How much is your business worth? A simple question with often a not so simple answer. If you are looking to buy or sell a business, split the ownership or simply need to know for tax reasons, a business valuation could be around the corner. Knowing the methods by which businesses are valued will give you confidence to make some calculations and plan for the inevitable negotiations.
“Risk comes from not knowing what you’re doing”.
– Warren Buffet
Buying or selling a business is, at the end of the day, a negotiable transaction dictated by the seller’s willingness to sell and the buyer’s eagerness to buy. However, knowing the main methods of calculating business value, and when best to use them, puts you in the driver’s seat when it comes to negotiating a sale price.
Another key to negotiations is having your financial records in order. Emotion may play a part; however, most buyers and sellers of businesses are focused on the numbers. Reliable financial records allow the value of the business to be easily communicated to the widest audience.
Methods of Calculating Business Valuation
There are many methods to arrive at a business valuation. A few common approaches used, primarily for small business, are as follows:
1. Income Method
This method looks closely at the financial records of the business. These can show whether the business is low-risk and reliable in delivering consistent profits. The profit and loss statement is key to this method and used to project future profits and debts of the business. These projections can then be used to arrive at a valuation figure.
For example, if the business has delivered a net profit of $100,000 for the past 3 years and looks on track for the same in the coming year you might also consider valuing that business at that same figure.
2. Times Revenue Method
For businesses without a consistent or long historical background, the times revenue method aims to predict the future business performance. This method takes the current revenue of the business and uses an industry multiplier to determine the likely future price of the business.
The multiplier will vary from industry to industry and could range from 0.5 to 2 times the current revenue depending on industry and other evidence supporting the business outlook. Revenue of course does not mean profit so valuing on revenue projections alone means this method has some limitations and also risk.
3. Market Method
Much like buying a house, the market method uses similar businesses in the area as a benchmark for the sale price. If you own a hairdressing salon for example, then you might use this method to baseline the sale price close to what other hairdressers had recently sold for in the area.
This method however doesn’t take into account historic or future revenue, available assets or the value of a regular client base.
4. Asset based (Book Value) Method
If you are looking for a fast sale, then this method may not get the best price, but it is easily calculated and also communicated. By tallying up the assets (things that add value to the business) minus the liabilities (debts owed to creditors) the ‘book value’ can be obtained. The book value is actually shown as the owner’s equity on the company balance sheet.
5. Liquidation Method
Liquidation value is similar to the book value except that liquidation value uses the price of the assets at today’s prices to settle debts. This is a fire sale where everything that can be sold is sold immediately to settle debts. After debts are paid, anything left over is the amount the owner walks away with the business essentially folding.
There may be many more ways to calculate a business valuation, particularly in larger or publicly listed companies. However, in any business valuation, having clean and crisp financial records is key. So too is having someone who can clearly present the business from a number’s perspective. This gives buyers confidence of what they are buying in to and confidence to ultimately proceed.
Saige Accountants and Financial Planners can assist you in creating a business valuation for a business you are selling or one that you are looking to buy. We can also help in preparing the necessary financial statements that help demonstrate past business performance or can be used to project future performance. Lastly, we can help you properly manage the lump sum received from a business sale tax effectively.