Three Methods to Effectively Value Your Business

What’s Your Exit Plan__

While watching a documentary on Andrew Carnegie, one of the scenes really stood out to me. It depicted the earlier years of his career, stressing over unpaid bills and expenses, and trying to make payroll. It was something every successful business owner can relate to.

In hindsight, it’s easy to admire Carnegie. He ultimately had the most successful exit of any business in history, selling to JP Morgan for ~$400 Million. Adjusted for inflation, it would make him, hands down, the wealthiest man in the world.

Had he not endured and dealt with the stress and uncertainty – juggling all the moving parts early on, or if even one ball had dropped – the entire enterprise would have collapsed. That fortitude and spirit to persevere is shared by all successful entrepreneurs.

The Challenges of Entrepreneurship

Your story most likely includes countless challenges. You spend weeks and weekends away from your friends and family, nurturing the growth, and carving out a space for your business amongst your competitors. You have a vision that nobody else can see – one so vivid and clear to you that you could take big risks and stretch yourself beyond the limits to make your vision come to life.

Now you’ve reached a critical point, the pinnacle of your enterprise. You’re ready to start planning your exit and outlining your goals. You mustn’t rush to market and should treat your exit with the same diligence and carefully crafted strategy as you did all other aspects of your business.

How Much Is Your Business Worth?

A topic that comes up way too often is small to mid-sized business owners’ tendency to miscalculate their business’s value. It’s common to make a comparison to a competitor that recently sold, or to overestimate the importance of the company without a formal valuation process. I highly recommend not cutting corners when it comes to the value of the empire you have built. It is critical that you hire professionals who are knowledgeable and dedicated to positioning businesses for sale.

The critical process of business valuation is fundamental for any owner looking to sell their business. Understanding how much your business is worth and how that value is determined is crucial for setting realistic expectations for your exit. In this blog, you will learn the three primary valuation techniques:

  • Asset-Based Approach
  • Income Approach
  • Market Approach

Each method offers a different perspective and can be used under other circumstances, depending on the nature of your business and the purpose of the valuation:

Asset-Based Approach focuses on the company’s net asset value, total assets minus total liabilities. This approach is ideal for businesses with significant tangible assets. This method is ideal for companies that maintain inventory and other assets.

There are two primary methods within this approach:

  • Going concern asset-based approach considers the company’s balance sheet but adjusts the asset and liabilities’ values to their fair market value.
  • Liquidation asset-based approach is used when a business is not expected to continue operations, and assets are to be sold off. It estimates the net cash received if all assets were sold and liabilities paid off.

The Income Approach values a business based on its ability to generate future income or cash flow. This approach is ideal for companies with a stable and predictable income stream.

The most common methods under this approach are:

  • Discounted Cash Flow (DCF) forecasts the business’s future cash flows and then uses a discount rate to calculate the present value of those cash flows.
  • Capitalization of Earnings is used when a business maintains a relatively stable and predictable earnings stream. The business’s value is calculated by dividing the expected earnings by a capitalization rate.

This method is ideal for companies that have annuitized their revenue streams, such as those with subscription models. A potential buyer can have a firm estimate of their ROI based on the net present value of future cash flows. I have seen higher multiples used in these types of companies that help maximize exit values.

The Market Approach values a business by how similar companies are valued. This approach is practical when there are sufficient comparable businesses to provide a realistic picture.

The most common method used in a Market Approach is a Comparable Sales Method, which involves researching sale prices of similar businesses in the same industry and geographic area. This method uses industry-specific formulas and multiples based on revenue, earnings, or other metrics to estimate business value.

There are other variables to consider when using a market approach as well. For example, competitive companies can often look the same on the outside but with unseen differences in the infrastructure that make them more or less attractive to buyers. Intangibles such as leadership, organizational structure, brand equity, client loyalty, marketing strategies, employee incentives to stay with the firm post-exit and, most importantly, culture can vary. This approach is the most concerning as there are too many unquantifiable variables.

What Approach Works Best for Your Business?

Selecting the appropriate valuation technique or combination of methods depends on your industry, the nature of your business and the primary purpose of your valuation. The purpose is based on your exit goals, which should be your north star in every aspect of your journey. Familiarizing yourself with these methods will give you a realistic picture of your company’s worth and provide a solid foundation for building a successful exit strategy.

From my experience, a combination of these approaches should be used to cross-validate the value and to ensure a comprehensive understanding of your business’s worth. It’s critical that you have a thorough understanding of these options. Working with professional advisors specializing in exit planning, valuation, tax and wealth management will provide you with the structure, control and peace of mind that you have developed a solid foundation to build a successful exit strategy.

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