At some point during the life of your business, there’s a good chance that you’ll need to figure out the value of your small business. Valuing a small business is not an easy task, and there are often pitfalls if you don’t have business valuation experience. Knowing the basics of business valuation will help you understand how to value your business or at least how your business may be valued by a valuation professional. Today I’ve highlighted some of the main points from a recent post on the iVLG blog that discusses business valuation basics.
What is Value?
According to most, including the IRS, value is the price a willing buyer would pay a willing seller (when there are no other circumstances that are directly influencing the transaction). Also known as “fair market value,” this definition of value (often) takes into account the value of a going concern, i.e. taking into account that the business is going to continue to operate and not liquidate its assets in the near future.
Art or Science? It Depends
“Rationalists” tend to favor complex calculations for finding a reliable estimate of the value of the business. These folks prefer to create complex formulas to interpret market data and determine the value of a business based on these formulas and data.
“Marketeers” tend to favor valuations based on relative measures that can be observed in the market, e.g. comparable businesses or assets in a particular industry. These folks generally look at recent sales to determine approximate values of businesses.
Common Valuation Methods
Income. The income-based approach is favored by rationalists because it relies on analyzing the income an asset produces over its useful life. This approach is prominent in retail, wholesale, manufacturing, subscription, and service industries.
Market. Implied by the name, marketeers prefer this approach because it looks at the objective measurements in the market to provide a comparison for value. By comparing objective market data for similar assets, you can determine a value range for your business. This approach is common across all industries.
Net Asset Value. This approach adjusts the book value of the business based on the market. The assets of the business are appraised to determine fair market value, and the sum of the assets is adjusted by the value of off balance sheet and contingent assets and liabilities to determine the value of the business. This approach is common with investment, real estate, and other companies with significant capital assets.
In this end, it is generally best to work with a valuation professional to determine the value of your small business; however, knowing business valuation basics will help you understand why your business is valued under a particular method.
Click here to learn more about business valuation basics, including adjustments to value, assumptions and manipulations of value, and pre v. post money value.
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