or residual value), also discounted.
Rate of return: What rate of return will the investor expect?
Investors want to calculate their rate of return. To do that they must compare the amount of the investment to the amount they will earn at the end of the investment period. But how can they know what they will earn in the future? Again, they must use the discounted cash flow projections to estimate the future value of their investment. To do so, they will need to:
- Estimate the cash flow in the final year
- Estimate the value of the business based on the cash flow
- Calculate the final value of their share in the business
- Determine their rate of return
Value, return and exit strategy
The method used to calculate values and rates of return depends on the specific exit strategy used. Commonly-used methods include going-concern value, book value, and liquidation value.
The going-concern value method calculates your business' value based on its capacity to produce a stream of cash flow in the future. The greater the cash flow your business generates in the future, the higher your business' value today.
How it works
The going concern value, like discounted cash flow, compares the current investment to the future receipts (cash inflows). This method uses the revenues of previous years to project future revenues, and it assumes those revenues will not change.
This value is the net worth, or shareholders' equity, of your business as shown in its financial statements. At its most simplified, subtracting your liabilities from your assets will give you your business' net worth or book value. Book value can be described as the historical value of an asset that, at a given time (the day it was purchased), represented the economic or market value of the asset, less its accumulated depreciation.
How it works
To determine the book value, subtract your liabilities from the value of your assets. The difference gives you your net worth or shareholders' equity. In practice, book value is seldom used in the process of securing venture capital, although it can be a realistic approach to measuring a small business' net worth.
A liquidation value is assigned to a business being sold in order to satisfy its creditors. Tangible assets, such as land, usually have a liquidation value close to their market value. Inventories and accounts receivable, on the other hand, are usually valued at less than what is shown in the books.
How it works
To determine the liquidation value, all assets are assigned distressed values, and all debts are totalled at book value. Most assets sold under duress are discounted from their fair market value. The difference between the distressed value of the assets and the actual or book value of the liabilities is referred to as the liquidation value.
The liquidation value doesn't reflect the real worth of an asset or a business; in most cases, it is substantially less than the market and book values. This method is typically used only if a business is in serious financial trouble.
Should I seek a financial advisor for help with valuation?
Business valuation is a complex task, and a financial advisor with experience in business valuation can be an invaluable asset.
A professional valuator can:
- Provide the experience needed to accurately determine the value of your business
- Offer an objective view of your business' worth
- Give investors more confidence in the credibility of your valuation
There is a saying in the venture capital industry: "The value of a business is only what someone is willing to pay for it." In other words, the market, and your ability to attract investors and negotiate with them will determine the value or selling price.
Remember that many factors affect the value of your business. Seeking professional assistance can help you calculate an accurate value for your business.