PUTTING A PRICE ON YOUR BUSINESS
WHAT IS THE VALUE OF YOUR BUSINESS?
During the latter half of 2019, 2,400 small businesses were sold with the median value being around $278,000. This median value is up a little over 3% from 2018. During an entrepreneurs early years, primary concerns are about succeeding and not being forced to permanently close the doors, making enough money to break even, marketing within budget while staying competitive…the list goes on. Therefore, determining the businesses value and creating a succession plan is normally put on the backburner.
Determining the value of a business is important in business succession, estate tax estimates, or qualifying for a loan. Knowing the value of the business is important when choosing a funding strategy in a buy/sell agreement.
There are several valuation techniques, ranging from the simple to the very complex. Outlined below are three different approaches to valuing a business.
- Asset Based: Calculates the value of all tangible and intangible assets held by the business. This approach ignores the future earning potential of the company. Thus, a pure asset-based valuation model is often used for companies that are bankrupt or looking to liquidate.
- Earnings Based: Seeks to arrive at a business’ value by applying a multiple to normalized earnings, i.e., earnings adjusted to subtract owner’s compensation and related expenses. The multiplier can vary substantially, depending upon the industry and the outlook for the business.
- Market Based: Compares the business to recent sales of similar companies.
Business valuation is not just a formulaic exercise. For instance, there are non-quantitative factors: a business is much more valuable if it is a “going concern” rather than a startup. Ownership percentage will also matter; purchasing a minority share that has limited control may result in a discount to the actual value. The prospects for the business can impact its value. A greater premium will likely apply to a company engaged in a leading-edge technology than it would to one involved in a mature market.
Don’t be misled or assume that business valuation is a science; if there were an algorithm that were able to consider all the relevant factors in calculating a business value, things would be much simpler in business planning. Valuing a small business is not an exact science, many aspects are very subjective (e.g., the value of the company’s reputation).
Willing “Buyer & Seller”
The true value of anything can only be determined when a willing seller and a willing buyer agree on a price of exchange. Consequently, any valuation exercise may yield only a rough estimate.
A businesses value is important, but projected or future values and the expected change in values over time is very important in succession planning too. As alluded too above, business valuations are important when developing buy/sell agreements and choosing a funding source/strategy. If a business is in a high growth industry and there are multiple owners, funding a buy/sell agreement with cash may be very risky. If one of the owners passes 10 years in the future and the valuation of the deceased owners shares are much higher than cash set aside due to unforeseen business growth, this can be detrimental to the continuity of the business.
Using Indexed Universal Life insurance, a funding strategy can be implemented that allows the cash and the death benefit to grow over time, so if one of the partners passes further in the future the policy would have grown alongside the business value. It won’t be a perfect match, but these are important strategies to consider. It is why working with licensed and experienced insurance professionals, financial advisors, estate planning attorneys and CPAs is very important when completing business succession plans!