Understanding Business Valuation: Why & When You Need One
Business Valuations are critical for sale, transition, and business planning
Steve Mize, ASA
November 18, 2020
If you are an entrepreneur or business owner, understanding business valuation, why, and when you need one is essential. Here’s a quick rundown of what you need to know about valuation, and the process you might expect to encounter in order to get one.
To arrive at an estimation of value, as a starting point you can expect a business valuation professional to:
- Review financial statements
- Identify income statement and balance sheet adjustments
- Review the business operation
- Determine the appropriate valuation model
- Review economic and industry data
- Compare market transactions for similar companies
The business valuation will also likely consider additional factors:
- The capital structure of the business
- Prospects for future earnings
- The market value of physical assets
A business valuation professional follows one of three standard approaches:
- Cost-based, a balance sheet approach which estimates the value of a business as the sum total of the costs required to create another business of equal economic utility
- Market-based, which measures the value of a business based on transactions of similar businesses that have taken place in the open market
- Income-based, which estimates the present value of the economic income the business is expected to generate in the future
Business risk is always an important consideration for valuation. Methodology to interpret risk will vary from one valuation firm to the next.
Who Requests a Business Valuation – and Why is the Valuation Needed?
The need for a business valuation arises for several reasons, and the request can come from different sources. For a closely held business, the valuation plays an important role for purposes that include – but are not limited to – business planning, determination of tax liability, and listing a business for sale.
A prospective lender may request a valuation to support a loan for a business acquisition, partner buy-out, or to refinance debt. If you are pursuing SBA-backed financing, a specific set of valuation guidelines will apply to meet the SBA’s standard operating procedures.
If you are considering the sale of all or part of your business, a business broker (acting either for you or a prospective buyer) will need an objective and independent estimate of value for the business to anchor any negotiation.
Whether for the purposes of estate planning or eventual retirement, a CPA or financial advisor can use a business valuation to help you plan for a secure future for you and your family. Gift and estate tax returns that include a well-supported and documented valuation will help defend the value of the business to taxing authorities.
Should you need to defend the value of your business as part of a shareholder dispute, purchase or sale process, or divorce, your attorney will need a credible valuation to support your case.
The Most Durable Business Valuations Are the Product of Science and Art
You’ll hear it said that business valuation calls for both science and art. Valuation science involves extracting a cogent, defensible story from the numbers, while the art deploys human wisdom and experience to ensure that less tangible – but always important – variables receive appropriate consideration.