Suppose as a business many of your products earned a legendary reputation, you have a loyal customer, and your revenue grows steadily each year. But now you’re considering retirement or perhaps expanding into a franchise. Suppose you’re seeking investors to scale operations. A clear valuation shows potential backers how their money will grow. Suppose you are into a legal dispute, say, a divorce or partnership breakup. Now the valuation will ensure fair division of assets
What’s the Big Deal About Valuation Anyway?
Business valuation tells the owner how valuable his business is right now. But it’s not just about calculating the material cost and real estate price. It’s also about assessing the value of your loyal customers. Valuation is about taking into consideration many such aspects that make a brand possible.
Now, let’s say your cousin wants to buy into the business. Without a valuation, you’re both just guessing. You might lowball yourself because you’re too humble, or overprice it because you’re emotionally attached. A valuation cuts through that noise. It’s like having a neutral third party say, “Here’s what the numbers and the heart of this business are worth.
Why You Should Care?
Sure, selling is the obvious reason to know your business’s value. But let’s talk about the less obvious ones. When as a business you are applying for loan the bank doesn’t really care about your emotion for the business. That’s when you need a solid valuation.
In case your business partner just wants to part ways, how can you split assets without a valuation? A valuation in such cases acts like a referee, ensuring everyone walks away feeling respected.
And what about estate planning? If you pass the business to your kids, the IRS will want to know its value for tax purposes. Guess too low, and you risk audits. Guess too high, and your heirs might face a hefty tax bill. Valuation keeps you honest, and safe.
The Three Methods: Which One Feels Right for You?
Let’s get practical. There are three main ways to value a business, and none of them involve crystal balls. Think of them as different lenses to view your company’s worth.
Asset-Based Approach
This one’s straightforward: Add up everything you own and subtract what you owe. It’s like holding a garage sale for your business. Your industrial mixer? $8,000. Your delivery van? $15,000. That stash of organic vanilla beans? $500. But here’s the catch: This method assumes your business is worth only its stuff.
There are two flavors under this approach. The first one is book value or what your balance sheet says. If you bought that oven for $10,000 and it’s depreciated to $6,000, that’s its book value. The liquidation value is what you will get if you sold everything just now.
This method works best for businesses that are all about physical assets, like a furniture workshop or a fleet of food trucks. But if your value lies in your brand or loyal customers, this approach might leave you shortchanged.
Earnings-Based Approach
If your business prints cash, this method is for you. Here are the key components of this method.
- Price-to-Earnings (P/E) Ratio: Imagine your bakery nets $100k yearly. Similar bakeries sell for 5x their earnings. Bam, $500k valuation. But multipliers vary wildly. A tech startup might fetch 20x earnings, while a laundromat might get 3x.
- Discounted Cash Flow (DCF): This one’s for the nerds (in a good way). You forecast future earnings, then adjust for risk. If you expect $120k next year but investors want a 10% return, that $120k is only worth $109k today. Add up those adjusted numbers over 5-10 years, and voilà, your valuation.
For this method you always need accurate financials. If your books are a shoebox of receipts, this method gets shaky. It’s more ideal for stable and big businesses.
Market-Based Approach
This is all about comparison. How much did the café down the street sell for? What’s the going rate for yoga studios? It’s like Zillow for businesses. If a competitor with similar revenue sold for $600k, you can expect a similar valuation.
Public companies also offer clues. If Starbucks trades at 8x earnings, maybe your indie coffee shop can too. But finding comparable sales is tough for niche businesses.
Hidden Factors That Make or Break Your Value
There are several hidden and less visible factors that work far better than numbers for business valuation. Let’s have a look at them.
- Brand Vibe: Customers may like the quirky logo. Or, they may like the way you remember every customer’s name. A buyer isn’t just buying equipment, they’re buying the goodwill you’ve built.
- Location: The location of the business can bring more real-estate value.
- Team: If you have an award winning team of skilled experts, their skills add value. A buyer might pay extra to keep them on.
- Trends: Some trendy products still make more business. So, compared to outdated choices, trendy product range will add value.
And don’t forget the economy. In a recession, you may struggle to find buyers even with string fundamentals. In a boom scenario, this can be just the opposite.
Step-by-Step Valuation
Let’s now describe the steps to do a business valuation.
- Gather Your Financials: Find out out three years of tax returns, profit/loss statements, and balance sheets.
- Pick Your Method: Start with one method, but always cross-check with another method as well.
- Adjust for Reality: Factor all the new things related to the business in the valuation.
- Get a Second Opinion: Even if you are doing it on your own, get it checked by your accountant or an expert.
Ending Notes
Valuation isn’t a one time deal. Treat it like a living, breathing mirror of your business. Revisit it and use it to make smarter business decisions and choices. Valuation is about understanding what you have built. Valuation should give you the power to write the next chapter of your business.
