You may think you can make a fair guess as to what your business is worth – but too many times business owners who think this find the valuations are not quite as accurate as they imagined.

And finding out you’re wrong, or at least not of the same mindset as others may be as to your business’ value, can come in forms with unpleasant consequences (think: potential buyers who won’t meet your asking price, or – worse – the IRS imposing a different value after a sale or a transfer of ownership to family members via gift(s) or inheritance) which could be costly, to you and/or your heirs.

When to Have Your Closely Held Business’ Value Appraised

When should you have your business appraised? The answer is: almost any time you want a clearer picture of your business’ value.

But you should certainly contract with an independent, credentialed business valuation specialist:

• When you start planning for a possible sale of your business (preferably 3 to 5 years before you anticipate making the sale).
• When you are selling the business – have a new appraisal done as close to the sale date as possible.
• When making succession plans for your business.
• When you are putting your succession plans into effect.
• When you are selling, or making gifts of minority ownership in the business – especially to family members, as such sales and gifts often trigger extra scrutiny by the IRS. In such circumstances, have the appraisal done as closely as possible to the date of the sale or gift.
• If you are initiating a new partnership or making changes to an existing partnership agreement. It’s a good idea to incorporate appraisals at regular intervals, or in anticipation of specific events, into your partnership agreement.
• If you are dissolving your business.
• If you are divorcing your spouse.
• If you (and potentially other family members) inherit a family-owned business at the owner’s death. An appraisal can be done, at the estate executor’s discretion, either as of the date of death, six months after the death, or as of both dates (sometimes the wisest choice). However, if the business appraisal chosen for use is as of six months after the death, this date must be used to determine all the estate’s assets.

We cannot recommend too strongly that you hire an experienced business valuation specialist. Such specialists can create a sound business appraisal considering the circumstance(s) which have led you to seek their services – e.g., a business appraisal with a view to selling your business may differ from an appraisal generated for the purposes of gifting a minority ownership.

How Business Valuations Are Determined

There are several ways via which your business can be valued. Often a business valuation specialist will use two, and sometimes all three of the approaches below to determine the value of your business. The various methods can verify one another, providing confidence.

The most common methods of appraisal are:

Income Based

The most common valuation methods are based on your business’ expectations as to income. Expected returns are either discounted or capitalized as appropriate to adjust for potential investor sensibilities and any risks inherent in your business.

Income-based valuations either highlight future expected cash flows or historical earnings. There are numerous methodologies available under this approach:

• Seller’s Discretionary Earnings (SDE): this is the most common valuation metric used for businesses worth less than $5 million. SDE takes the business’ pre-tax net income, and adds back the owner’s compensation (plus any excessive salaries paid to other family members), interest, depreciation, amortization, discretionary expenses, and unusual non-recurring expenses to arrive at a valuation. But bear in mind that some lenders may not accept a business valuation based entirely on SDE – some of the items, such as high-level salaries to family members, they may decline to add back for their own valuation purposes.
• Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA): this is similar to SDE, in that it takes pre-tax net income, and adds back interest, depreciation, and amortization expenses. Usually, some form of EBITDA or related methodology is used as one prong of an appraisal or evaluation of your business.
• Adjusted EBITDA: this approach is a deeper EBITDA dive, adjusting and standardizing your business’ EBITDA via removal of non-recurring, unusual, and one-time expenses and/or income entries. EBITDA may also be adjusted to account for additional staffing or other expenses which a new owner is likely to incur.
• Discounted Cash Flow (DCF): this approach is most often used for valuing a still-growing concern. The DCF Method projects the value of a business as anticipated future earnings (usually over a period of years), discounted to arrive at the current present worth of those projected earnings. It is one of the most commonly used valuation methods when a business is preparing for a sale.
• Capitalization of Earnings: this method is also widely used, especially for very small closely held businesses with measurable track records and anticipated stable growth going forward. It projects future earnings based on past growth numbers. This approach, however, is based more on judgment calls than on more technical calculations, and is therefore potentially subject to an appraiser’s personal take.

Market Based

Market-based valuations compare your business with publicly traded companies in your industry. These methods assume that the value of your business can be determined based on the price paid by investors for shares in similar companies on the market. Tracking stock price to the financial statements (earnings, cash flows, and other considerations) of these companies can assist in determining appropriate ratios to value your business.

However, there are so many company-specific factors (e.g., management, market share, etc.) involved in appropriate pricing for any individual concern that a market valuation is often used as a check on a valuation based on income or assets.

Asset Based

An asset-based approach to valuation can provide a bottom-line – no business, after all, can be worth less than the value of its assets minus its liabilities. Some asset-based approaches to valuation are:

• Net Asset Value Method: this is a simple approach, which assumes that the values of the assets as stated on your balance sheet represent those assets’ fair market value, and considers intangible assets such as transferrable goodwill.
• Adjusted Net Book Value Method: this involves adjusting the asset values to more accurately reflect their fair market value. This approach assumes there is no expectation of intangible values, and that there is no transferable goodwill.

Some factors which may have impact on a business’ value can include:

• The location(s) of your business
• What competition your business faces
• Whether your business or its location and/or competitors or lack of them makes it a unique property
• The degree of your business’ resilience in a recession
• The extent and quality of your client list
• Your marketing process
• Other intangible goodwill assets, including the length of your business’ track record and its reputation within your industry

Again, this is something to discuss with experts – if you are even considering a potential sale of your business, please reach out to our Transaction Advisors for guidance – we can help you through every stage of the process.

Please click here to email us directly – we are here to help you.

Until next time –

Peace,

Eric

For more on valuing your closely held business, read:

Valuations – What Is Your Business Worth?
What is Your Closely Held Businesses Worth?
Valuing Your Closely Held Business For Sale