This post was originally published June 04, 2018, and extensively updated April 8, 2021
At Cook Martin, we work with business owners every day. We help them with everything from day-to-day accounting to creating a business succession plan. One of the most common questions we get is this:
How much is my business worth?
It’s a good question to ask and an important number to know. Whether you’re planning to sell a business, acquire a company, or pass your business down to a family member, you need to be sure that you are valuing it properly.
What is Business Valuation?
Business valuation is the process that determines the economic value of a business. There are a variety of methods that can be used in business valuation. In a service business, the valuation should take into account the client base, lifetime value of clients, business reputation, and physical assets such as property and equipment.
It is common to read about business valuation regarding selling a business, but valuations can also be done for purposes of taxation, valuing a business partnership or ownership percentage, divorce, or inheritance.
The business value can be determined by evaluating similar businesses that have been sold. The primary methods used to value businesses include:
- Market capitalization method
- Times revenue method
- Discounted cash flow method
- Earnings multiplier
- Book value
- Liquidation value
Why Is Business Valuation Important?
Why does business valuation matter? Imagine that you are planning to sell your business. Perhaps someone makes an offer. It sounds like a lot of money, but can you be sure that you are not undervaluing your business?
The short answer is no, you can’t. Many business owners make the mistake of using a “nuts and bolts” approach to valuation that leaves them short of their company’s true market value.
That’s because a business’s worth is about more than the bottom line. Often, there are intangible items that add to the value of a business. For example, a strong brand name with a great reputation is going to be worth more than a brand that nobody’s heard of.
Of course, selling a business isn’t the only reason you need to know how much it’s worth. You also need an accurate value if you are:
- Creating a business succession plan, which requires the owner to place a value on the business for the eventual buy-out or transfer of ownership
- Reporting the company’s value to the IRS in the event of a death
- Merging with another company (in which case you’ll need the value of your company, the value of the other company, and an estimated value of the merged entities)
- Purchasing another company outright (you need to know its value before you draw up a purchase agreement)
- Forming or dissolving a partnership
You can see why getting a proper valuation of your business (or a business you are buying or merging with) is essential. Without it, you might undervalue or overvalue a business and that can cause problems down the line.
What Affects the Value of a Business?
Many things can affect the value of a business. Part of the business valuation process is understanding where your company's value lies and how that translates into a fair price, whether you are selling your company or simply want to know its worth. Here are the things that can affect the value of service businesses.
- The type of business (industry/niche)
- Monthly cash flow
- EBIDTA (Earnings Before Interest, Depreciation, Taxes, and Amortization)
- Revenue trends
- Profit margins
- Customer concentration
- Market share
- Management team (experience, depth, etc.)
- Reputation and brand recognition
- Competition/competitive advantage
If you need a valuation for your small business, you should make sure that you have a good overview of your advantages and market share. We go into more detail about how to prepare for a small business valuation below.
The Difference Between Book Valuation and Fair Market Valuation
The most common mistake business owners make when they’re estimating the value of their business is using what we call book value. We understand why that happens, but we also know how dangerous it can be to focus on the wrong things when estimating the value of a business.
What is Book Value?
Book value is the value of a company based on facts and figures. Specifically, it uses balance sheet assets minus liabilities to arrive at a value.
Why is that a problem? Most businesses are sold for more than their book value. The reason is that your company’s balance sheet shows your assets at their original cost, minus accumulated depreciation, instead of using the true replacement value.
Imagine that you bought a piece of equipment for $30,000. The accumulated depreciation is $8,000, leaving the machine with a value of only $22,000. That’s an issue because the same machine might cost $35,000 to replace. That’s its fair market value.
As mentioned earlier, there are intangibles to take into consideration too and they don’t show up on a balance sheet. Calculating the book value of your business is helpful as a starting point, but it’s not enough to help you understand what it’s worth.
What is Fair Market Value?
You know what book value is, but what is fair market value? Fair market value is harder to define, but it boils down to this:
The fair market value of a business is the price at which it can change hands between a willing buyer and a willing seller when both have reasonable knowledge of the facts that relate to its value.
It is helpful to think of what market value is when you’re buying a home. When it’s a seller’s market and prices are high, buyers are willing to pay a high price to get the home they want. Their conception of its value relates to many things, including the condition of the home, its size, location, and what other homes in the area have sold for.
In other words, the fair market value of your business is what someone is willing to pay for it based on a reasonable assessment of both your tangible assets and the intangible items that might not show up on your balance sheet, including your business name, reputation, and brand.
How to Value a Service Business: Valuation Methods
The best way to get a fair market valuation of your business is to hire a professional business appraiser to calculate it. Below are various methods that are commonly used:
- Capitalization of earnings. This method starts by calculating the business’s annual earnings over one or several years. Then, the earnings are divided by a “cap rate.” For example, a company that had annual earnings of $300,000 and a cap rate of 10% would have an estimated value of $300,000/10%, or $3 million.
- Discounted cash flow. This is a method that is sometimes used to estimate the value of new businesses or companies whose earnings are volatile. It starts with forecasting earnings over several years. Then, to account for the value of money over time, a discount rate is applied to each year of forecasted earnings.
- Comparable sales and discounts. This method is akin to what happens when a real estate agent sets a sale price on a home based on the sales prices of other homes in the area. It analyzes recent sales of similar companies in the same industry to arrive at the market value of a business.
The methods used vary from appraiser to appraiser, but the goal is always to arrive at a number that is fair to both the seller and the buyer.
How Much Does a Business Valuation Cost?
If you’ve been thinking about the value of your business, you might have looked around to see what your options are. When it comes to business valuation, it’s important to remember that you get what you pay for.
For example, there are low-cost business valuation software options. These prices are attractive when compared to hiring a professional appraiser. Software is inexpensive, but will it provide you with an accurate value for your business?
The truth is that there’s no substitute for the experience of a professional appraiser. Software can help you crunch numbers and evaluate the bottom line, but it’s not going to understand the nuances of your business.
The cost of a professional appraisal can range from several hundred dollars to tens of thousands of dollars. The size and complexity of your business, your industry, and other factors impact the cost.
How to Prepare for a Business Valuation
You will have the smoothest possible experience during your business valuation if you have prepared for it ahead of time. Here are some steps to follow to make sure you go into your valuation with the information you need.
- Gather information about the company's corporate and tax structure, owners, officers, and ownership percentages.
- Create an organizational chart that shows the entire management team and their functions, including information about board members. Also, you should include employment contracts.
- Gather payroll data for all employees, including key salaries and other relevant information.
- Know the information regarding employee benefits, including bonuses, profit sharing, and stock options.
- Create a detailed description of the business and its operations, including which portions of the company are for sale and which, if any, are not. Make sure to include all business assets, such as equipment and inventory, that will be included in the valuation.
- Know the last five years of tax returns for the business, including information on any IRS audits or other investigations.
- Have five years’ worth of financial statements and other relevant financial documents, including cash flow statements, P & L reports, sales reports, and cash flow reports.
- Create a list of your top customers and the percentage of the business they represent.
- Have a payment history for all customers.
- Gather accounts receivable aging reports for the most recent three years.
- Have a vendor/supplier concentration analysis.
- Do a competitive analysis that includes an overview of top competitors and their services.
- Acquire details of any loans or liens.
The more thorough you are in your preparation, the easier it is to get an accurate and advantageous valuation for your small business.
How Frequently Does a Business Valuation Need to be Performed?
When you own a service business, it is essential to know what it is worth even if you are not planning to sell or buy out a partner. Owners of service businesses can sometimes undervalue their businesses, particularly if the last time they had a business valuation was years ago.
Things like cash flow and annual sales may change dramatically over time. The valuation methods that you used in the past may not be appropriate now. Either way, most experts suggest that you should value a business at regular intervals to ensure you understand its worth.
Unless something drastic changes for your service firm, a business valuation should be good for at least a year. We suggest that our clients determine the value of their business once a year.
That doesn't mean you need to hire an expert every time, but it is helpful to know your business's value at any given time.
Business Appraisals by Cook Martin
At Cook Martin, we have a team of experienced business valuation experts who can appraise your business and arrive at the proper value. We are Certified Valuation Analysts (CVAs), a credential that’s widely recognized in business valuation. CVAs meet the standards for the IRS, the court system, and various other authorities.
Our valuation services adhere to the professional standards of the American Institute of Certified Public Accountants (AICPA) and the National Association of Certified Valuators and Analysts (NACVA).
To learn more about our business valuation services or to book a free consultation to speak with one of our valuation experts, contact us today!