What's Your Business Worth? 5 Steps to a Favorable Valuation
January 6, 2015 | Business and Careers
Is your business worth what you think it’s worth? As a business owner, you probably have a figure in mind—but should you rely on it for your future plans?
Conventional wisdom might say that you want your business’s value to be as high as possible, but that’s not always the case. For instance, if you’re buying out a business partner, you probably don’t want to pay the highest price possible. Or if you’re transferring your business interest to your kids, you’ll want a low valuation to reduce the gift tax value.
Business valuation may vary depending on a variety of factors. “Business valuation is not a static, black-and-white concept,” says Ken Elbert, director of Advanced Planning at Northwestern Mutual. “Reasonable parties can place different values on the same business due to different perspectives on the business, the market, the nature of the transfer and future plans.”
Fortunately, there are ways to influence the value of your business to suit your long-term goals. Consider these five steps:
1. Determine the purpose of the valuation. What is prompting the valuation? Common reasons for business valuation include the following:
- Creating a buy-sell agreement with your partner
- Transferring your business to a family member
- Conducting a third-party sale
- Determining your net worth
- Obtaining financing or insurance
- Negotiating a prenuptial agreement or divorce settlement
- Estate planning
In any of these cases, the value must be realistic to pass Internal Revenue Service standards. “The IRS will generally want to see valuations based on fair market value,” Elbert cautions.
2. Consider your type of business.
- Asset-oriented businesses are often valued based on the value of those assets. In manufacturing, for example, the value will include property, machinery and tools.
- Service-oriented businesses are often valued based on cash flow (present and future) and future profit potential. There may be goodwill value associated with the business based on its reputation, customer relationships and business practices.
3. Evaluate possible methods. Depending on the purpose of the valuation and your business goals, you might consider one of three basic strategies:
- Book value (assets minus liabilities)
- Multiple of earnings
- Comparable sales
Informal valuations based on book value or multiple of earnings may help with certain aspects of financial or estate planning. However, sometimes a formal appraisal is required.
“If you hire an appraiser, be sure to explain the purpose of the valuation,” says Elbert. The formal appraisal will likely be based on a variety of factors, including business assets, operations and cash flow, as well as economic outlook and sales of comparable businesses. Because there is both an art and a science involved with appraising, different appraisers can arrive at different valuations.
4. Tweak the value. Depending on the purpose for your valuation, there might be additional factors that influence the overall value of the business. This is where your valuation team has a chance to be creative.
- Changes in expenses. “Lots of valuations are based on income,” says Elbert, “but the income statement should not be taken at face value.” He gives the example of a business owner/manager who is taking a salary of $300,000. Another owner may hire someone to manage the business for $100,000, immediately increasing the net income of the business.
- Depreciating assets. Assets may be depreciated for book purposes, but the fair market value may exceed the book value. Often it is the fair market value rather than the book value that is relevant in valuations.
- Earnout. “When there is uncertainty about future cash flows, parties may negotiate an earnout provision,” says Elbert. “Part of the purchase price can be fixed, and part can be based on future earnings.”
- Intangibles. Business value is not always apparent from the balance sheet or income statement. There may be intangible factors that influence how someone values a business. “Buyers may be willing to pay a higher price for your business because it is complementary to their business or it opens up new markets,” says Elbert.
- Changes in liabilities. In general, business value can be increased as liabilities are transferred or paid down. Value can also be intentionally decreased if unfunded liabilities are put in place, such as deferred compensation arrangements.
- Minority/controlling interests. Minority interests in closely held business are generally eligible for valuation discounts due to limited marketability and control. In contrast, buyers may be willing to pay more for a controlling business interest.
5. Revisit the valuation regularly. Business values fluctuate over time, so periodically review your valuation to ensure that any agreements dependent on value are up to date. In particular, buy-sell agreements should be periodically reviewed to ensure they reflect current values and are properly funded. Also keep in mind how the business value impacts your broader goals and plans. “Business owners should ensure that their goals regarding retirement and estate planning are satisfied even though business values may change,” says Elbert.
If you need a valuation for your business, work with an experienced financial professional who can help you determine whether the valuation should be formal or informal. A trusted advisor can also help you develop a strategy for leaving your business and coordinate it with your personal financial plans.