Business Valuation 101: What is a Business Valuation?

How much is my company worth? It seems like a simple question. You might be asking it because you are working on your estate plan. Or you may be creating a buy/sell agreement. Or you may be completing your annual business financing applications and personal financial statements and question the appropriate inclusion for your balance sheet. Or you may be considering the acquisition of a strategic partner and evaluating purchase terms. Or maybe you are embarking on a strategic planning exercise want to identify the factors that would prove most significant in enhancing value and market position.  Regardless of the reason you’re asking the question, the answer is the same: you need a business valuation. Simply put, a business valuation is exactly what it sounds like: it determines and communicates the value of your company. However, it gets more complicated when you begin to consider all the factors involved in determining value.

Understanding what a business valuation is means understanding the factors that impact what your company is worth. Listed below are some of the key drivers:

  • Purpose. The purpose of the valuation and the parties involved impact the value of your business. Your company is worth more for certain purposes than others and to certain parties than others. For example, an investment or financial buyer, someone who is purely interested in the assets and earnings opportunities for the firm, may not value the company as much as a strategic buyer, someone who sees valuable synergies between your operations and theirs. The value among family members, a liquidator, an ex-spouse, or the IRS, will differ as well.
  • Relative Risks to Earnings. A valuation is a process that attempts to estimate the value of an entity through the identification of market comparables and through an understanding of the likely estimated earnings stream coupled with an evaluation of the risks associated with the realization of that earnings stream.  While a summary of historical earnings is an important benchmark, an understanding of the expected future earnings in the hands of a likely buyer predicates the value to that buyer. A valuation typically does not does not look at one good year but rather what factors affect growth over time and can be realistically expected to continue into the future.
  • Control. There is often a question of the ability of an investor/ owner to exercise control over the entity and its operations. The valuation subject must be clearly identified. Is the valuation to consider the enterprise as a whole or a segment of the ownership? If a segment, is the ownership position a controlling or non-controlling segment? To the extent the owner lacks control, it must be determined if earnings distributions and salaries as well as control of management are outside of their control and if so the relative impact on the value of the interest.
  • Market. It is usually difficult in the privately held enterprise market to find accurate market comparables. Enterprises are usually unique in product, staffing, skills and market positioning. Further, public sources for the data that would be needed to identify comparable trades is generally not available. Rules of thumb may be available but usually fail to consider crucial factors and characteristics. That being said, consideration of market trends and positioning is essential to the valuation process. The ever changing markets and the impact of new products, technologies and business models requires consideration whenever one is attempting to evaluate future expectations for an enterprise
  • Qualitative factors. It seems logical that the value of a company would come mostly from the financial statements. However, many qualitative factors impact how much your company is worth, including brand reputation, personal goodwill, expected loyalty of key management and intellectual property. For example, if the revenues of the company are largely dependent on the relationships built by one key person, contracts insuring the longevity of those relationships increase the value of the business.

Purpose, market, risks, control and qualitative factors impact the methods chosen to determine of the value of your business. Understanding the standards, premise and methodologies is key to the accuracy and usefulness of the valuation findings. Our Business Valuation 101 series will continue with the next post in the series: Necessary Knowledge for a Business Valuation.