The true value of your business is essentially what a potential buyer is willing to pay for it. However, this statement, while accurate, doesn't consider the fact that the method you use to determine your business's value can provide you with crucial leverage when it comes to justifying your asking price. This, in turn, can influence what a prospective buyer is willing to pay. This article will provide a comprehensive overview of the various methodologies commonly used for business valuation, whether for imminent sale or otherwise.
Asset valuation is typically used by businesses with predominantly physical assets, especially inventory. This approach is common among manufacturing and retail businesses. The valuation takes into account the fair market value of fixed assets and equipment, the value of leasehold improvements, owner benefit (the seller's discretionary cash for one year, derived from the adjusted income statement), and inventory.
This method is used by businesses with predominantly intangible assets, placing no value on physical assets. It's typically used by service businesses. Under this method, various factors are given a weighting of 0-5, with 5 being the most positive score. The average of these factors yields the "capitalization rate", which is then multiplied by the buyer's discretionary cash (75% of the owner benefit) to arrive at the market value of the business.
This method is based on the rate of return anticipated by the investor. Small businesses are expected to have a rate of return of 20-25%. So, if your small business has expected earnings of $10,000 for the year, its value may be $40,000 - $50,000.
This method is simply based on how much of a loan the purchaser could get based on the adjusted cash flow of the business. The adjustments to cash flow are for amortization, depreciation, and equipment replacement. The value of the business fluctuates with changing interest rates when using this method.
This method discounts the business's projected earnings to adjust for real growth, inflation, and risk. It calculates the value today (i.e., discounted for time) of the business's future earnings.
This method is used when the buyer wants to save the cost, time, and effort of starting a new business. The buyer estimates what it would have cost to start the business less what is missing plus a premium for saved time.
Similar to the capitalized earnings approach, but the return on assets is separated from other earnings which are deemed "excess" earnings generated. The return on assets is usually determined by industry averages.
This method is based on the seller's discretionary cash flow. It is usually used for businesses whose value comes from its ability to generate cash flow and profit. The formula is to simply multiply the owner benefit by 2.2727.
These are rough guides based on industry averages. Many industry organizations have developed methods for their particular industries. They are highly unscientific and hardly rigorous but act as a good "gut-check".
This method is basically a value of the business's current assets and nothing else. Typically used where the business is losing money. This approach will usually be utilized when selling the business is just a matter of getting the best possible price for the equipment, inventory, and other assets of the business.
A multiple of the cash flow of the business is used to calculate its value.
The value of the business is based on how much it would have cost the buyer to generate the intangible asset. Typically used where specific intangible assets that come with the business are highly valuable such as a customer base.
The most appropriate valuation method for you depends very much on the nature of your business. If you manufacture widgets, for example, you'll want to use the asset valuation method. If you offer website design services, on the other hand, you'll want to use the capitalization of income method instead. If you're selling a web-based business where the major asset is your high traffic volume and/or list of ezine subscribers, you will probably want to use the value of specific intangible assets method.
Is more than one valuation method applicable to your business? If so, calculate the value of your business in accordance with all of them and see which gives the best result (i.e., highest value). Another good approach is to average your calculations to get a reasonable ballpark figure.
Whichever method you choose, understand it inside out so that when the time comes, you can authoritatively justify your asking price to potential buyers. By following this approach you may not necessarily get the value you are after, but at least you have a solid starting point for negotiations and are much more likely to be able to negotiate a price both buyer and seller are able to live with.
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