Understanding Business Valuation: A Guide for Business Owners

I have accepted the fact that our driveway currently looks like a used car lot. With five children, four of whom are driving, Annaliese and I have progressively increased our family fleet to five automobiles. Needless to say, our auto insurance premium has increased at an even faster pace—a topic for another article! In early June, we begrudgingly added the fifth vehicle to our used car collection to meet the growing transportation needs of our family. With plenty of experience buying used vehicles, the process was fairly straightforward for us. After setting an amount we were willing to spend, we identified the make and model of the vehicle we wanted to purchase, used Kelley Blue Book (KBB) to determine a fair price, and began our search. Shortly thereafter, we found the car we were looking to purchase at a reputable dealership and were able to negotiate an agreeable price. Not surprisingly, the cost of the vehicle ended up in the value range provided by KBB. We purchased the vehicle, confident that we paid a fair price as the KBB value took into account thousands of recent transactions for a similar vehicle.

If you are the owner of a closely held business, you understand that determining the value of your business is not as simple as looking up the price of a used automobile. Unfortunately, you are unlikely to find a database of transactions involving companies that look exactly like yours from which you can confidently determine value. Instead, a qualified business appraiser must consider the unique aspects of your business and utilize appropriate valuation approaches to ascertain its approximate value. We think you will agree that knowing your company’s value is an important factor in navigating significant ownership decisions.

Why do you need to know what your company is worth?

There are various situations during the lifecycle of ownership when a company should be appraised. We have provided below some of the more common reasons encountered.

• Succession Planning: If you plan to sell your business to a third party, knowing its value is essential for a fair negotiation. If you plan to transfer your ownership to family, a proper understanding of value helps determine the appropriate structure to ensure a successful transition.
• Tax and Estate Planning: Accurate business valuation helps in effective tax and estate planning strategies, ensuring you keep tax costs as low as possible.
• Offering Shares to Employees: If you intend to offer shares to your employees through employee stock ownership plans (ESOPs) or other equity participation programs, knowing the value of your business is critical so that you know the actual cost of your employees’ compensation.
• Buying Out Current Owners: If you are considering buying out existing owners or negotiating with potential buyers, understanding your company’s value is essential to avoid unreconcilable conflicts and facilitate fair negotiations.
• Buy/Sell Agreements: Often, a buy/sell agreement between owners requires an appraisal to determine value for certain triggering events (i.e. death or disability of a shareholder).
• Tax Reporting: An appraisal is required by taxing authorities to report the value of business assets gifted during one’s lifetime or bequeathed at the owner’s death. Taxing authorities also require an appraisal for ownership interests gifted or bequeathed to a charity.

It is important to emphasize that it’s common for business owners to have different value expectations compared to potential buyers, family successors, financial partners, or tax assessors. These differing perceptions often lead to disputes, derail negotiations, or affect post-transaction plans. To mitigate these challenges, obtaining a third-party valuation can provide an objective and realistic understanding of your company’s value, offering clarity on the best path forward.

Common Approaches to Business Valuation

Professional appraisers commonly use several valuation methods, often combining multiple approaches to determine the most appropriate value for a specific business. The following are three commonly used approaches to valuation.

• Income Approach: The income approach looks at the present value of the business’s expected future cash flows. It involves reviewing and forecasting earnings or cash flow. The two typically used income-based approaches are the Discounted Cash Flow Method and the Capitalization of Earnings Method. The Discounted Cash Flow Method involves projecting the company’s cash flows over a specific period and then discounting them back to their present value. The Capitalization of Earnings Method involves estimating the company’s future earnings, which are then divided by a capitalization rate that reflects the risk associated with the investment. Appraisers commonly use an income approach for valuing closely held businesses. 
• Market Approach: The market approach involves comparing the business to similar businesses that have been sold or are listed for sale. It utilizes various metrics such as Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA), revenue, or other industry-specific ratios. There are two market approaches commonly used. The Guideline Public Company Method compares the business to publicly traded companies in the same industry. The Guideline Transaction Method focuses on analyzing transactions of similar businesses that have been sold or acquired. The challenge with this approach is identifying public companies comparable to the business being valued, particularly when appraising a small, closely held company. 
• Asset Approach: The asset approach focuses on the net asset value of the business by subtracting total liabilities from total assets. These methods are suitable for businesses with significant tangible assets (i.e., real estate or equipment). There are two common asset approaches used. The Adjusted Net Asset Method involves adjusting the company’s assets and liabilities to their fair market value, which may differ from the book value reported on financial statements. The Liquidation Value Method involves estimating the net proceeds that would be received if the business were to be sold off and its assets liquidated. The Liquidation Value Method is often used when the company is in financial distress or its ongoing operations are not generating sufficient returns.

Key Drivers of Value

A valuation provides valuable insights into the key drivers of your business’s value, highlighting opportunities for improvement and growth. Consider the following factors:

• Revenue and Profitability: Higher revenue and profitability typically translate to a higher business value. Analyzing revenue and profitability together can guide you on where to invest resources to increase your company’s value.
• Cash Flow: Strong and stable cash flow is critical in business valuation, representing the amount of cash generated by your company’s operations. Businesses with reliable cash flow are generally considered more valuable. You should consider the factors that will enhance the predictability of future cash flows—broad customer base, limited concentration in any one customer, stable and diversified supplier base, etc.
• Management Team: The strength and experience of your management team can significantly impact the value of your business. A proven track record and industry expertise increase the likelihood of future success, thereby enhancing your company’s value. A review of your management team will help identify gaps that need to be addressed and highlight deficiencies in the leadership succession plan.
• Market Competition and Industry Trends: The competitive landscape and industry trends can affect your company’s value. Strong competition may lower value, while a dominant position in a niche market can increase value. Stay aware of industry trends, technological advancements, changes in consumer behavior, and regulatory shifts that could impact your business’s value.

Other Important Considerations

• The value of your business may vary depending on the specific transaction or scenario. Different types of transactions, such as intra-family transfers or sales to third parties, can impact the value and may involve the application of specific valuation discounts or premiums.
• Intra-family transactions, such as gifts or sales to family members or trusts, often involve the transfer of non-controlling interests. In these cases, appraisers typically apply a discount to the value of the interests being transferred, reflecting the lack of control associated with minority ownership.
• It’s important to note that when appraising the value of your business for a 100% sale to a third party, the appraised value will be higher as minority interest discounts will not apply.
• The value of your business is not static and can fluctuate over time. An appraisal report is prepared for a specific date and may require periodic updates, depending on the purpose of the analysis and changes in market conditions.

Understanding these additional considerations will help you have a more comprehensive understanding of your business’s value and the factors that can influence it in different transaction scenarios.

In conclusion, understanding the value of your business is crucial for making informed ownership decisions. Properly determining your company’s worth requires careful consideration and appropriate valuation approaches. Whether you’re planning for succession, engaging in tax and estate planning, offering shares to employees, negotiating with other owners, establishing buy/sell agreements, or complying with tax reporting, knowing your business’s value is essential.

This information is believed to be accurate at the time of publication but should not be used as specific investment or tax advice as opinions and legislation are subject to change. You should always consult your tax professional or other advisors before acting on the ideas presented here.