How and Why to Value Your Business?
You’re looking to sell your leather manufacturing business. A buyer comes along and asks you to make her an offer. What’s the best way to determine the worth of your business? There isn’t one “right” formula. But, here are a few common valuation techniques: (1) asset-based, (2) income-based, and (3) market comparable. The most appropriate method will depend on your company’s individual history, market, asset mix and management strengths.
The most rudimentary method of valuing a business is valuing its assets and liabilities. At a minimum, a leather manufacturer has inventory and equipment, and these assets have value. In essence, this approach enables you to determine the cost of building a leather manufacturing business from scratch. But, depending on the nature of the business, the asset-based approach may result in a lower valuation. For example, it doesn’t take into consideration the intangible, going concern value of the business.
The income-based approach determines the value of a business based on its income potential. It looks at cash flow, and does not place value on the fixed assets of the business. This valuation method is best suited for solid cash-generating businesses (i.e. businesses that are not asset intensive). The Discounted Cash Flow method is a subset of income-based approach and this calculation is often used in M&A transactions. This method is based on estimating the current value of future cash flow. It is appropriate for businesses which have forecasted steady cash flow over several years.
The Market comparable approach looks to other businesses in the same or similar industry that have been sold and values the business on the average of such other similarly situated business. However, this approach can be risky because it may not capture the true value of your business. For instance, it is possible that the other similarly situated businesses sold at a lower price because of poor management, poor market share, lower than normal EBITDA, or other factors that would affect value and that may not be a problem for your business.
Bear in mind that all of the valuation techniques that are applied in the market must be used as either/or and not a combination. For example, if you are using Discounted Cash Flow, the tangible assets are not included in the calculation of your company’s value. Therefore, a leather manufacturer that owns and occupies a $1 million warehouse is going to be better of using the asset-based valuation method, whereas a professional services firm that expects to earn $1 million in profit next year, but has zero hard assets, will be better of using the income-based or the market comparable approach. Nonetheless, it may be a prudent idea to compute value using the different approaches to see what the results demonstrate.
There are many reasons for valuing a business, besides at the point of sale. A valuation of your business will help you understand your business’ weaknesses and strengths and improve its real or perceived value. It can help the entrepreneur in motivating his/her management team. Regular valuation is a good discipline and can help you take the necessary steps and make the necessary adjustments to generate the maximum value or an eventual sale.
Austin Potenza is a member of the Vistage Deal Network Advisory Board, a founding shareholder and attorney at May, Potenza, Barran & Gillespie, based in Phoenix. He is the head of the Corporate/Transactional Practice Group and his practice focuses on corporate law, commercial transactions, mergers and acquisitions, healthcare law, estate planning, and tax planning.
Shruti Gurudanti is an associate at May, Potenza, Barran & Gillespie, in the Corporate/Transactional Practice Group. Shruti is developing her practice in the area of corporate law, mergers and acquisitions, and emerging businesses.