Business succession planning: Valuing your business

Whether it's a local bakery, a medical practice or a tech startup in its early stages, determining the value of a business is important for several reasons, including developing an appropriate succession strategy. Unlike publicly traded companies with readily available market data, valuing a private business can be a complex task.

Business owners generally aren’t experts at business valuation and may overvalue their business relative to what the market would reflect. Without a professional, objective valuation, an owner’s subjective view of their business’s worth can lead to unrealistic expectations and disappointment.

It’s important to know a business’s value even in advance of a planned succession event – and potentially early in a business’s life. The more you know about your business’s financial performance, market position, assets, liabilities and other factors that affect value, the earlier and more easily you can adjust if something heads in the wrong direction. Knowing an objective value over your company’s life cycle can also help set expectations for you and future owners.

Various professionals may be able to offer an opinion of value – your CPA, your company’s chief financial officer or a business broker, for example. Other professionals, such as insurance professionals, can help value individual parts of your business. But working with a qualified valuation professional is often considered the most reliable option for formal valuations – not only will a qualified valuation professional address different methods of valuing a business to determine which is most appropriate, but that professional may also be able to offer opinions of value for different purposes. If you plan to sell your business, you’ll want to get the highest price possible. But if, before a sale, you want to transfer ownership of part or all of the business to family members, especially in the form of a gift, the valuation’s assumptions and purpose can materially affect the result. A qualified valuation professional should be adept at providing a value consistent with your stated goals for the valuation. However, remember that it is important to consult with tax advisors or legal professionals to ensure that the valuation complies with applicable tax laws and regulations.

Understanding the basics of business valuation can help clarify your options as you get closer to succession – and can help you choose the right professional to determine your company’s value.

Fundamentals of valuation

The primary factors that go into the valuation of a business are:

Business valuation: methodology

Business valuation is as much an art as a science. There are a number of ways to value a business. The three most common valuation methods are the asset approach, the income approach and the market approach. Many qualified valuation professionals will review one, two or all three, then select one or weigh multiple methods if more than one is appropriate. A thorough appraisal will cover the background of the business and its industry, explain the method or methods used and why they were selected, and arrive at a conclusion of value. 

Asset approach 

The asset approach arrives at a business’s value based on a business’s balance sheet as of the valuation date. This approach uses the fundamental equation associated with the balance sheet:

Assets = Liabilities + Equity

The asset approach consists of two methods: the book value of equity (BVE) method and the adjusted book value of equity (ABVE) method.

The BVE method is the most straightforward way of valuing the business because it simply looks at the equity on the balance sheet. This method is not used frequently since it does not reflect the fair market value of the business’s assets and liabilities. As a result, it may materially misstate the business’s value.

The ABVE method solves for this discrepancy. Under the ABVE method, the assets and liabilities on the balance sheet are adjusted to fair market value. This adjustment to assets and liabilities results in a more accurate estimate of the value of the business.

The asset approach does not consider the business’s ability to generate profits from its assets, because this approach looks strictly at what’s available on the business’s balance sheet. Most businesses use their tangible and intangible assets to generate a profit. By not considering these profits, the asset approach can undervalue a company that generates large profits. As a result, the asset approach is generally only used for businesses where a large portion of the value is attached to the business’s fixed assets and not its ability to generate profits, such as a real estate holding company.

Income approach

The income approach arrives at the business’s value by analyzing a company’s free cash flow and then discounting or capitalizing it. A business’s free cash flow is how much cash the business has after paying its operating expenses and maintaining its capital expenditures.

Does the business generate net cash after paying:

The income approach also looks at the discount or capitalization rate, which is a measure of risk and return. The discount rate can either be the weighted average cost of capital (WACC) or the cost of equity (COE).

The discount rate is usually expressed as a percentage. The higher the discount rate, the lower the current value will be, and a riskier business will generally have a high discount rate.

There are two ways to apply the income approach to arrive at a value: the capitalization of earnings method and the discounted cash flow method.

The capitalization of earnings method values a business based on its future free cash flows with the expectation of relatively stable, modest growth over time. The free cash flow is then divided by a capitalization rate. Generally, this method is reserved for mature businesses, where the free cash flow is a good indication of the subject business’s future performance.

The discounted cash flow method values a business based on its projected free cash flows discounted by the appropriate discount rate. This method is used where historical free cash flow is not a good indication of the business’s future performance. The discounted cash flow method can be used for many types of businesses where there is a possibility of increased free cash flow over time. The discounted cash flow method adds up the present value of all future cash flows, plus the terminal value of the enterprise, to arrive at a present value.

Market approach

The market approach arrives at a business’s value by comparing a company to other similar companies, either publicly traded or based on prior private sales. This approach assumes that a similar business will sell for a similar multiple of earnings as other businesses in a similar industry and of a similar size.

While the market approach can provide valuable insights, finding comparable businesses to the one being valued is often challenging, particularly for private companies. A qualified valuation professional might help identify suitable comparisons and adjust for differences.

The most common multiple used in this approach is often based on earnings before interest, taxes, depreciation and amortization (EBITDA). You may also see revenue or gross profit multiples. Because those look at top line revenue or gross profit and don’t fully reflect a business’s operating expenses and cost structure, this can skew the valuation. Whatever the chosen multiple is, it is then multiplied by the corresponding financial metric (e.g., business’s EBITDA x EBITDA multiple) to arrive at the value. The key to arriving at a good estimate of value under the market approach is to use appropriate comparable businesses that are similar in size and structure.

Uses for a business valuation

In prior editions of this series, we addressed some of the risks and mitigants for business owners in different stages of the company’s life cycle. Valuation can play a role in all of them.

As you’re starting out, and particularly if you seek capital to help your business grow, knowing whether to borrow money (issue debt) or sell equity can be an important decision. Early-stage debt may come with equity features (such as warrants or conversion terms) to compensate lenders for the risk of lending to a young business. Issuing equity requires you to know how much your company is worth so you know how much of the company you’re parting with. 10% of a company valued at $250,000 ($25,000) is the same amount of money as 2.5% of a company with a value of $1 million – but if you valued your company at $250,000 you’d be selling four times as much equity as if you valued it at $1 million. Note that valuations for equity sales can be complex and subject to negotiation, depending on market conditions and business specifics. Professional guidance is essential when determining the best course of action for selling equity.

As your company grows and you take on partners, knowing the value of the company can help as you think about risk management. Do you need to insure real estate or other tangible assets? Do you need key person insurance to fund a buy-sell agreement?

While the value for buy-sell agreement purposes isn’t necessarily the same as fair market value, it can be helpful to know if those values are far apart. Too much disparity could lead to unnecessary complexity and possibly litigation if the time comes that one owner or the business has to buy a deceased owner’s interest from their family. In buy-sell agreements, it’s important to consult legal and financial advisors so all parties agree on valuation methods and expectations.

As your business matures and you look to succession planning, valuation becomes critical. Does the business have value outside of your involvement? Can its management and employees carry on the business without you? Will a new owner – whether a family member or an outside third party – be able to retain key personnel and continue to grow the business? If your transition relies on the new owners paying you over time based on the cash flow from the business, those questions can be key in determining how much you’ll want to take as a down payment, how much interest you’ll charge, and so forth – and knowing the base value will help both parties determine the feasibility of the transition.

On the personal side, will the transition of the business give you enough (either cash flow over time or a lump sum from a sale) to allow you to accomplish your financial goals, whatever they are? Having a financial plan that shows you the likelihood of you achieving your goals at various prices for your business can give you a good sense of how much you need to sell the business for – and can inform your timing, if the business today won’t support that valuation.

Valuation supports important business decisions throughout a company’s life. A professional valuation, refreshed periodically, can help you make more informed decisions as your company grows and as you approach succession.

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