As anyone who has watched the ABC reality-TV competition "Shark Tank" knows, figuring out the magic number of a business's value can make — or a break — a deal. Accurately valuing a business, just like any property appraisal, requires both art and science.
“A valuation is both quantitative and subjective," said Edward Nelling, author of "Business Valuation Demystified" and a professor of finance at Drexel University.
Why It Matters
Prepping for a sale is the most obvious reason a business owner might need an accurate valuation. But you also may require one for transferring ownership within a family from one generation to another, starting an Employee Stock Ownership Plan (ESOP) or if you are getting divorced.
“Business owners are often so focused on operations and day-to-day collections and how the business meets its plan, that sometimes it is just important to understand what the value is of the asset that the owner created," said Scott Cathcart, senior vice president for corporate finance for SunTrust. “Having a perspective on value is something you ought to refresh. Operational characteristics and then of course the market can drive changes to that valuation."
Here are important tips for seeking an accurate valuation:
1. Consult the right people. Although local accountants, valuation firms and investment banking firms can all handle valuations, the right choice for your business depends in part on why you need to value the company. A valuation for ESOP purposes, for example, would have different requirements than one for investment banking purposes, Cathcart notes.
To get the most accurate valuation, you need someone who can do more than crunch numbers, said Gerry O'Meara, managing director and head of mergers and acquisitions for SunTrust Robinson Humphrey. “You should identify someone who is a subject matter expert on your business," he said.
Finding the right person who can offer "authentic guidance" can even drive up the value of your company, especially privately held companies that are focused on operations, added Cathcart.
2. Understand your competition. A valuation can help you estimate your competitive brand advantage — or lack thereof.
“You need to know what makes your company special, what makes it impossible for others to reproduce," Nelling said. “For instance, do you have a brand name that everyone knows? Or a patent or some type of technology that's not easy to replicate?"
Owners can gain insight into their business by looking at “where comparable businesses in their market are trading. What do public companies look like that are similar to them and how they are trading?" Cathcart added.
3. Evaluate your growth potential. Traditional valuation methods look at revenue, net income and profit, or earnings before interest, taxes, depreciation and amortization (EBITDA). A business valuation also typically includes a five-year growth forecast.
“Growth potential is a product of the overall size of the market and the business's market share," Nelling said. “It depends on the underlying market and the barriers to entry for other potential competitors, which include both psychological and quantitative factors."
4. Consider both quantitative and qualitative indicators. According to Cathcart, questions to ask include: “Is the business in a sector that's got headwinds or tailwinds? Is the business one that requires a significant amount of investment for it to continue to grow? What kind of capital allocation needs to be set aside down the road that will have an impact on what someone is going to pay for the business?"
Leadership is also essential to the quality of the company and therefore its value. “If there's a very good team of people running that company, then that business should command a higher value for its particular space," Cathcart said.
5. Understand your key risks. A business valuation typically accentuates the positives, but it should also identify negatives that could reduce a company's value.
A restaurant associated with a famous chef, for example, could be subject to so-called key person risk — and lose value — if it were sold to a third party.
A lack of liquidity or marketability can further reduce value. “You need to evaluate whether you could be outmaneuvered on a technology basis or whether your business could become obsolete or just less important because of changing consumer preferences," Nelling said.
As important as valuations are, they are no substitute for an actual offer.
“Once you're actually in the market, what someone pays may be in the range of that valuation or it may not be," Cathcart said. “It may be above it or may be below it, depending on where the market is."
Whatever your reasons for getting an accurate valuation, doing so can provide a snapshot for today and a road map for the future.
"We believe that understanding the value of your company allows you to make informed decisions," O'Meara said.