What is a business valuation? To Simply put, business valuation is a process and a series of procedures required to determine the total value of a business. While this may sound simple, executing your business valuation done right requires thought and preparation.
All based on Assumptions
Firstly, there is no simple and cut out a method of establishing what the value of a business is. This is because business value means different things to different entities. While business owners might believe business connections to a community is worth a lot, investors might feel the business value is completely defined by its historic income.
Additionally, economic conditions affect the perceived value of a business. Example, when jobs are hard to come by, many business buyers enter the market increasing competition which leads to higher business selling prices.
Circumstances call the shots as well. There is a great difference between businesses being shown as part of a well-planned marketing campaign to pull interested buyers alongside a quick sale of business assets during an auction.
Why would a business need a valuation?
Here are a few of the most common reasons businesses require a valuation:
- A merger or sale to other entities
- Raising investment capital
- A change in ownership due to retirement or succession
- Going through a divorce
- New partner/shareholder coming on board
- Estate tax purposes
Presumed business value
Thus, business value is truly an expected price it would sell to a buyer for. The real price could differ a bit according to the one determining the business value. Compare the buyer choosing the business now thanks to it fitting important lifestyle goals versus buyers who purchase an income stream at its lowest price.
A selling price is also determined by how business sales are handled. Compare a ‘fire sale’ to a well-conducted business campaign.
Three approaches to business valuation
There are commonly accepted ways to measure a business value:
- Market approach
- Income approach
- Asset approach
Market approach
This approach is reliant on real marketplace signs determining just what the business is worth. The economic principle of competition applies here:
What is the value of businesses similar to my business?
No business takes place in vacuums. If the work you do is great the chances you are doing the same thing is high. If you are seeking to purchase a business, you decide the type of businesses you are interested in and then seek out the ‘going rate’ for other businesses of this type.
When you are deciding to sell your business, you check the market to understand what similar businesses sell for.
It is natural to feel what the market will settle to as some kind of idea of business price equilibrium – value buyers are choosing to pay and sellers accepting.
The business price that a buyer might be willing to pay and a willing seller is going to accept for the business. Each party assumes to act in full knowledge of relevant facts, and neither party is under compulsion to conclude the sale.
Asset Approach
In this approach, the business is viewed as a set of assets and liabilities being used as building blocks in building a picture of business value. This approach is based on the economic principle of substitution addressing the question:
What is the cost of replicating the business keeping the same economic benefits?
The challenge lies in the details of figuring out the assets and liabilities which must be included in the valuation, selecting the standard of measurement and then actually determining the value of each asset and liability.
Income approach
The core reason for running a business is scrutinized – making money.
If I invest money, effort and time into business ownership, what are the economic benefits I will receive?
As there is no money in the bank yet, there is a measured risk. In addition to figuring out the type of money your business will bring in, the income valuation approach must factor in the risk.
How different business valuation techniques produce different results
Can you use the income business valuation techniques and come up with differing results? Take into consideration two prospective buyers – each buyer will have a differing perception of risk involved. Each buyer could also have different plans for the business affecting how they project the income stream.
The flexibility to measure business worth to match the owner’s objectives is the greatest strength of the income valuation approach.
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