How to Value Your Business in Six Steps

Posted on 7/21/2016 by John Davis

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Why should you perform a business valuation? A valuation provides the business owner with a realistic view of their business as it currently stands. There are a variety of reasons for doing so which include succession and exit planning, estate planning, and fundraising.  Regardless of the specific reason, business valuation provides a clear picture of your business' overall financial health. 

Generally, there are six steps in the valuation process:

1. Analyze historical earning of the Company. The recommended number of years is anywhere from 5 to 7 or more years. Financial statements using generally accepted accounting policies (GAAP) are best, but tax returns adjusted for tax related items can also be used.

2. Normalized earnings are the reported earnings of the business (tax or GAAP) adjusted for unusual items. These could be one-time expenses (i.e. legal fees) or expenses higher than the norm (i.e. compensation adjusted for bonuses, owner’s compensation, or lower than the norm for the area or the industry (i.e. lower than market rent).

3. A weighting can then be applied if it is felt the most recent years should be emphasized as more representative of the company’s future earning potential. If a 5 year history is used, in order to place more weight on the current year it is given a factor of 5. The prior years are given a lower factor usually decreasing by one for each previous year (5-4-3-2-1). Each year is then multiplied by its factor, a total is derived and then the sum of the years is divided by 15 (the sum of the factors 1 through 5).

4. Determine a capitalization rate which corresponds to an appropriate rate for a safe return, adjusting is accordingly to reflect the perceived level of risk associated with the size of the Company and specific industry and company risks.

5. The average amount of earnings determined in step 3 above is then capitalized (divided) by the capitalization rate determined in step 4. The amount thus derived is the estimated total value of the business.

6. Where applicable, discounts should be determined to apply to the value of the company as a whole. In some cases this will include a minority interest discount or a lack of marketability discount or a combination of the two.

Whether you are a start-up entrepreneur contemplating your options for fundraising or one who is beginning to focus on selling your business, a valuation will give you the clear financial picture you need to meet your long-term goals.

Some reasons for valuing a business include:

  • Negotiating favorable price and terms as a buyer or seller in a transaction 
  • Settling a tax dispute with the IRS regarding estate taxation
  • Resolving the asset distribution in a marital estate resulting from divorce
  • Obtaining an SBA loan or commitment from a venture capitalist or angel investor 
  • Purchasing an adequate amount of insurance for various purposes
  • Settling a "Buy-Sell" provision in a partnership arrangement
  • Aiding in establishing proper exit strategy
  • Satisfying the general curiosity of the typical entrepreneur

 

John W. Davis, Partner, Davis & Hodgdon Associates CPAs