Business valuation is required to establish fair value and realistic price for businesses. Valuation is required for several reasons including:
- Buying and selling businesses (acquisitions).
- As a Key Performance Indicator (KPI) to maximize business value.
- Facilitate business mergers.
- Settle legal issues.
It is considered as a good practice to keep the business valuation reasonably current. When buying or selling a business, both parties must value the business independently. If the buyer’s valuation and seller’s valuations are in the zone of probable agreement (ZOPA) there may be potential to negotiate and close the deal.
Valuing a small businesses requires collecting and analyzing relevant information. Collecting information for business valuation starts with industry analysis and analyzing the company’s financial statements. Industry analysis can be completed using Porter’s five force analysis. Additional due-diligence includes quantifying addressable market and determining the current market share of the business.
There are several financial valuation techniques to determine the intrinsic value of a business. The valuation methods are broadly based on Market Value, Asset value and Earnings value of the business. Market value methods use industry multipliers to determine the value of a business. Asset value methods are based on discounting future cash flow of the business and earnings value methods are based on discounting future earnings of the business. Business buyers should ask for at-least five years of financial statements and tax returns before valuing a business.
Market Value Techniques
Market value techniques can be used to quickly determine the value of a business. Businesses use “Rules of Thumb” to quickly value their business. It is a great approach to quickly determine the value of a company before conducting deeper financial analysis using asset based and earnings based valuation techniques. There are “Rules of Thumb” for almost every type and size of business and they are generally based on multiples of earnings, cash flow and annual revenue. Following are examples of market based valuation.
- Accounting firms are generally valued at 100-125% of annual revenue.
- Gourmet coffee shops are valued at 40% of annual sales + inventory
- Law Practices are valued at 90–100% of annuals revenues
Usually industry associations can provide Rules-Of-Thumb multipliers. Market value techniques should not be used as the only technique to determine value. It is used to give the business owner a rough idea of the business and must be followed up with detailed financial analysis.
The most popular method to value privately held business is the use of EBITDA multiples. EBITDA multiple and re-casted EBITDA multiple account for more than 65% of all valuations. Across all business types the average multiple for businesses with EBITDA between $0 and $1 Million is approximately 4.2.
Intangible assets are non-physical assets that create value for the business owner and have legal rights attached to them. Intangible assets are not factored into intrinsic value of the business. In some cases intangible assets can account for a very large component of a business, and ignoring it can skew valuation. So it is important for a business owner to keep track of all intangible assets and add it to the intrinsic value to get the correct picture. Valuing intangible assets starts with first identifying and listing all intangible assets. Following are examples of intangible capital in a business:
- Brand value – A strong brand can easily be monetized by keeping prices higher than the competition.
- Systems of differentiation developed by the small business to compete effectively in the market place.
- Customer relationships, which includes loyal customer base and loyalty systems.
- Internal Business Processes, Technical expertise, Patents, Copyrights, Trademarks, Trade names, Non-compete agreements and R&D.
- Licensing agreements, Service contracts, Supply agreements, and Franchise agreements.
Nitin Gandhi is a student at Cornell, and writes a blog about small business mergers and acquisitions.