You've examined your company's historical financial statements, thought carefully about your prospects for future growth, and perhaps had your accountant recast your statements to reflect how new ownership would affect your company's earnings and cash flow. You've also considered the market value of any real estate, equipment, inventory, and other hard assets that would be transferred in the sale, as well as the intangible aspects that make your business appealing.
How do you boil all of this down into an asking price for your business?"
Hopefully, you'll take our advice and hire an expert business appraiser to do this for you. The process can be very complex and time-consuming, and takes quite a lot of experience to do well. There are a number of valuation methods that business appraisers have at their disposal, and even choosing the correct method (or more likely, the correct combination of methods) to use in a given situation is more of an art than a science.
The following provides a rundown of the major approaches commonly used to put a price tag on small businesses. We're not going to overwhelm you with details: a staggering number of variables and mathematical formulas come into play with virtually every method. Our objective here is simply to give you a feel for the process that your appraiser will be going through.
Business valuation methods fall into the following categories, depending upon their major focus:
- business assets, including book value and liquidation value methods
- historical earnings, including debt-paying ability, capitalization of earnings or cash flow, gross income multipliers, and dividend-paying ability methods
- a combination of assets and earnings, namely, the excess earnings method
- the market for similar businesses, including comparable sales, industry rule of thumb, and p/e ratio methods
- future earnings, namely, discounted future cash flow or earnings methods
Although no substitute for an appraisal and valuation by qualified professions, the Interactive Business Valuation Calculator can provide you with a rough idea of the value of your business.
Asset-Based Valuation Focuses on Salable Parts
At a minimum, your company should be valued at the sum of the value of its easily salable parts. Two commonly used business valuation methods look primarily at the value of your hard assets. Thus, they could result in a serious undervaluation of the goodwill component of your business.
Book value. Book value is the number shown as "owner's equity" on your balance sheet. This is not a very useful number, since the balance sheet reflects historical costs and depreciation of assets rather than their current market value. However, if you adjust the book value in the process of recasting your financials, the current adjusted book value can be used as a "bare minimum" price for your business.
Liquidation value. Liquidation value is the amount that would be left over if you had to sell your business quickly, without taking the time to get the full market value, and then used the proceeds to pay off all debts. There's little point in going through all the trouble of negotiating a sale of your business if you end up selling for liquidation value — it would be easier to simply go out of business, and save yourself the time, broker's commission, attorney's fees, and other costs involved in selling a going concern. Thus, liquidation value is not even considered a valid floor for the price of your business (and you can use this argument in negotiations if you get an offer that approaches liquidation value.)
Historical Earnings Methods Are Commonly Used
In contrast to the asset-based methods, historical earnings methods allow an appropriate value for the goodwill of your business over and above the market value of the assets, if that's justified by your earnings. Although savvy buyers will be more concerned about the future of your business than its past, predicting the future is difficult. The assumption here is that your past history provides a conservative indication of the amount, predictability, and growth trend of your earnings in the future.
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