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The Importance of Conducting a Valuation of Your Small Business

Apr 19, 2023

Can you really put a price on all of the hard work that went into building your small business? You most likely can.

Whether your exit plan is succession to the next generation of family members or sale to the highest bidder — a thorough valuation of your business might be in order.

Owners of privately held companies may also need to establish a value of their businesses for a variety of additional reasons, such as:

  • buying out a partner,
  • qualifying for bank financing,
  • establishing employee stock ownership plans (ESOPs),
  • responding to tax and estate planning needs, and
  • dealing with a divorce or the death of a family member.

Types of Small Business Valuations

While there is no denying that you have put all of your heart and soul into your company, its value ultimately lies in the eyes of the buyer. Buyers interested in snatching up market share or adding a company that complements their own may be willing to pay a premium. On the other hand, private equity investors typically target companies they consider to be undervalued but scalable. Their goal is to make money, so they look for a bargain.

Ultimately, small business valuation is as much an art as it is a science. Business valuation professionals are trained to handle a number of different scenarios — from discounted cash flow and multiples of book value to market comparison and adjusted net worth — that can help business owners prepare for a successful exit. But, in general, valuation boils down to three approaches:

  • Income-based. This approach is prominent in retail, wholesale, manufacturing, and service industries. It relies on analyzing the income an asset (business) produces over its useful life.
  • Market-based. This method is common across all industries. By comparing objective market data for similar assets, business valuators determine a value range for your business.
  • Net asset value. This approach is best for companies that have significant capital assets, such as investments and real estate. The valuator appraises the assets of the business to determine fair market value. The valuator then subtracts the value of off-balance-sheet and contingent assets and liabilities to determine the value of the business.

How to Prepare for the Process

In preparation for a small business valuation, you may need to face the fact that the value might not match the number in your head. Otherwise, you risk being disappointed by valuation results that you deem too low. By contrast, a valuation may reveal some pleasant surprises. It may bring to light your company’s strong market position, its unique value drivers, or its potential — and yield a higher-than-expected value.

As part of your valuation reality check, make sure you approach broad rules of thumb with caution. For example, you may have heard that some companies in certain industries – such as wholesale, retail, and manufacturing – sell for five to seven times the amount in sales earnings before interest, tax, depreciation, and amortization (EBITDA). The reality is that no two companies are alike. If your company is an industry leader, then you may earn more than what the rule of thumb dictates. If your company is lagging, then you may have a lower-than-average valuation.

It is also important to remember that valuations are forward-looking. They are based on estimated future cash flows — not past performance. So even if your company has had a weaker showing over the past few years, you could see significant gains in the years ahead— especially if your industry is cyclical.

Understanding the Small Business Valuation Process

Speaking of value: Is a valuation really worth the cost? In almost every case, the answer is “yes.” A buyer will want a credible, unbiased, professional valuation before proceeding with the purchase. In the case of a divorce or shareholder dispute, you will need a valuation that can stand strong in court. Additionally, if a business owner is strategizing about estate tax planning, then the IRS will require a professional valuation.

If you are preparing to make a business decision based on the value of your business, then consider taking the first steps of the valuation process now. Contact your CRI advisor if your company is ready for your valuation. Additionally, contact the team at CRI Capital Advisors to prepare for the next part of your exit strategy: the selling process.

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