As your business grows and matures, it is never too early to start thinking about what it’s worth and how to maximize its value. Even as you are trying to grow and manage day-to-day operational decisions, it is useful to know what key variables will impact value, and what you can to do increase the value if or when you decide to sell.
What is Business Value?
It is important to first understand what a business valuation is, and how it can be determined. Business valuation is a process of determining the economic value of a whole business or company unit. Business valuation can be used to determine the fair market value of a business for many reasons, including sale value, establishing partner ownership, taxation, and even divorce proceedings.
An important part of understanding the concept of business value is the definition of the term “fair market value”. The International Glossary of Business Valuation Terms defines “fair market value” as:
The highest price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.
Valuations of Public and Private Businesses
Valuing a privately owned business is different from valuing large publicly traded corporations. In the case of publicly traded companies, their market value (more commonly referred to as “market capitalization”) is determined based on the current price that shares of the company are trading for, and the number of outstanding shares that exist. It is important to note that the market capitalization of publicly traded companies does not necessarily represent their fair market values, as there may be abnormalities in the market such as temporary booms or sudden panic that cause market values to differ from their fair market values.
Unlike publicly traded corporations, shares of privately held corporations do not trade on an open market. These shares are held by one or more individuals or other businesses, and typically change ownership infrequently. Privately owned business can either be valued in an open market through the process of negotiation and due diligence between a seller and a buyer, or in what is called a “notional market”.
A notional market valuation is used to value privately held businesses when the owners have no intention of selling in the open market, but the determination of value is still required. In this scenario, a theoretical value of the business must be determined.
How Are Privately Owned Businesses Valued?
Generally speaking, there are three approaches to determining the notional value of a business:
- Income Approach
- Market Approach
- Asset Approach
Under the income approach to valuation, a business is valued based on the income stream that it generates. The cash flow of the business is typically used as a measure of income, and is most commonly represented by EBITDA (earnings before interest, taxes, depreciation, and amortization) and is often further adjusted to remove discretionary expenses or non-business income. A multiple is then applied to this income stream. The multiple reflects how much a buyer is willing to pay for that stream of income.
There are two basic issues that determine the multiple – one is the “time value of money,” and the other is the risk associated with the future cash flows.
The concept of the “time value of money” suggests a dollar tomorrow is worth less than a dollar today. When we layer risk on top of that, it is worth even less.
In terms of risk, the lower the risk associated with an income stream, the higher the multiple it will receive. This is because the more assurance you have that a certain cash flow would continue forever, the more you would pay for it.
If you compare multiples available in our current economy, you can buy low risk government bonds that yield 1-2%, which translates to a multiple of 50-100x (this reflects the pure time value of money since there is minimal default risk), or you can buy shares of blue chip stocks that include a dividend and some growth for a multiple of 10-15x (more risk), or you can buy various types of real estate assets for multiples of 10-15x (more risk), or you can buy a private company for EBITDA multiples of 3-5x (even more risk).
The multiple paid for any type of business is primarily a function of the risk of that business – the higher the risk, the lower the multiple. Businesses that are less risky have some standard elements, such as:
- Proven processes & procedures
- Solid management team (that stays)
- Well trained employees
- Repeat clientele
- Strong brand and reputation
- Allows the owner to take holidays
- Affords an appropriate salary to the owner
If a business has yet to generate steady income, for instance a startup, the forecasted future earnings of the company can be valued instead of using historical income. In this scenario, cash flow generated by the business is projected for future years. The future income stream is then discounted to reflect the risks associated with the business as well as the time-value of money. A terminal value, which is the value of a business beyond the forecast period when future cash flows can be estimated, is then calculated by applying a multiple to the expected cash flow at the end of the period. A terminal value assumes a business will grow at a set growth rate forever after the forecast period.
Depending on what industry a business operates in and its size, a market-based approach may also be used to value the business. This approach takes into account multiples that are commonly applied to a certain type of business, or will determine a suitable multiple by examining recent transactions that have occurred in the open market. For this approach to be accurate, there must be sufficient data on comparable transactions/industry benchmarks, which is often unrealistic because the details of private company transactions are not typically publicized.
Under this approach, a business is valued by determining the fair market value of all of the assets held by the business, less all of its outstanding liabilities. This approach is used when the tangible (real) assets owned by the business are of higher value in the open market than the income stream generated by the business would be, which can occur in capital intensive businesses or when the business owns specialized assets that hold significant value.