3 Business Valuation Methods
How to Determine What a Company Is Worth
A business valuation is a way to determine the economic value of a company, which could be useful in several situations. For example:
- You may need to sell the business due to retirement, health, divorce, or for family reasons.
- You may need debt or equity financing for expansion or due to cash flow problems, in which case potential investors will want to see that the business has sufficient worth.
- You may be adding shareholders (or one or more shareholders may ask for a buyout). In this case, the share value will need to be determined.
Whatever the reason, performing a business valuation will help you set an appropriate price for the sale of the business.
Three Business Valuation Methods
When determining the value of a company, there are three ways to evaluate worth:
- Asset-based approaches
- Earning value approaches
- Market value approaches
Each approach has its considerations, and if you own a sole proprietorship there are further factors to consider.
Essentially, an asset-based business valuation will total up all the investments in the company. Asset-based business valuations can be done in one of two ways:
- A going concern asset-based approach takes a look at the company's balance sheet, lists the business's total assets, and subtracts its total liabilities. This is also called book value.
- A liquidation asset-based approach determines the liquidation value, or the net cash that would be received if all assets were sold and liabilities paid off.
Asset-based Valuations of Sole Proprietorships
Using the asset-based approach to value a sole proprietorship is more difficult. In a corporation, all assets are owned by the company and would normally be included in the sale of the business. Assets in a sole proprietorship, on the other hand, exist in the name of the owner, and separating business assets from personal ones can be difficult.
For instance, a sole proprietor in a lawn care business may own various pieces of lawn care equipment for both business and personal use. A potential purchaser of the business would need to sort out which assets the owner intends to sell as part of the business.
Earning Value Approaches
An earning value approach is based on the idea that a business's value lies in its ability to produce wealth in the future.
- Capitalizing Past Earning determines an expected level of cash flow for the company using a company's record of past earnings, normalizes them for unusual revenue or expenses, and multiplies the expected normalized cash flows by a capitalization factor. The capitalization factor is a reflection of what rate of return a reasonable purchaser would expect on the investment, as well as a measure of the risk that the expected earnings will not be achieved.
- Discounted Future Earnings is another earning value approach to business valuation where instead of an average of past earnings, an average of the trend of predicted future earnings is used and divided by the capitalization factor.
Earning-Based Valuations of Sole Proprietorships
Valuation of a sole proprietorship in terms of past earnings can be tricky, as customer loyalty is directly tied to the identity of the business owner. Whether the business involves plumbing or management consulting, the question is: Will existing customers automatically expect that a new owner will deliver the same degree of service and professionalism?
Any valuation of a service-oriented sole proprietorship needs to involve an estimate of the percentage of business that might be lost under a change of ownership.
Market Value Approach
Market value approaches to business valuation attempt to establish the value of your business by comparing your company to similar ones that have recently sold. The idea is similar to using real estate comps, or comparables, to value a house. This method only works well if there are a sufficient number of similar businesses to compare.
Market-Based Valuations of Sole Proprietorships
Assigning a value to a sole proprietorship based on market value is particularly difficult. By definition, sole proprietorships are individually owned, so attempting to find public information on prior sales of similar businesses is not an easy task.
The Best Choice May Be a Combination
Although the Earning Value Approach is the most popular business valuation method, for most businesses, some combination of business valuation methods will be the fairest way to set a selling price. The first step is to hire a professional Business Valuator; she will be able to advise you on the best method or methods to use to set your price so you can successfully sell your business.
Having the Valuation Done Professionally
Business owners should not do their own business valuation; they won't have the necessary distance to be objective.
To ensure that you set—and get—the best price when selling a business, have it performed by a professional. A Chartered Business Valuator (CBV) can be found through the American Society of Appraisers (ASA) in the U.S.; in Canada, you can find them through the Canadian CBV Institute.
Non-competition clauses are frequently included in agreements for the sale of a business, particularly in cases where goodwill forms a significant part of the valuation. No one wants to purchase a business on the assumption that current customers will continue to patronize the business only to have the previous owner immediately join a competitor or even open a similar business in the same area.
Non-competition clauses typically contain restrictions such as:
- Forbidding the seller from opening up a competing business in the same geographical area
- Placing a time limit restricting the seller from direct competition—say, for five years
Non-competition agreements can be a thorny legal issue and are often the subject of court cases between buyers and sellers after a business is sold.
From a legal standpoint, to enforce the restrictions placed in a non-competition clause, they must be clearly defined and 'reasonable'. Non-competition covenants can be nullified by the courts if it is determined that enforcement places overly broad and/or unreasonable restrictions on the seller's ability to continue his trade and earn a living.
Non-competition clauses should be reviewed by the legal representatives of both buyer and seller prior to the sale of the business.
What About Franchise Businesses?
Franchise agreements generally define how a franchise can be sold, and these vary by franchise vendor, so check your franchise contract. Some contracts stipulate that the franchisors will buy back your franchise directly for a fixed price. Others assist with valuation and locating a buyer, as it is in their best interest to make sure that the business continues uninterrupted.