Have you ever wondered what your business is worth? At some point, your business must be sold unless you are planning to give it away. If you are a shareholder of a corporation, a member of a limited liability company or a partner in partnership, there should be a mechanism in the corporate bylaws, operating agreement, or partnership agreement that establishes your ownership value. If not, it is time to think about drafting one.
The easiest way to establish the value of a business is to identify a “Stated Value.” Stated value is a fixed amount that an owner will receive when he or she exits the business. The amount is established by the owners themselves. Often this type of valuation method provides that the owners must make adjustments from time to time. Over time, this requirement is forgotten and an exiting owner may be stuck with an amount that does not represent the true value of their interest.
In many situations, an appraiser is needed to determine the value of a business. An appraisal may occur as a result of the contract language of the business, during a divorce when marital property needs to be determined, on the death of one of the owners to help establish the value of the estate, or for any number of reasons. Not all appraisers are right for all businesses; some businesses sell inventory, others sell services. The goal is to select an appraiser that has experience with your type of business.
There are three main approaches to business valuations: 1) asset-based method; 2) income-based method; and lastly 3) market-based method. Each method has strengths and weaknesses. In many cases, the appraiser must make assumptions about the business, time-value of money, or ownership interest (majority versus minority ownership). These assumptions could have significant impact on the final valuation.
In the asset-based method, the appraiser examines a business’s assets and liabilities to determine its economic worth. This method works best for business that have tangible assets such as inventories. The appraiser usually adjusts the business’s balance sheet assets and liabilities to its fair market value. Once the assets and liabilities have been adjusted, the net assets value of the business is determined by subtracting the liabilities from the assets. One weaknesses of this approach is goodwill. In this case, goodwill is defined as the favorable attributes of business such as its good reputation in the community, innovative management, or skilled employees.
The second approach to business valuation is the income-based valuation method. This approach is used when a business has a history of positive earnings. There are two types of income-based valuation methods. The first is the discounted future income method, which is used when the business’s future income is expected to differ significantly from its current income. The second is the capitalization of income method, which is used when the business’s future income is expected to closely resemble its current income.
In the discounted future income method, the appraiser attempts to project future earnings and cash flows over several years. Once this stream of projected earnings has been arrived at, the appraiser uses a discount rate to determine a present value. The discount rate may be based on the rate of return of a long-term government security. The selection of the discount rate is a highly subjective process, and the present value amount can vary greatly depending on the assumptions of the appraiser.
When an appraiser uses the capitalization of income method, a base year of the business’s earnings are selected and normalized. The normalized earnings are multiplied by a capitalization rate. The capitalization rate is defined as the discount rate appropriate for the business reduced by its estimated growth rate over the long term. Using this method the appraiser is assuming a constant income stream.
The third approach to business valuation is the market-based valuation method. Using this method, the appraiser compares the owner’s business to comparable businesses. The appraiser uses valuation multiples since the owner’s business and comparable businesses are not exactly identical. In addition, the appraiser may wish to compare the owner’s business to the data of industry guideline companies which are published in national journals. The weakness of this method is that the comparable businesses or industry data are not exactly the same as the owner’s business and variations exist.
Business valuations approaches are complicated procedures and this article only covered the general concepts of each approach. As an owner, you should have a business valuation method in your business contract. If not or if it is outdated, you should consult an attorney who can help develop the appropriate method for your business.