Valuation Basics for Business Owners and Investors

Feb 2, 2024

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Whether you’re looking to buy a closely held business, or sell your business, attract investors, gift a portion to your family, or simply understand its worth, here are some basic tips for business owners and investors regarding valuation:

Understand Different Valuation Methods

Various methods exist for valuing a business, including the Market Approach (sales of comparable businesses), Income Approach (a projection of cash flow), and Asset-Based Approach (book value, or assets less liabilities, all stated at market value). While the business owner or investor should not have the same expertise as a credentialled business appraiser, they should understand these methods to see which are most appropriate for their business. Asset methods can produce varying results for a company that has a modest investment in long-term assets and long-term liabilities.  Service companies typically are not valued based on their balance sheet. Real estate holding companies often are. A market approach is often not appropriate in valuing a bespoke, small company.  And most small businesses are bespoke, small companies!  The gigantic public companies and their valuation multiples are way too large, much more diversified and serve a broader geographic market to be relevant.  Private transaction data of sales of similar small companies is frequently too limited to use. An income approach may be suitable.  Under this approach, earnings are normalized to remove nonrecurring transactions such as lawsuits and PPP loan forgiveness.  Owner’s compensation and rent paid to related companies are adjusted to market rates. The objective of this normalizing process is to present financial statements that reflect the results a buyer would see after they purchase the company. No one buys nonrecurring transactions, and no one pays more (or less) than market rates.

Financial Statements and Other Records

Are the financial statements accurate and up-to-date?  Potential buyers or investors will closely examine a company’s financials, including income statements, balance sheets, and cash flow statements. Maintain at least five years’ worth of financial records and support. Preferably, this is more than just tax returns. Growth trends should be highlighted. Some advisors recommend keeping a corporate book outlining not just your financial results but your sales and marketing approach and how you meet customer needs.  Presenting this to a potential buyer will put you well ahead of other opportunities they are reviewing.  You’re the seller that is prepared!

Market Trends and Industry Comparisons

Stay informed about market trends and industry benchmarks and adapt as appropriate. Understanding how a business compares to others in its industry can provide valuable insights into its valuation. A company that is poised to reap the benefit of current or upcoming disruptions in the industry (e.g., use of AI to improve efficiency, use of social media and SEO in marketing), is in a better position than a company that has not adapted.

Customer Base and Revenue Diversity

A diverse customer base and revenue streams can enhance a business’s valuation. Dependence on a single customer or a few key ones may be viewed negatively. Why?  What if the competitive landscape changes and several key customers leave? The Company’s cash flows would significantly decline.  The added risk of customer concentration is imputed in the valuation.  An investor demands to be compensated for the risk in the future cash flows related to customer concentration, for example. Revenue diversity is important.  If consumer preferences shift away from a company’s only product or service, the Company must scramble to diversify revenue. Cash flow would decline.  Investors demand to be compensated for this risk, too.

Intellectual Property (“IP”) and Assets

Identify and value IP, patents, trademarks, and other assets, and protect them. The contribution to the overall value of the business is measured by the incremental cash flow the IP brings to the business.  If the IP is not yet cash flow positive, projections should be used to model probable future earnings as a proxy for value.

Future Growth Prospects

Communicate the business’s growth potential. A solid business plan outlining future opportunities and expansion strategies can positively impact its valuation. Is the business poised for economic change (this can come from a variety of sources including increased manufacturing capacity, a new product line, a shift to online sales and/or remote offices)?  If so, modeling potential growth scenarios would be helpful in the valuation of the business.

Management Team

A competent and experienced management team (including a succession plan) is an asset.  Highlight the skills and expertise of the management team. If the Company operates with one key person – typically the founder- take some time to create a succession plan and train/hire accordingly before the company markets itself for sale.  A younger buyer often does not want to be a one-person team.

Legal and Compliance Issues

Address any legal or compliance issues proactively. Clear documentation and compliance with regulations can instill confidence in potential buyers or investors.

Engage Professionals

Consider hiring professional business valuators, accountants, or financial advisors. Their expertise can provide a more accurate and unbiased assessment of a business’s value. Remember that valuation is both an art and a science, and it often involves negotiation. It’s essential to approach the process with transparency and a realistic understanding of a business’s strengths and weaknesses.   Please feel free to reach out with any questions or comments.