Tuesday, April 4, 2017

3 Business Valuation All Entrepreneurs Should Know

What is your business worth?

Remember that article I wrote about your balance sheet a while back? That’s where you can find the very literal answer to the above question.

The book value of your business, or total equity, is what your business is worth at a given moment in time. But it’s never the value used when valuing a business for purposes of a sale or investment. There are many things that need to be considered when you are valuing a business, and there are different ways of looking at it.

What follows are three business valuation methods all entrepreneurs should know.

The “textbook” valuation methods are fair market value, going concern, and liquidation value. These can be rolled up into two broader categories:

  • Market value
  • Asset based

Then I want to add in my favorite business valuation method, which is really a combination of the above:

  • ROI based

The majority of small private firms are sold as asset sales while the majority of middle-market transactions involve the sale of equity.

The reason why the valuation is needed will usually determine the best valuation approach. Business brokers can (and in most cases should) be hired to assist buyers and owners in this process.

Let’s dive deeper into each of the three business valuation methods. (Or take a look at our business valuation methods template here.)

Market Value Business Valuation Method

Market value is, perhaps, the most subjective. This method attempts to compare your business to similar businesses. This is particularly challenging for sole proprietors, because it is difficult to get comparative data. There is no public database to go by.

Broken down very simply, market value is subjective and, accordingly, will ultimately be based on a negotiation. What can you convince a buyer your business is worth?

The most common approach to market value is what is called the “income approach.” Here we seek to value a business based on multiples, capitalization rates, and discount rates (based on expected cash flow).

Can you sell your business on hype? Sure you can, but a savvy investor can see through that.

Can you sell your business on the fundamentals? Certainly, and that brings us to the asset- and ROI-based approaches.

Asset-Based Business Valuation Method

Going Concern

The going concern, asset-based approach looks at business valuation from the perspective of a business that is planned to continue. This is what I described above. The total equity (or assets – liabilities).

Liquidation Value

The liquidation value, asset-based approach to business valuation is based on the assumption that the business is finished. The net amount is what would be realized if the business is terminated and its assets sold off.

Now let’s look at my favorite business valuation method all entrepreneurs should know.

ROI-Based Business Valuation Method

First, let’s flip the script so you can understand this from a very practical standpoint. If you have ever invested in anything, what is your first and primary concern? Return on investment, or ROI.

If you buy stock in a company, you want a return. Is 25% considered good? Well, that depends on the market, right?

This is why business valuation is so subjective. Looking at the above, let’s flip back over to valuing your business. While we’re at it, let’s go on the show Shark Tank for a minute. You can learn a lot about business valuation from watching this show if you pay attention.

The first thing a Shark Tank contestant does when they come on the show is tell the sharks how much of an investment they want and what percentage of their company they are willing to give up in exchange. In that very moment, they are valuing their business.

Notice the sharks immediately write something on their pads. I’ve never seen their pads, but I would bet 25% of my company that, in most cases, they are writing down the valuation at 100%.

If I am asking for $250,000 in exchange for 25% of my business, then I am valuing my business at $1 million. The math is simple. Divide the amount desired by the % offered, and you have the business valuation at 100%.

Now you have the rest of your pitch to convince the sharks of this valuation.

Here’s what the sharks need to know in the end:

  • Will my money go to work for me?
  • Will I get an ROI that gets me excited to make this investment and partner with this business owner?
  • How long will it take to recover my original investment?
  • After that, when I look at my share of the expected net income, compared with my investment, what does my return look like?
  • Is that number realistic?
  • Is it conservative?
  • Does it make me want to invest in this company?

Take a look at the short video above to illustrate what this looks like, and don’t forget to check out the business valuation methods template here.

The post 3 Business Valuation All Entrepreneurs Should Know appeared first on Fundera Ledger.

from Fundera Ledger https://www.fundera.com/blog/business-valuation-methods

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