This guest post was previously published on Schencksc.com on October 31, 2018.
As business advisors, we are often asked, “What is my business worth?” The valuation of a business is not an exact science. In fact, it’s more of an art than it is a science.
The value of a business is based on its fair market value. By definition, fair market value is "the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts."
When is a valuation needed?
Certain situations may require a formal business valuation, including estate planning, gifting, merger or acquisition transactions, divorce, litigation matters, buy-sell agreements and SBA loan applications. However, in some situations, informal methods of quickly approximating the value of a business may be appropriate.
How are informal valuations calculated?
There are several guidelines and rules of thumb that can be used for a close approximation of value, each dependent on the type of business being valued. Generally, these guidelines provide an approximate range of value but, in the end, the value depends on a number of factors such as location, financial performance, age and condition of equipment, as well as occupancy costs and whether it’s a lease or real estate purchase.
Rules of thumb to approximate the value of your business may be more appropriate in certain industries and generally are calculated as multiples of one or more of the following:
● Gross profit
● Seller’s discretionary earnings
● Earnings before interest, income taxes, depreciation and amortization (EBITDA)
● Earnings before interest and income taxes (EBIT)
In certain types of businesses, the value of inventory is also considered in determining the approximate value.
For reference, discretionary earnings are the pre-tax and pre-interest profits before noncash expenses (such as depreciation), one owner’s benefits, one-time investments, and any nonbusiness income or expenses. If there are multiple owners who actively participate in a business, this part of discretionary earnings requires an estimate of the cost to replace each owner’s efforts or work. The ultimate goal of identifying discretionary earnings is to properly identify what a new owner can reasonably expect for annual earnings.
Prepare for the future with a valuation
You do not have complete control over the timing of many of life’s events, including the need to evaluate your business. It’s a good idea to assess the value of your business annually.
For many, their business is their “retirement plan.” It’s important to understand that financial worth cannot be created overnight, and it takes time to establish value. Life might throw something unexpected at you and you may be forced to sell your business. You’ll be in a better position if you take the time to understand and carefully build the value of your business before these situations arise.
There are a number of situations in which a valuation may be needed. For more information or assistance in having a valuation performed, reach out to one of our business bankers and we can put you in touch with an appropriate valuation expert.
About the authors:
Chris Hendricks, CPA, CVA, shareholder, specializes in the planning, supervision and review of various financial reporting engagements. He also has experience performing business valuations of privately held companies for estate, gifting and stock sales, and is member of the National Association of Certified Valuators and Analysts.
Donna Schultz, CFP®, CVA, is a senior manager and valuation analyst. A leader of Schenck’s valuation team, Donna has many years of business valuation experience for purposes of transition planning, buy-sell agreements and management planning in a wide variety of industries.