July 23rd, 2024
Every business person or entrepreneurs, at some point, will wonder what is the value of their business. Also, when attempting to sell your business, potential buyers would ask you: how did you arrive to the value or price for your business?
A business venture can be valued a few different ways and these methods are not always scientific and can vary depending on how the valuation model is applied to that specific business model, or industry or product/services.
A starting point is to ask a few relevant questions about the business.
How much is the stock worth?
How much are the assets worth?
How much value is attributed to the management team?
Does the company have a long-standing management team with a successful track record?
Does the company have a strong balance sheet?
What is the price of a share?
Are their dividends paid or not?
At the end of this article, you will agree: there is not a perfect way to determine a business’s value.
You could always hire a professional or a highly respected valuation appraiser to give you a certified document. Still, if you are selling your business, a buyer may not agree with your valuation. And if you are buying, you can simply make an offer far below the valuation/price, and then walk away if the seller does not agree to your price. The seller has no option other than to react to your assessment of his/her business value.
There are a few things that everyone can agree to, however.
These are the factors that affect the value/price of a business:
1. Tangible assets, which are things like inventory, equipment, machinery, computers, servers, property, and other such tangible assets.
2. Intangible assets, which are things like patents, trademarks, other intellectual property rights, domain names, and brand recognition. Intangible assets are thing that ADD VALUE, to your business. It is often hard for business owners to have a real value of their intangible assets. These assets are most often undervalued as business owners are often inclined to look at problem solving (and hence problems with a business), rather than opportunity measurement (considering the value from someone else’s point of view).
3. Liabilities are the debts of the business which very much affects the value of the business, of course.
4. Financial metrics refers to the standing of the current position of the company/business. For instance, is it profitable? Is it about to go bankrupt? Is debt due that cannot be paid? How much revenue does it bring in? Is the market for this product/service growing rapidly? Is the industry on the rise or declining?
By establishing a clear determination of your tangible and intangible business assets, an owner can understand and make decisions based on a realistic valuation. It allows owners to ask pertinent questions, like:
1. Is the direction of the business one that is viable and practical?
2. Is the brand valuable and does it have a perceived worth?
3. Is the revenue growth and market share acquisition and retention make the business valuable?
4. Is a lot of the capital in the business tied up to inventory?
5. Who are the 20% clients that generate 80% of the business revenue?
All of these help with establishing a more realistic valuation of the business, whether you are a buyer or a seller.
Couple of formulas that are often thrown around are SDE and EBITDA. Most accounting systems in U.S. are based on GAAP (Generally Accepted Accounting Principles). These two terms (formulas) are important to discuss here.
SDE, refers to “Seller’s Discretionary Earnings”, which is the business’s net income prior to deducting the owner’s salary. Other discretionary and non-operating expenses are added back in for calculating SDE.
EBITDA refers to earnings before interest, depreciation, and amortization. The calculation for EBITDA is really straight forward.
SDE is often used for small business valuation and EBITDA is often used for larger corporations which have a more complex business structure.
Some people prefer using a “Comps method” for small business valuation. This method simply uses the comparative method to compare a business to others in the same industry and get an accurate idea what that business is worth.
In most cases, three valuation principles help in determining a business’s worth:
1. Asset-based approach to valuation
2. Earnings-based approach to valuation
3. Market-value comparisons and marketing share prospecting valuation
Valuation can also take a more analytical view of a business. For instance, it looks at the business itself in more detail to establish value and capitalization and the operations of the business.
Things to consider are:
1. Efficiency ratios (revenue generated per employee)
2. Business leverage ratios (debt to equity)
3. Interest coverage
4. Profit margins
5. Patents/trademarks and proprietary product positioning in the industry
6. Number and quality/experience of management team
7. Use of proceeds from the business (re-investment or debt repayment, or salaries)
8. Operating base (regional, nationwide, or international)
9. Operating history
10. Product differentiation, brand, innovation, and reputation
All of these or often, a combination of these, are used to determine the valuation of a business for buyer or the seller.
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