Valuation

A business is like any other asset one may own. It has value. The business may grow in value if managed well, or it may decline in value if not managed well. Of course, factors beyond the owner's control may occur which will have positive or negative effects on the value of the business.

The answer to the question, "How much is a business worth?" ultimately comes down to how much a potential buyer is willing to pay for the business.

Since the 1920's and prohibition (see the History of Valuation) professionals have been developing mathematical models to apply to a very complicated set of variables to arrive at an answer for the question, "How much is a business worth?"

There are three methods of valuing a business: the asset method, which estimates the value of the assets of the business including goodwill; the income method, which measures the amount of cash a business generates; and the market method, which looks to the sale of similar businesses, develops ratios from the information available and then applies those "multiples" to the business being valued.

Why Have a Business Valuation Prepared?

There are many reasons to have a business valued:

• Bankruptcy
• ESOPS
• Estate tax
• Gift Tax
• Divorce
• Disagreements between owners
• Measure losses related to business interruption.
• Buy-sell agreements, and mergers and acquisitions.
• Exit planning.
• C to S Corp Conversion

A Word about Exit Planning

Most small businesses don't plan for how they will sell their business or how much they want to realize from the sale of their business. The majority of small business owners do not make plans to sell their business. They most often reach a place in their lives when they must stop working for physical reasons or they just become burned out and just want out of the business.

Negotiating a sales price for your business with a potential buyer is best done from a position of strength. This means you have had valuations prepared in the two-five years leading up to the proposed sale. You have based your sales price on these calculations, not what you think your business is worth. Because you are selling your business based on a plan of action and not a desperate attempt “to get out”, you are prepared to walk away and find another buyer.

Valuation Process

The valuation process is series of steps to arrive at a conclusion about the worth of a business. The steps can be described as follows:

It’s About Cash Flow

One major factor in determining the worth of a business is determining its cash flow either from a historical perspective or the estimated cash flow going into the future.

Think of it this way. How much would you pay for a business throwing off average cash flow of $300,000 per year if you wanted to make a certain percentage, for example 18%, on your money? That is one of the questions valuation theory seeks to answer.

History of Valuation

The theory and practice of the valuation of business gained prominence during the period of prohibition in the 1920’s. Between 1860 and 1880 the population of the United States grew from 6 million to 14 million people. Many of these people were recent immigrants. They found themselves working long hard hours in factories in abominable conditions. For many getting drunk was their only respite from this life. There was a concern that a “culture of drink” was beginning to form in American society.  Due to technological processes like the telegraph, the railroad, and refrigeration, “big business” was able to grow. Pabst of Milwaukee and Anheuser Busch of St. Louis greatly expanded their operations.

The 18th amendment to the Constitution became effective on January 16, 1920. Many companies who sold alcohol were forced to close their doors. The U.S. Government allowed these companies tax breaks or compensated the company for its lost sales and profits. Up until this time, the value of a company was thought to be its equity or its assets minus its liabilities. Valuation theory developed the idea that the value of a company is measured by its goodwill and its ability to generate cash flow. Goodwill can be comprised of different components such as a trained work force, customer base, trade names, and reputation in the community.

The Internal Revenue Service has been a major contributor to the principles and practice of valuation. One such official pronouncement, the Appeals and Revenue Memorandum (ARM 34) established two important ideas. First, if a business has earnings in excess of another “like business”, goodwill exists; and second the “current value” of those excess earnings is the value of goodwill.  Since the 1920’s and the end of prohibition, the practice and theory of valuation of business has been greatly developed. The Internal Revenue Service and the court system have continued to be a major contributor to the art and science of valuation. A comprehensive industry has grown comprised of writers, professionals, organizations, and supporting agencies.