As a small business in the lower middle market (annual sales <$20M), you’re likely curious about what the valuation process is like when it comes time to sell. Business valuations are critical components of the sales process and can dictate multiple factors, including the types of buyers you attract and the price of the sale.
If you’ve ever asked yourself, “How do you value a business to sell?” then you’ve come to the right place. This article outlines the basics about how to value a company and the different methods that are commonly used.
The Basics of Business Valuations
Before getting into the details of how to value a company, it’s important to first understand the basics of business valuations. Advisors and appraisers offer professional business valuation services to help business owners determine how much their company, or some part of their company, is worth.
Valuations can help owners see how their business compares to similar companies, which in turn, allows them to make strategic decisions and better prepare for the future.
How to Value a Company
Knowing how to value a company depends on a few key factors. Ultimately, the way a company is valued depends on who wants to know. Buyers and sellers will likely have different interpretations of a company’s market value. This is what often leads to a valuation gap, which can delay — and completely derail — the sale of a business. As such, having trusted advisors on your side is critical as they can determine which valuation method is best for your company and goals.
There are certain valuation methods, like the use of price/earning ratios (P/E ratios), that are relevant for public companies but not for small businesses. For our purposes, we’re focusing strictly on valuation methods for small businesses in the lower middle market — specifically those that are privately held and structured as pass-through entities. Here are several common methods for assigning value to a business.
While this method isn’t typically used to price a business for sale, your advisor will likely review asset values for a few reasons. This method is used primarily to obtain a liquidation value for bankruptcy, or when you need to know the value of tangible assets.
As a business in the lower middle market, you’ll likely be sold under an asset sale (instead of a stock sale). This means that your business advisor will analyze the value of all assets that create revenue to determine what they are worth.
Investors might find it more attractive to purchase a business with a greater proportion of tangible assets on the balance sheets as it can make the business easier to finance.
The market value method is the most common approach for valuing businesses in the lower middle market. It assumes that the business will be sold as a going concern and continue to be run as-is. This gives buyers a baseline from which to analyze a potential acquisition. It is especially beneficial for those structured as:
- Pass-through entities
Market value is based primarily on the past performance of the business and assumes that future cash flow will remain consistent under new ownership. While pro forma projections are useful for attracting investment-minded buyers, they are not built into this valuation formula.
Under the market value method, your advisor will determine the value of all intangible assets – including the tangible assets supporting them – and use comparable transaction data to find an accurate multiplier.
DCF (Discounted Cash Flow)
Advisors use the discounted cash flow method for high-growth companies like technology startups; venture capitalists often use this method as well. It’s not as common in traditional small business valuations, which rely on historic financial performance.
Under this method, valuations are based on expected future cash flows. Specifically, advisors will find the present value of expected future cash flows by applying a discount rate.
If you have outstanding shares, then your advisor may focus on enterprise values, which are used specifically if a company has shares of stock. This method is often used for businesses structured as C-Corps.
Under this method, advisors will determine your market capitalization by multiplying the share price by the number of shares outstanding. They will then add liabilities like short-term and long-term debt, and subtract any cash or cash equivalents seen on the balance sheet. [Enterprise Value = Debt + Equity – Cash]
This is a valuation method you should be wary of. A strategic buyer is a specific type of buyer who might be willing to pay a premium for your company. As the name indicates, there’s a strategy in place. Perhaps they’re after a piece of real estate because it’s critical to the growth of their company or you have a particular product line they would like to own.
Only the strategic buyer knows what they’re willing to pay to acquire your business. Beware of any outsider who tells you they can calculate the strategic value of your business. Your advisors can estimate the value of your company or assets on the open market, but they can’t get inside the mind of a strategic buyer. Strategic purchases can be more subjective than objective.
Why Company Valuations Are Critical
Now that you have a better understanding of how to value a company, it’s crucial to know why these valuations are important.
First and foremost, business valuations help prevent the valuation gap, which appears all too often during the merger and acquisition (M&A) process. This gap occurs when sellers believe that their business is worth more than it actually is.
As a result, the sales process is hindered or halted completely and sellers are left holding onto false hope and chasing unrealistic expectations. Knowing the fair market value of the company before a sale can help protect owners and prevent the valuation gap.
Additionally, knowing the current market value of a company allows business owners to make strategic decisions about the future of the company. Part of a valuation may include comparing the business to similar companies. By doing so, owners can see how they stack up against these comparable companies and identify areas where they may need to improve to meet their goals.
Lastly, business valuations can assist with retirement planning. By the time you’re ready to sell your company, it’ll be too late to make major adjustments to boost revenue growth or alter your business plan in an effort to improve the value of your business. Your metrics are what they are at that point.
If you’re relying on the sale of your company to fund your retirement, you’ll need to make sure you receive enough money from the sale to make that happen. The sooner you have a valuation, the more time you’ll give yourself to make any necessary changes. In an ideal world, you’d have valuations completed at least three to five years before you’re looking to sell.
Knowing How to Value a Company Helps Business Owners
As a business owner, receiving regular valuations from trusted advisors is essential. Even if you’re not planning on selling your company anytime soon, having regular valuations will show you how you stack up against similar businesses, allowing you to make strategic adjustments. Regular valuations can also help you avoid the valuation gap when it’s time to sell.
There are various methods of valuation to determine the value of a business, but the one your advisor chooses can depend largely on the size of your business, your business structure, and other important criteria.
While many parts of a valuation are objective, there are subjective portions as well. This is one of the main reasons why it’s important to use trusted advisors for your business valuation. You’ll want a team who will diligently pore through your financial statements and apply multipliers correctly to determine the true value of your business. Contact the team at Allan Taylor & Company to learn more about how we can help.