The Importance of Small Business Valuation
Because they establish the economic value of an owner’s interest, business valuations are important tools for determining a fair sale or acquisition price for a business of any size. Understanding the factors that determine that value, can also pay tangible dividends to a firm’s current operations by allowing management to increase short- and long-term profitability.
Yet despite the many benefits, few undergo the process of formal business valuation. Joel Peck, CEO of Joel Peck & Associates, certified public accountant, business valuation expert and financial planner, believes that is because so few understand what is involved in the process and many believe it is too expensive.
“However,” he adds, “it is absolutely vital if businesses plan to have any kind of long-range future.”
Why Value Your Company?
For Dave Matera, CEO of OOH Pitch Inc., a New York City–based marketing and advertising agency, conducting a formal business valuation became necessary when the company began receiving interest from buyers.
“We had companies looking at us, offering all different values, and we could not understand how they came up with their offers. We needed to find out what we were worth, why we were worth it and what we could change to be worth more,” said Matera.
While the sales process generally requires that valuations be completed, Peck recommends that businesses complete the process every three to five years or in the event of a major business change. These include the illness, disability or retirement of a partner, the admittance of a new partner, changes in key management, or changes in product lines, as these factors have a direct impact on a business’s financials and operations.
Conducting regular valuations will also ensure that proper planning for an ownership transition is underway and critical business and estate planning issues have been addressed.
Business Valuation Experts
Central to the valuation process is the utilization of an independent business valuation expert. Business owners should seek out a certified independent business valuation expert who will ask probing questions to uncover not only the financial value of a company but also the effectiveness of current management and operations.
Certification with the National Association of Certified Valuation Analysts (NACVA) is also something to look for, as many members are also CPAs who are inherently involved in a business’s financials.
While many companies believe that a business broker can assist them in valuing their company, Peck notes that business brokers may carry a bias into the process and tend to overvalue companies in an attempt to help the company sell.
Further, business brokers typically use rule-of-thumb equations to value the business, such as two times revenue or one and a half times net income, which results in median multiple values that are typically inaccurate. That is because the median value is simply a convenient midpoint and does not represent the revenue multiple for any actual transaction.
“Using these rules of thumb is probably the most common mistake that I see,” said Peck. “Even if two companies produce the same annual revenue, there is no way that they could be valued the same. It is all about the management team and how the company is run.”
The Valuation Process
What a business is worth depends on several factors that influence business operations. On the financial side of operations, valuation experts look at three key areas: 1) the amount of revenue the business currently generates, 2) the expected revenue growth in the foreseeable future and 3) the return buyers require on their investment in the business.
Customer and supplier relationships are also an important factor, allowing valuation experts to analyze and identify the weaknesses of the company behind the numbers. Further, current management plays a key role in the company’s value, with valuation experts paying careful attention to the dependence the company places on the current management team.
“Too many small business owners do not own a company, they own a job,” said Peck. “The difference is whether or not the company has value when you remove the current owner. If the company only has value with that owner in place, then the owner owns a job and not a company, and you cannot sell a job.”
In terms of information, business owners and managers should be prepared to provide valuation experts with a comprehensive list of information. This includes but is not limited to:
- Company history
- Three to five years of the company’s financial history
- Business projections for the next 24 months
- Information on the management team, including salary levels
- The top 10 customers
- The top 10 suppliers
- Perks that current ownership may be taking out of the business that a future owner may not
Although this level of information may seem overwhelming, compiling it is not a burden that management must bear alone. Matera and OOH Pitch relied on their accountants to prepare financial documents, from past tax returns to balance sheets, while the management team was responsible for providing insights on projections for the upcoming years.
The burden is also much lighter than perceived in terms of cost.
“For a business owner who simply wants to know what their business is worth, I would say that a standard valuation will cost them around $5,000. Typically, business owners hear numbers two and three times this,” said Peck.
These larger numbers may be more accurate for valuations evaluating gift tax, estate tax or divorce ligation. Those reports are typically longer because they must stand on their own before the Internal Revenue Service (IRS) and the courts, so they require much more time to complete and, therefore, cost more.
For Matera and Peck, however, the process is worth the cost.
“After having our business valued, we now have a true and comfortable valuation of our worth now and possibly a year from now. What’s more, the company that made us an offer was way off target, and this allowed us to stop any conversations of going further with the sale process,” said Matera.
Peck notes that valuation is imperative for businesses when forming an exit strategy, as owners must know how much their business is worth in the eyes of their potential buyer.
He adds, “Everybody knows how they got into business, but very few know how they are going to get out. If you don’t have an exit strategy, it is likely that you own a job, and you’ll want to get to a point where you own a business.”
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