If you own or co-own a business, it’s likely the most valuable asset in your possession. But the question is and will remain throughout your tenure as an owner: Just how valuable is it?
The answer is variable because, as you’re likely aware, the value of a company rises and falls depending on a number of factors — not the least of which is the national economy and the state of your local market as it rebounds from the COVID-19 pandemic. For this reason, it’s important that any business owner place a high value on small business valuation.
More than M&A
Perhaps the most common purpose of a small business valuation is a prospective ownership transfer, such as a merger or acquisition. Yet strategic investments — such as expanding into a new construction specialty or buying a large piece (or multiple pieces) of new equipment — can also greatly benefit from an accurate appraisal. As growth opportunities arise, business owners have only limited resources to pursue chosen strategies. A small business valuation can help plot the most likely route to success.
But hold on, you might say, why not simply rely on our tried-and-true projected financial statements for strategic planning? One reason is that projections ignore the time value of money because, by definition, they describe what’s going to happen given a set of circumstances. Thus, it can be difficult to compare detailed projections against other investments under consideration.
Valuators, however, can convert your financial statement projections into cash flow projections and then incorporate the time value of money into your decision-making. For instance, in a net present value (NPV) analysis, an appraiser projects each alternative investment’s expected cash flows. Then he or she discounts each period’s projected cash flow to its present value, using a discount rate proportionate to its risk.
If the sum of these present values — the NPV — is greater than zero, the investment is likely worthwhile. When comparing alternatives, a higher NPV is generally better.
READ MORE: Crafting a Buy-Sell Agreement
Critical parts of the small business valuation process
Understandably, many business owners don’t know what to expect from a valuation. To simplify matters, you can break down the appraisal process into three critical parts.
First, there’s the purpose. This could be as clear-cut as an impending sale, of course. But perhaps an owner is divorcing his or her spouse and needs to determine the value of the business interest that’s includable in the marital estate. In other cases, an appraisal may be driven by, as mentioned, strategic planning. Have I grown the business enough to cash out now? Or how much further could we grow based on our current estimated value? The valuation’s purpose strongly affects how an appraiser will proceed.
Second is something called the standard of value. Generally, small business valuations are based on fair market value — the price at which property would change hands in a hypothetical transaction involving informed buyers and sellers not under duress to buy or sell. But some assignments call for a different standard of value. For example, say you’re contemplating selling to a competitor. In this case, you might be best off getting an appraisal for the “strategic value” of your company — that is, the value to a particular investor, including buyer-specific synergies.
Third is the basis of value. Private business interests typically are designated as either “controlling” or “minority” (nonmarketable). In other words, do you truly control your business or are you a noncontrolling owner? Defining the appropriate basis of value isn’t always straightforward. Suppose a company is split equally between two partners. Because each owner has some control, stalemates could impair decision-making. An appraiser will need to definitively establish basis of value when selecting a valuation methodology and applying valuation discounts.
The right expertise
As you can see, small business valuation is hardly a simple process. But it’s typically an insightful one when performed by a professional appraiser with thorough knowledge and experience in your industry. Contact us today to talk to one of our small business valuation analysts who can answer your questions.
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