Introduction to Business Valuation

Non-Financial Due-DiligenceValuing a business should not be put off to the last minute when a business is looking for an exit. Most business and finance professionals agree keeping valuation numbers current is a good idea. Using valuation as a measurable key performance indicator (KPI) allows the owner to continuously make changes that maximize value. Valuing a business frequently provides the owner several additional insights such as whether selling the business will provide sufficient funds to retire or whether merging a business is a better option to selling the business.

Overall, there are several reasons to value a business where buying or selling a business is the most important one. Reasons to value a business can be summarized as:

  • Keeping score of value created
  • Making changes continuously to maximize value
  • Facilitate business merger or sale
  • Division of assets within a family and estate planning
  • Tax planning and other disputes
  • Litigation
  • Keep track of valuation for retirement

Valuating small businesses is tricky because there is no central database that keeps track of all transactions. Therefore, valuing a business requires a lot of work and information. Both business buyers and business sellers need to value businesses. The business seller usually has completed valuation and has a price. Regardless of the business seller’s price, the buyer must independently value the business as well. Usually the business buyer will value the business a price that is lower than the asking price. If the two valuations are in the zone of probable agreement (ZOPA) then there is room to negotiate and potentially close the deal.

Collecting this information for a business valuation starts from understanding the industry to conducting detailed financial analysis of the company’s financial statements. For industry analysis the evaluator must determine if the industry is growing or declining and how well the business is positioned within the industry. The evaluator must also complete competitive analysis using Porter’s five force analysis. Other elements of due – diligence includes quantifying the addressable market and current market share of the business.

There are several valuation methods one can use to determine the intrinsic value of a company. These valuation techniques are broadly classified as Asset value methods, Earnings value methods and Market Value based methods. The valuation methods listed above are based on discounting future cash flow, discounting future earnings and using industry specific multipliers. Corporate financial statements including the tax returns are the best source for intrinsic valuation and buyers should ask for at-least five years of data before valuing businesses.

Companies should enlist valuation experts for business valuation. Valuation experts can also help business owner’s benchmark against industry best practices and performance. Experts in business valuation fall in one of the following areas:

  • Business brokers
  • Certified appraisers and valuation experts
  • Forensic accountants
  • Attorneys and lawyers

Business owners tend to resist getting their business valued by a professional because of the cost involved. So, while it is important for business professionals to learn how to continuously value their business informally and they must also value their business formally.