Determining the Value of a Business
Business valuation is a subject many business owners don’t think much about. This isn’t too surprising when you consider the fact that most owners work long, hard hours building their businesses. This often leaves little time to think about business appraisal, business valuation methods or how much their business is worth.
Also, many owners think that they only need to know how to value a company when they’re planning on selling their business. However, this is a mistaken assumption: There are many situations in which a company valuation may be useful to business owners, including the following:
- The formation of an estate plan.
- Estate, gift or income tax planning.
- A pending retirement.
- The addition of a new partner(s) to a business.
- A merger or acquisition with another business.
- Creation of an employee stock ownership plan.
- The drafting of a buy-sell agreement.
- The creation of a family limited partnership.
- Dealing with shareholder disputes.
- Divorce, bankruptcy or damage claims litigation.
For all these reasons and more, you should consider having a company valuation performed by a certified business valuation professional such as O’Brien & Panchuk — even if you’re not planning to sell your business anytime soon. We have worked with business buyers and sellers in the Coachella Valley for many years and possess the training, judgment and experience required to combine the objective and subjective factors that will go into creating a formal business valuation.
Business Valuation Challenges
One of the biggest challenges owners often face when it comes to valuing a business is separating their emotions from the business appraisal process. Owners of closely held businesses usually see their companies in a very different light than potential buyers do, which can make determining the value of a business difficult.
For example, as a small business owner, you have invested a lot of “sweat equity” into your company. You are the one who has worked 70 or 80 hours a week (or longer) for many years to build the company into what it is today. You are the one who made sacrifices in order to help the business succeed. And you are the one who took the risk to start the business in the first place.
However, buyers attach little if any value to factors like these when it comes to business valuation. From their perspective, company valuation is derived from numbers and data that indicate their potential return on investment in your business. More specifically, they will want to determine how much they can increase future cash flow and earnings. This is sometimes referred to as EBITDA, which stands for Earnings Before Interest, Taxes, Depreciation and Amortization.
Common Business Valuation Methods
The best way to value a small business and narrow the gap between how much you believe your business is worth and how much a buyer believes it’s worth is to hire a professional business appraiser like O’Brien & Panchuk. We will use one of several common business valuation methods to arrive at a defensible business valuation, such as:
This approach subtracts the fair market value of your business’ liabilities from the fair market value of its tangible assets to arrive at an adjusted net asset value for the business.
This approach looks at the selling price of other companies similar to yours and bases the value of your business primarily on this. It’s similar to the approach used by real estate agents who set the asking price of houses based on the prices of similar homes (or comps) that have sold in the area.
This approach is more numbers-based. The valuation professional will consider financial indicators such as cash flow and price-earnings multiples to calculate an adjusted earnings capitalization. Based on this, future earnings can then be projected and a value assigned based on this.
Using a valuation method such as these, the business appraiser will assign a fair market value (or FMV) to your company. The American Institute of Certified Public Accounts (AICPA) defines FMV as follows:
The price, expressed in cash equivalents, at which property or business would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, where neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.
Regardless of which method is used, the business appraiser will usually start by identifying all of your business assets (both tangible and intangible) and assigning a value to them. Tangible assets are things like cash, inventory, fixed assets and accounts receivable while intangible assets are things like patents, industry reputation, customer lists and goodwill.
There are a number of other factors the appraiser will consider when performing a business valuation, such as:
- The business’ operating history.
- The overall outlook for the industry.
- The strengths and weaknesses of the management team.
- The business’ competitive position and unique selling proposition (or USP).
- The overall outlook for the U.S. economy, as well as overseas economies if it’s an international business.
When performing a business valuation, the business appraiser will assign a discount rate to the business being appraised. Also known as the cost of capital, this is used to adjust future cash flow back to present value. The appraiser will use both quantitative and qualitative factors when assigning a discount rate. Making sure that the discount rate is accurate is one of the most important factors in performing a quality business valuation.
Keep in mind that smaller businesses with wide swings in cash flow and high degrees of volatility can feature very high discount rates. In this scenario, future cash flows may be discounted back to present value, which can result in a lower business valuation.
Concerns of Business Buyers
Remember that one of the main concerns of most business buyers is whether the business will be able to maintain and improve its current level of financial performance in the future. In other words, buyers will try to determine the present value of future ownership benefits as measured by rising EBITDA. More specifically, they want to know the expected amount of future cash flow and earnings, how certain these are, what their timing is and what factors could put them in jeopardy.
The greater the risk that future financial performance will falter, the less value buyers will usually assign to a company. Conversely, the more certainty there is that future financial performance will be strong, the higher value buyers will typically assign to a company. So it’s usually in your interest to focus on reducing financial risk before having a business valuation performed by making projected future earnings and cash flow as certain as possible.
For example, is there a high degree of customer concentration in your business? Or in other words, is most of your revenue and/or profits concentrated among a few large customers? If so, try to reduce this concentration risk before having a business valuation performed. Also, do you have long-term (and legally enforceable) contracts in place with your largest customers and vendors? This can help ensure a steady stream of income and profits and predictable raw material and labor costs for years to come, thus protecting future earnings and cash flow.
Ways to Boost Your Business Valuation
Given the heavy emphasis by business buyers on financial performance, it’s also critical to prepare updated financial statements and projections for at least three years before having a business valuation performed. Financial statements should be prepared by a CPA and accurately reflect the recent trajectory of your company, while projections should be based on realistic assumptions about the business and your industry and marketplace.
Here are a few more steps you can take that may result in a higher business valuation for your company:
Focus on strengthening financial performance. You want to be able to demonstrate a history of consistent sales and revenue growth, strong margins and healthy cash flow. Start measuring and monitoring the most important key performance indicators (or KPIs) for your business now and strive for steady improvement in the numbers over time.
Ensure accounting integrity and financial statement quality. You should have your financial statements audited or reviewed by a CPA annually. Not having professionally prepared financial statements can result in a lower business valuation than you might be expecting, all other things being equal.
Emphasize strong growth prospects. Given the importance of rising EBITDA to most business buyers, it’s critical to demonstrate how the company will grow in the future. Your strategic plan should detail growth strategies, such as tapping new niches, expanding into new geographic territories or taking advantage of new technologies.
Build sustainable competitive advantages. Clearly demonstrate what sets your business apart from your competitors — or in other words, why customers choose your business over them. For example, do you provide the highest quality products, the best customer service or the lowest price?
Surround yourself with strong managers and executives. The more irreplaceable you are as the leader of your business, the lower your business valuation will probably be. You need to build a strong management team that can keep operations running smoothly after you depart the company. Start delegating more responsibility to your managers and introducing them to key customers and vendors so they can easily step into your shoes when the time comes.
Emphasize talent recruitment. Having a well-trained and highly skilled workforce is one of the best ways to build value in a closely held business. Also strive to keep employee turnover low by paying wages that are within industry ranges, offering a competitive benefits package, creating a vibrant and dynamic workplace, and investing in ongoing training so employees can do their jobs efficiently.
Business Valuation Services From Professionals
O’Brien & Panchuk is an experienced local business valuation firm located in Indian Wells. As accredited valuation professionals, we have worked with countless owners of closely held businesses in the preparation of company valuations and business appraisals, using a wide range of business valuation methods and business valuation formulas.
We will leverage our specialized knowledge and time-tested methodologies to perform a business valuation that is accurate and defensible. By retaining O’Brien and Panchuk to conduct a business valuation, you will be assured of professional service by experts who are trained in both the art and science of business valuation.
O’Brien and Panchuk is a progressive CPA firm that focuses on the specific needs and circumstances of each one of our clients. This enables us to provide tailored services and solutions designed to meet your needs — not off-the-shelf, cookie-cutter solutions offered by many large CPA firms that could be applied to any business.
The forensic accountants at O’Brien & Panchuk use their vast knowledge of accounting with investigative skills to conduct forensic research to locate and identify assets for a company. We conduct forensic analysis of financial data, and create forensic accounting reports from their findings. In preparation for litigation, our professionals prepare analytical data for litigation and will testify as to their investigations. This is known as a forensic audit, an examinations of evidence for litigation purposes. An external audit is performed by one of our tax and accounting CPAs to render a professional opinion as to the stability of a business or another aspect of the company, such as sales processes or accounts receivables.
The business evaluation advice provided by O’Brien & Panchuk, an experienced business valuation firm in Indian Wells, will be an expert appraisals from professional forensic accountants who have conducted this process on numerous occasions for prospective buyers and sellers, retiring business owners, and those setting up estate plan strategies. They provide accurate results that will enable you to move forward with your plans in the most informed and effective manner.