Understanding Business Valuation: A Guide for Small Business Owners
For many people, a house or a retirement nest egg is their most valuable asset. Financial planning around those things is the common approach to help individuals reach financial independence. For small business owners, though, a thriving venture often becomes the largest chunk of their net worth. Determining the business’s value thus becomes a critical step in short- and long-term planning.
But your business doesn’t have shares that trade on the New York Stock Exchange. Figuring out what your stake is worth can only be done by crunching numbers via a handful of valuation techniques – some are intuitive while others are less straightforward. Small-business valuation endeavors harness multiple pricing methods to arrive at an evidence-based best guess of what an arms-length buyer would pay for it.
Knowing what your business is worth is crucial whether you intend to sell, plan for the next generation of ownership, or just aim to optimize your tax situation. An on-point valuation empowers you to make the right decisions to maximize not only your net worth but also your peace of mind. Let’s dive into why business valuation matters and why you should think about it now even if you plan to remain at the helm for many years to come.
Why Business Valuation Matters
I help small business owners manage their assets and liabilities on their path toward financial freedom or as they seek to build their own empires. Whether the strategy is to divest, maintain, or expand, we must have a grip on the business’s worth. Here are some of the common purposes of a valuation:
Preparing to Buy or Sell
No matter the asset, being involved in buy/sell negotiations demands that you clearly understand the fair value so you can maximize your ROI.
Focusing on family-owned operations, a firm valuation fosters an easier exit or transition to the next generation. It also reduces emotion and angst regarding equitable distribution, all while preserving your legacy as owner.
An accurate valuation is not just about getting the most out of an investment or making everybody happy; it’s about satisfying the tax man too. A true and well-documented determination of worth is a must when it comes to gift and estate tax calculations.
Many entrepreneurs just want to know where they stand on the road to retirement. Valuing their business augments a broader financial plan and instills confidence that they are on the right track.
Valuation turns complex when integrating a small business with another enterprise. Often, industry experts and attorneys are called in to ensure the valuation covers all the bases.
Common Business Valuation Methods
It’s now time to go back to business school. Many moons ago, you may have learned about the various approaches to valuation, while experienced executives likely consider them routinely throughout the year. Let’s shed light on the most well-known methods.
This is a somewhat simple method of tallying assets and liabilities to determine a net worth. It’s ideal for companies with significant tangible assets, such as those operating in retail, manufacturing, or real estate. Pricing each asset can be done using either its book value, replacement value, or liquidation value. The downside is that it doesn’t consider future cash flow potential or if a firm operates in an asset-light industry, like technology.
The income-based approach addresses that last concern. If your business generates cash flow and earnings without using significant physical assets, then capitalizing earnings or performing discounted cash flow (DCF) analysis may be the right method. It helps to have stable and predictable profits.
Rather than looking strictly internally, assessing recent transactions within your industry offers a helpful look into real-world deals. What valuation multiples (price-to-earnings, price-to-sales, EV/EBITDA) were used? How long did the process take? Some industries may even post relevant transaction details for small business owners like you to reference. No two companies are alike, however, so you must take the data with a grain of salt.
What’s Your Company Worth?
It’s clear that there are a lot of numbers to flesh out and guesstimates involved when valuing a company. The business’s financial performance, broader industry trends, the state of your customer base, growth potential, and how much intangible assets are worth are all key factors. The valuation process itself is also time-consuming and requires the help of experts.
You must first gather financial documents like income statements, balance sheets, cash flow reports, and tax returns. Full transparency around financial data ensures the best valuation you can bring to the table. Being up to speed on the latest industry trends also helps, particularly with market-based valuation methods.
From there, you must use any of the valuation techniques mentioned above, or maybe a few of them. Each will yield a different number, and it’s common to take a weighted average of all the solutions. Applying more than one valuation technique provides a cross-check, too.
Also be sure to consider the value of non-physical assets like your brand, the strength of customer relationships, and patents or other intellectual property that could significantly boost your company’s worth.
With so many boxes to check and potential pitfalls, it’s crucial to work with an experienced team of professionals who have experience helping small business owners (like you) embark on business valuation, particularly if you are looking to sell soon. Not only is accurately gauging market value difficult and riddled with assumptions but regulations must be followed as well. Having CPAs and other accredited experts in your corner instills credibility when dealing with potential buyers, tax authorities, and other legal entities.
Preserving Your Legacy: Succession Planning
I team with many family-owned businesses. Here, of course the dollars and cents matter, but there’s also an emotional element involved. Determining the business’s fair value is an important step in generational financial planning. That may mean plotting out equal distribution following a sale one day or properly shifting ownership from parents to their children. Crafting buy-sell agreements, for instance, helps lay the foundation for a smooth transition and asset protection.
An Eye on Taxes
Y’all know I nerd out on taxes. It is a serious consideration when divesting a business. A properly documented business valuation allows tax planners to go about estate planning the right way (including minimizing estate tax liability). There may also be gifting strategies to maximize the after-tax return to shareholders and family members. Lastly, it might be worth it to analyze whether incorporating or establishing stock option plans may help optimize your ownership stake and possible transition.
The Bottom Line
Just as a pilot needs an accurate set of gauges to fly an aircraft, you as a business owner must have a sense of what your company is worth to make the best decision about the future.
For many entrepreneurs, the business is the most valuable asset. By understanding valuation methods, key determinants of company value, and common pitfalls, you can be proactive in determining the worth of your firm. Remember that a business valuation is not a one-time event. Like a financial plan, it should be constantly revisited and updated.
With the right help, you can see your business reach new heights or come down to earth safely and lucratively so that you can retire on your terms and preserve your legacy.