Business Valuation Methods: Everything You Need to Know
Business valuation is important because prospective investors might want to determine the company's value. 3 min read
Importance of Business Valuation Methods
Business valuation methods are used to determine how much a business is worth. Business valuation may come in handy for when an entrepreneur needs to sell their business due to retirement, health issues, divorce, or other family concerns. Or, an owner may need debt or equity financing for company development or operational expense problems.
Business valuation is important because prospective investors might want to determine the company's value. If an owner wants a valuation done right, it takes a lot of preparation and planning and should be done by a professional. Business valuation methods all rely on the same economic principle, but use different mathematical details and procedures.
There is no one way to establish what a business is worth because business value means different things to different people. For example, economic conditions might influence what a person believes a particular business is worth. When jobs are hard to come by, there’s an increased competition which results in a business being valued at a much higher price.
Three Methods of Business Valuation
Every business valuation method falls under three categories:
- Asset approach
- Market approach
- Income approach
An asset-based approach, occasionally referred to as a cost-based approach, will look at the sum of all the business’s investments. These valuations can either be done on a going concern, or a liquidation basis.
A going concern asset-based valuation itemizes the net balance sheet value of its assets, and deducts the value of its liabilities. The net asset value of your company is the total market value of all the assets it holds, such as machinery, equipment, cars, computers, and properties. You must subtract the value of any liabilities, including finance, leases, debts, or other money or equipment owed. A liquidation asset-based valuation computes for the net amount to be received for selling assets and paying off liabilities. Because assets in a sole proprietorship are indistinguishable from the owner's personal assets, unlike in a corporation, using an asset-based valuation method may be difficult.
An income-based approach will look at how much wealth the business can produce in the future and determine its value based off of that. Capitalizing Past Earning is the most common approach and uses a business' record of previous earnings to determine the cash flow to be expected.
Because customer loyalty is proportional to the identity of the owner in a sole proprietorship, valuation through past earning may be difficult. Service oriented sole proprietorship must take into consideration possible losses to be incurred during a change in ownership, which can possibly only be reduced if the successor is a trusted family member.
A market-based approach determines the business’s value by looking at similar businesses that have been sold and what they sold for. This approach is only feasible if there are a substantial number of similar business in the market.
Because sole proprietorships are privately owned and that have limited information out in public, it is difficult to conduct a valuation based on its market value. Transactions concerning small capitalization public companies are frequently used as indication of business value for privately owned firms. Valuation Formulas resulting from similar business sales are a typical way to determine the business fair market value.
However, the best way to determine a business’s value is to combine each of the three valuation methods described above. Using multiple methods allows the business owner to have the most accurate assumption about how much is business can sell for. Although each method might produce varying results, the business valuation differences need to be reconciled.
With regard to franchise businesses, it is better to refer to a franchise agreement. These agreements state how a franchise can be sold. Certain franchise contracts specify that franchisors may buy back a franchise for a fixed price, while others may provide assistance with valuation and finding potential buyers.
Other valuation aspects
Businesses are commonly valued without considering extra cash or long-term debts. Valuation runs as if there is no debt or surplus; the real price of selling is then adjusted to take them into account.
Companies need a definite amount of working capital to operate for a practical period of time; any extra amount is considered as surplus cash. The quantity of surplus cash varies from business to business. The precise figures must be discussed and agreed upon between the buyer and you.
If you need help in valuated your business, you can post your legal need on UpCounsel’s marketplace.