It’s important to know your business’s value for multiple reasons. You’ll likely need to present this figure when speaking to investors and financial institutions. If you sell your business, you must make sure to offer an appropriate price. When reaching out for media coverage, attaching an impressive valuation to your business will greatly increase your appeal.
Some business owners determine value by simply looking at the “total equity” section of their balance sheet. This will tell you your business’s “book value,” or your business’s worth at this particular time. But that’s based on just one method of business valuation. Alternative business valuation methods incorporate numerous other factors and can therefore produce wildly different results.
It’s up to you to figure out which business valuation method will ultimately give you the highest or most sensible number. Welcome to yet another essential skill of the modern business leader: choosing the right valuation method. Though one particular method will likely make the most sense for your business, every entrepreneur should understand the three primary methods: market value, asset-based, and ROI-based.
In this guide, we’ll explain how to apply the primary methods as well as several others with highly specific criteria.
What Are Business Valuation Methods?
Before delving into what makes each valuation method different, we must first establish what they have in common. All business valuation methods have the same purpose: to determine the current worth of your business. They accomplish through calculations that can involve your business’s assets, like equipment, inventory and property, along with financial data like revenue, profitability, and projected earnings.
But different industries measure their success in different ways. Even the most successful restaurants, for example, have notoriously low profit margins. Plenty of businesses also don’t own property or expensive equipment. And you can’t disregard location: it costs so much money to operate in certain cities that merely staying open for several years could warrant an increase in worth.
Then, you have to consider the reason for doing these calculations in the first place. If you’re selling your business, the buyer will likely gain much more than just tangible assets. There’s the value of the brand name, the amount of existing customers, and the inherited partnerships with your most loyal suppliers. But some of these factors likely wouldn’t come into play when establishing partner ownership percentages or applying for small business loans.
As you can see, determining the best valuation method for your business can get pretty complicated. That’s why certain situations, like buying an existing business, undoubtedly call for the expertise of business valuation professionals.
Yes, these services can cost several thousand dollars but you won’t have to worry about possibly using the wrong valuation method. And if you do use the wrong method, you stand to lose much more than the cost of good help.
3 Primary Types of Business Valuation Methods
Most businesses use one of the following three methods to determine their value. Though each option incorporates its own criteria, it’s not uncommon for the same business to use multiple methods at different stages of its development. Thus, all entrepreneurs should know how to calculate each method under the right circumstances:
1. Market Value Business Valuation Method
Instead of assets or financial data, this method derives the value of your business from the final selling price of other businesses in your industry and general location. This arguably makes the market method the most subjective option. It prevents you from overvaluing the business and coming up with an unrealistic figure.
You cannot accurately apply the market method, however, without proper data on local competitors. Sole proprietors should probably choose another method because unlike LLCs and corporations, they cannot access data on other sole proprietors simply by visiting an online database.
The market method also doesn’t involve as many exact, indisputable numbers as other methods. Two people could have different opinions as far as what makes your business more or less valuable than your competitors. For example, an increase in monthly rent doesn’t always mean the neighborhood has officially become the new hot spot for small businesses.
In other words, you might have to do some negotiating before both parties come to an agreement. Smart investors and buyers will not accept an initial offer based on your opinion or other indeterminable factors.
For that reason, many entrepreneurs only use market valuation to compare it to the other two methods. If the results of the other two don’t even enter the same ballpark as the first, it’s time to reconsider their criteria.
2. Asset-Based Business Valuation Methods
The two main asset-based valuation methods derive value from your business’s assets and their projected worth in the coming years. Both methods incorporate your total net asset value and your total liabilities, which you can find on your balance sheet. Subtracting the latter from the former will produce your business’s current total equity.
Now, let’s explain the differences between the two methods: Going-Concern and Liquidation Value.
“Going-Concern” is just another name for the balance sheet-based formula mentioned above: assets minus liabilities. This method, however, should only be used by businesses that will not be liquidated and do not plan on selling off any of their assets in the near future. To clarify, the Going Concern method is not meant for businesses with short lifespans. These businesses should instead use the Liquidation Value approach:
Assets are usually sold for lower prices than their current market value. So, rather than just using the data on your balance sheet, the Liquidation Value puts your net total assets at a lower number. The total value you come up with will therefore be significantly lower than what you would get with the Going Concern approach.
Remember, you wouldn’t use the Liquidation Value approach unless the business has breathed its last breath. In this case, you would want to sell the business as quickly as possible. The Liquidation Value approach simply makes it easier to do that by competitively pricing your total assets.
3. Earnings-Based Valuation Methods
These three methods derive value from arguably the most practical factor: financial data. This includes cash flow, revenue, profitability, etc. Most Earnings-Based valuation methods use current data to make projections, which makes them ideal for financially stable and consistent businesses. Successful young businesses, however, may benefit from Earning-Based valuation methods if they can essentially guarantee that their current numbers will only increase year after year.
Discounted Cash Flow (DCF)
The DCF method (also known as the “income” method) bases the business’s value entirely on cash flow. It takes the business’s current and projected cash flow to create an adjusted, or “discounted” cash flow that ultimately determines the final value.
Capitalization of Earnings
Like DCF, this method places the most emphasis on the business’s future financial health. But instead of projections for cash flow, Capitalization of Earnings bases the value on projections for profitability. The accuracy of these projections stems from the incorporation of numerous factors like current cash flow, the new owner’s expected annual ROI (return on investment), and the logistical value of the businesses in the coming years.
Times Revenue Method
This method (a.k.a. the “Multiples of Earnings” method) uses a multiple of the business’s current revenue to determine its maximum value. The chosen multiple depends on various factors, like industry, the financial health of other businesses in the area, and general economic climate. So, while the value of one business might be half of its current revenue, another business might be valued at twice its current revenue.
4. ROI-Based Business Valuation Method
The ROI-based business valuation method (a.k.a. the “Shark Tank” method) revolves around convincing investors to buy stock in your company. Rather than deriving value purely from assets or hard data, this method derives value from the company’s current and projected overall success. In other words, the ROI-Based valuation method ultimately allows you to propose valuations your current cash flow or profitability might not fully support.
Business owners who use this method typically intend to only sell percentages of their businesses. So, when speaking to investors, they usually won’t announce the business’s total value. Instead, they will just reveal the value of the prospective investor’s stake (yes, like on Shark Tank). The investor then uses this percentage to calculate the value of 100% of the business.
For example, let’s say the business owner offers an investor 25% of his or her business in exchange for $300,000. The investor would then do some simple math to arrive at a total valuation of $1.2 million.
If you’ve watched Shark Tank, you know that whenever an entrepreneur presents an offer, the sharks immediately start writing on their notepads. Are they merely writing down what the entrepreneur just told them? Nope: they are calculating the business’s total valuation. Once they have that written down, they can see if this valuation still makes sense after the entrepreneur throws some more numbers at them (revenue, profit margin, etc.).
Still Not Sure Which Method to Use?
Choosing the right valuation method for your business requires the consideration of myriad factors. On top of basics like industry and revenue, you must also account for the size of your business, growth rate, and financial stability. Since no two businesses will match up in every one of these areas, you cannot just choose the method that worked for your closest competitors.
The number of factors involved in this process should explain why it makes sense to look into business valuation professionals. Very few business owners have the time to lay out every potential factor and, based on this criteria, figure out which method to use.
Be Prepared to Explain Your Valuation Method
Investors and buyers will want to know which valuation method you used to arrive at your proposed price. So, you’ll have to explain why your chosen method makes sense for your business and what kind of math it involved.
Remember: your business valuation professional chose the right method for you after reviewing large swaths of data. Investors and buyers may ask for these figures (profit margins, asset value, etc.), and it’s your job to know them off the top of your head.
Business owners are accustomed to skirting the truth every now and then. In this case, however, you must answer all questions with the utmost honesty, especially if you are selling your business. The buyer’s team will eventually examine your financial statements. Admitting your flaws early on poses much less risk than the buyer unearthing something contradictory to your initial claims.
Everything Else You Need To Sell Your Business
Now that you know your business’s valuation, you can move on to gathering the other resources required for selling your business. The buyer’s accountant and lawyer will need to review significant paperwork, so you should probably get those documents in order and make sure they all check out. These documents must support your proposed valuation and prove that your business has no hidden issues that would dissuade the buyer.
Before letting the seller’s team examine your documents, you should ask the seller to sign a confidentiality or nondisclosure agreement. This confirms that the seller will not publicize any private information that gets uncovered during this process.
Here are the most important documents to have on-hand before selling your business:
Business Licenses and Permits
Every business needs some sort of licenses or permits. The buyer’s team will likely want to examine these documents first. If your business is missing or has not renewed an essential license or permit, you are technically breaking the law. Common examples include health permits, environmental permits, fire department permits, and seller’s licenses for products like liquor, firearms, or gasoline.
If your business is an LLC or corporation, you must show proof that you are registered with the state. LLCs must have articles of organization whereas corporations must have articles of incorporation. Like the previous section, an LLC or corporation without these documents is breaking the law.
Certificate of Good Standing
The buyer may request this document from your secretary of state to prove that your business has paid taxes, filed required documents, and complied with all other state-mandated regulations.
Contracts and Leases
This refers to business partnerships as well as unowned assets like the physical location, equipment, etc. You may have leases that will expire very soon or contracts with somewhat unfair terms. In this case, the new owner would have to negotiate new terms and therefore add one more thing to their already massive list of new duties.
The buyer will also want to look at your contracts to see if your business obtains the majority of its products or revenue from one client. What would happen if that client went out of business?
Lastly, check if the individual or company that drafted your current contracts and leases has no issue transferring them from your name to the new owner’s.
In addition to financial statements, this refers to tax returns, sales records, accounts receivables, accounts payables, and debt disclosures. Many businesses appear successful when in reality, they just got lucky not too long ago. The buyer’s accountant will test the legitimacy of your business’s success by examining three years’ worth of financial statements.
These documents will also denote whether your business’s profitability has increased or decreased. Businesses that have increased or maintained the same level of profitability for at least three years will most likely continue this path.
Closing The Deal
Once the two parties have agreed on a price and the buyer has financing in place, the final step is yet another checklist of documents. The final sale cannot take place without the following paperwork:
Bill of Sale
This document officially makes the buyer the new owner of the business’s assets.
This is the final purchase price, with all assets and expenses included.
If the buyer is taking over an existing lease or has negotiated a new one, this confirms that your former landlord is aware of the sale.
Is a vehicle among the buyer’s new assets? If so, he or she register as the new owner with the DMV.
This refers to the transfer of all patents, trademarks and copyrights to the new owner’s name.
This legally prohibits you (the seller) from opening up a competing business.
If you plan on staying onboard as an employee, this document shows that both parties are in agreement.
IRS Form 8594
Also known as an Asset Acquisition Statement, this document lists all the assets the buyer has acquired along with their value. Having all this information in one place comes in handy when new owners of existing businesses do their tax returns.
Bulk Sale Laws
“Bulk sales” or “bulk transfers” refer to the transfer of large amounts of assets, most notably inventory. Federal bulk sales laws typically only apply to businesses in bankruptcy. State bulk sales laws prevent businesses from doing bulk transfers solely to avoid state sales taxes.
Is the new owner inheriting a large amount of inventory? Depending on your state, the new owner may have to obtain a special certification to prove that you are not transferring over the inventory solely to avoid paying taxes on it.
Yes, This Could Take a While
You may think you’re ready to let go of your business. But being ready for the process of letting go of your business is a whole other story. For some businesses, this process can take well over an entire year. Working with the buyer’s team (people you’ve never met) for this long can be emotionally draining, especially if you still aren’t sure you are selling to the right person.
In summary, do not sell your business if you are not feeling 100% for any reason. Lacking the energy and focus required for the selling process increases the risk of careless decisions. When it comes to life-changing moments like this, even the tiniest bit of doubt can leave you unhappy for a very long time.