A Beginner’s Guide To Business Valuation
A business valuation can be a confusing subject if you aren’t well versed with how or when it’s done. However, if you plan to buy or sell a business, getting a valuation is the first step to make the right call. That’s because a business valuation represents the amount buyers in the market are willing to pay for a company, which can be very different from what you personally feel it’s worth.
The valuation of a business explains various facts and figures about the worth of a company in terms of income values, market competition, asset values, and more. With this information, you have an idea of how much you will earn or need to spend. On the other hand, without these details, you may have an inaccurate guess of the actual worth of the company and end up making decisions that could ruin your future financial plans.
To help you understand all the concepts and the procedures behind having a business valuation done accurately, Roxanne Coffelt CPA LLC has put together a Beginner’s Guide to business valuation. Through this guide, you will learn about different business valuation requirements and the methods of valuation most suitable for your needs.
Know when a valuation is required: To buy or sell a business, getting a business valuation done is of utmost importance. Similarly, a business valuation is also vital in case of gifting an interest in the business (gift tax return), inheritance tax returns, step up in basis upon inheritance, estate planning, Section 409a (deferred compensation), marital dissolution, buy or sell agreements, and more.
Keep business information ready: For a complete picture of the business, your valuation professional will need to have access to a lot of details like accurate financial statements or tax returns, information on key employees, wages and benefits, competitors, suppliers, and other particulars too. It may seem somewhat intrusive, but it may prevent you from having an unpleasant surprise down the road.
Understanding the valuation approach: There are three main approaches to valuing a business. They are as follows:
a. Asset approach: This method values a business based on the assets it owns, i.e., property, plant, and equipment. It is an excellent approach if someone is interested in buying only the assets, or if the company is going out of business and will liquidate. However, it is usually not the best method for what we call a “going concern,” or a business that will continue operations.
b. Market approach: This method looks at comparable sales. The valuation professional uses one or more databases of business sales to identify businesses in the same industry that sold, and how much they sold for. This may be expressed as a multiple of sales, for example, Business A sold for 1.2 times its annual revenue. It may or may not be the best method to use, however, It will be more appropriate if the business is a common one, giving it more sales to compare to. If the business is unique, there may not be any comparable sales. The other problem is that the details of each sale are unknown. For example, maybe Business D owns its shop while Business E is renting and the real estate was included in the sale. This is somewhat mitigated by throwing out any comparable sales that are outside of the normal range.
c. Income approach: This approach values a business from the point of view of investment. How much would a buyer pay to get the income stream that this investment will provide? Once again, we need to look at the specifics of that income stream and adjust for anything that would be different under a new owner. These are called normalizing entries. Sole owner businesses, particularly, often have discretionary expenses that a new owner might not have. Maybe the owner just bought a brand new $60,000 SUV and has it on the company books. Perhaps they put their spouse on the payroll even though they work somewhere else. Or, maybe the spouse works for free, and if you buy the company, they aren’t going to do that for you. Once the normalized income (or cash flow) is determined, a value is arrived at by “capitalizing” those earnings or discounting projected cash flows back to a present value.
There are also premiums or discounts involved. A discount may be applied for lack of marketability or minority interest. A premium, however, may be applied to a controlling interest. Other things to consider, regardless of the approach used, would be potential liabilities such as pending lawsuits or environmental cleanups.
Advice From The Pros
Rule of thumb: Some people use what is called a “rule of thumb” when valuing a business. This is usually expressed as a multiple of earnings or revenue. As each business is unique, a rule of thumb is not necessarily accurate. That is why, CPAs, according to our professional standards, are not allowed to value a business using a rule of thumb.
Use an experienced professional: If you need a business valuation, make sure you find someone who has specific training and experience in the area of business valuations rather than someone who will just use a rule of thumb without understanding the unique attributes of a business.
A CVA (Certified Valuation Analyst), has trained and demonstrated competency in business valuation. My goal, as your CVA, is to exceed your expectations through delivering exceptional, personalized valuation and consulting services to small and medium businesses. For satisfying solutions to all your business valuation, tax, financial planning and analysis, and litigation support needs, book an appointment with our Warsaw, Indiana CPA practice, Roxanne Coffelt CPA LLC.