What is Business Valuation?
Business valuation is a process and a set of procedures used to estimate the economic value of an owner’s interest in a business. Valuation is used by financial market participants to determine the price they are willing to pay or receive to effect a sale of a business. In addition to estimating the selling price of a business, the same valuation tools are often used by business appraisers to resolve disputes related to estate and gift taxation, divorce litigation, allocate business purchase price among business assets, establish a formula for estimating the value of partners’ ownership interest for buy-sell agreements, and many other business and legal purposes such as in shareholders deadlock, divorce litigation and estate contest.In some cases, the court would appoint a forensic accountant as the joint expert doing the business valuation.
Three Business Valuation Methods
1. Asset-Based Approaches
Basically, these business valuation methods total up all the investments in the business.
Asset-based business valuations can be done on a going concern or on a liquidation basis.
- A going concern asset-based approach lists the business’s net balance sheet value of its assets and subtracts the value of its liabilities.
- A liquidation asset-based approach determines the net cash that would be received if all assets were sold and liabilities paid off.
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 a sale of the business. Assets in a sole proprietorship exist in the name of the owner and separating assets from business and personal use can be difficult.
For instance, a sole proprietor in a lawn care business may use 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.
2. Earning Value Approaches
These business valuation methods are predicated on the idea that a business’s true value lies in its ability to produce wealth in the future. The most common earning value approach is Capitalizing Past Earning.
With this approach, a valuator 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.
What might such capitalization rates be? In a Management Issues paper discussing “How Much Is Your Business Worth?”, law firm Grant Thornton LLP suggests:
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, will existing customers automatically expect that a new owner delivers the same degree of service and professionalism?
Any Business 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. Note that this can be mitigated in many cases, such as when a trusted family member (who may already be familiar with the client list) takes over the business.
3. Market Value Approaches
Market value approaches to business valuation attempt to establish the value of your business by comparing your business to similar businesses that have recently sold. Obviously, this method is only going to work well if there are a sufficient number of similar businesses to compare.
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 like businesses is not an easy task.
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.
Why Do I Need A Business Valuation?
1. To Be Prepared for Unsolicited Offers or Unforeseen Events
2. To Be in a Position of Strength When Negotiating a Sale
3. To Manage Tax Transactions Efficiently
4. To Be Armed to Question a Potential Buyer’s Valuation
5. To Aid in the Avoidance of Buy-Sell Disputes
6. To Protect the Value of the Business
7. To Enhance the Performance of the Business
8. Third Parties Will Have an Interest in Valuing the Business
9. To Obtain the Best Combination of Price and Terms in the Market
10. To Evaluate the Impact of the Business on the Owner’s Personal Balance Sheet
11. To Determine the Return the Business Owner Realizes
12. To Determine the Optimal Use of Financial Leverage for the Business
13. to Assist in the Development of Dividend Policy
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