Business Valuation Blog | Understanding Buying / Selling a Company

I hear the phrase “the value is the value” oftentimes when discussing appraisal work with those not familiar with the profession. With machinery and equipment appraisals, the primary differences in value are fairly straightforward. They tend to correlate to the approach you most heavily rely upon and the definition of value that's estimated. Fair Market Value - Installed will drive a considerably higher value than any type of liquidation premise.

With business appraisals, it goes even further. Liquidation value is typically not a factor assuming the company is ongoing; however, the specific reason why an appraisal is needed will dictate the appropriate methodology and approach that best fits that perspective.

For example, if the purpose is for an outright sale of the company in the open market, the appraiser might need to back out the on-hand cash and liabilities from the balance sheet given the likelihood that the seller will cash out the liquid assets and be obligated to settle the liabilities at closing.

If the purpose is for a minority share buy-out or buy-in, the business appraiser will need to consider applying lack of control discounts to the overall value of the business when calculating the percentage share associated with the transaction. In other words, if 100% of the business is worth $500,000, a 20% non-controlling share will be less than $100,000, given the minority investors’ lack of control.

Another example may be a divorce scenario, where the company is being valued as part of a contested or negotiated division of assets. There may be factors pertaining to the ongoing litigation or settlement that will need to be considered before finalizing the value.

From a methodology perspective, it is quite often that a business appraisal can be reasonably valued using more than one approach. How these differing conclusions are weighed will factor into the overall estimate of value.

There is always going to be a level of subjectivity with any appraisal. Opinions will differ, depending on the data that is relied upon, the methodologies ultimately utilized, and the experience of the appraiser, who needs to make reasonable decisions to conclude on value.

When you need a business appraisal, take the time early in the process to cover these topics so you understand the approach that will be taken and ensure the methodology fits the overall purpose driven by the larger transactional picture.

A Business Appraisal relies on three broadly accepted approaches that consider all the potential variables that factor into a valuation: The Income Approach, Market Approach, and Asset Approach.

These approaches review and analyze historic performance, reasonable growth projections, and the underlying assets of a company to estimate value. Depending on the circumstances, one or all three will be weighed in the final assessment.

Within these three approaches, there are a multitude of methods by which business value can be measured, however, when appraising a small privately owned company, there are typically only three methods utilized. Here is a brief summary of each:

The Capitalization of Earnings Method under the Income Approach

This method looks at the future projected growth of a business where historic revenues can reasonably predict ongoing trends over the next few years. Future cash flows are discounted back to the present date of the appraisal to establish value on a current basis. This method is most appropriate when a small business has shown a relatively steady level of revenue and income over the last 3-5+ years.

The Direct Merger and Acquisition Method under the Market Approach

This method estimates the prices paid for closely held companies that are in a similar line of business and can be considered comparable. Based on the data available in the market, it develops multiples that can be applied to the gross revenue and discretionary earnings of the business being appraised.

The Adjusted Net Asset Method under the Asset Approach

This method reviews all the tangible assets in the company, including real property, equipment, F&E, and inventory. Estimates are ideally based on an assessment of market value, or if that is not available, net book value. It also factors in cash, receivables, and liabilities to realize a net asset value. This method can be applicable if a business is capital-intensive but not producing a lot of revenue or net income, while also being appropriate for a company that is winding down operations.

In summary, you can discuss these methods in more detail with a certified valuation professional to better qualify which approach would likely apply to your small business. Taking the steps necessary to understand these approaches and methods before committing to a business appraisal will help you avoid any unexpected surprises.

Business owners likely have particular ideas about the value of their company and how best to calculate it, given their experience and knowledge of their financial history, and understanding of the market and industry in which they operate. When you need to formally engage an experienced, certified business appraiser to value your company, it's important to understand the standard accepted approaches they consider and weigh during the process.

There are three approaches to business valuation, namely the Income Approach, the Market Approach, and the Asset Approach. Each of these methodologies can be broken down further and considered based on the type of business you own, available data to analyze, and the company’s current operational status. Here is a brief summary:

The income-based approach has two primary methods that take into account whether the business income is steady or inconsistent. Essentially, the company's income is measured over a period of time to determine its overall value. Under a “Capitalization of Earnings” approach, the appraiser will consider both historic and future income probability, based on a steady stream of revenue, and discount these streams to realize a net present value, while using appropriate rates of capitalization.

Under the “Discounted Future Earnings” approach, the appraiser will estimate value primarily from future income probability, or forecasts, over a fixed period of time, to a terminal value, and discount this back to the present

Market Approach

>The Market Approach determines business value where the subject company being appraised can be compared to available businesses traded in the public marketplace. Adjustments are made to better match the private business based on revenue and overall size.

These guidelines are either investor-driven or transactional, depending on the data available. For example, a similar publicly-traded company may have available the price investors paid for minority interests in that company. This can then be adjusted to match the subject private business profile.

Other methods which take components of both the income and market approach are the “Multiple of Discretionary Earnings” and “Gross Revenue Multiple” which consider the actual income of the business being appraised and apply a market-derived multiple to these earnings based on available public data.

Asset Approach

As a general rule, the asset approach is considered and primarily weighed when a business is operating at a loss or has shut down temporarily or permanently. The options available to the appraiser under this approach are as follows:

Adjusted Net Asset Value: Under this methodology, the appraiser will adjust the company's tangible assets based on an estimate of Fair Market Value, while taking into account existing liabilities.

Liquidation Value: If the business has permanently ceased operations, and a compulsion to sell the remaining assets is the only remaining option, the value of the assets is measured under an Orderly or Forced Liquidation premise.

Book Value: This method relies solely on the net book figures of the assets recorded on the company’s books, without adjusting to market or liquidation value. Given accounting depreciation methods are usually accelerated, this will likely lead to undervaluing the assets.

Excess Earnings: This method takes into account the historic earnings of the company and provides a broad way to measure intangible asset value as well as tangible, by estimating the goodwill of a business along with personal property, equipment, improvements buildings, and land. This is generally preferred for fully operational companies with a lot of tangible assets.

By gaining a better understanding of these valuation methods, you will be able to work together with your certified, experienced business appraiser, in a successful fashion, to properly appraise your company.

When you're considering having your company appraised, one thing that may not have come to mind yet are the different small business valuation methods. But what are they, how are they different and which one should be applied to your particular situation? Here's a quick overview of the most common methods used and how they're applied to your company's situation.

What are the small business valuation methods and how are they different?

There are three primary approaches to small business valuation: asset, income and market based. However, there are a number of different methods under each approach.

Asset-Based Approaches

Generally speaking, asset-based approaches don't work well for companies that are running in the black, but may be used in companies that are failing.

Adjusted Net Asset Value: This requires the appraiser adjust the company's assets and liabilities to fair market value.

Liquidation Value: When a company discontinues operations or restructures, the proceeds are calculated using the premise of an orderly or forced liquidation.

Book Value : Though it's sometimes used, this method has some flaws. It's based on accounting figures but often doesn't reflect the asset's actual value due to depreciation schedules.

Excess Earnings: This method combines asset and income based approaches by calculating earnings to measure intangible business assets as an extension or multiplier above a reasonable asset value.

Income-Based Approaches

An income-based approach has two methods depending on whether income is steady or inconsistent. The company's income over a period of time is multiplied to determine its overall value.

Capitalization of Earnings: When a steady income is the norm for a business, this method uses adjustments to normalize the income stream of a business for a single period, and then multiplies that benefit over a longer period of time.

Discounted Earnings: Also referred to as discounted cash flow, this takes an inconsistent or irregular income for a company and converts it to determine the current value of future income benefits for that company.

Market-Based Approaches

This type of approach uses current market conditions to determine the value of a business, whether based on income, a similar business or overall transactions.

Guideline Public Company: A similar publicly-traded company allows the appraiser uses the price investors paid for minority interests in that company and adjusts it to match the private company that's being appraised.

Guideline Company Transactions: A similar company that's closely held is used as a basis for the appraised company, with transactions analyzed and adjusted to match the appraised company.

Multiple of Discretionary Earnings: Financial statements from small companies are adjusted to represent an owner-operator. It compares adjusted earnings to create a valuation multiple.

Gross Revenue Multiple: This uses a comparable company and divides transaction price by that company's revenue to create a multiple of gross revenue.

By having a better understanding of small business valuation methods, you can gain an appreciation of what exactly your business appraisal means, how it was calculated and in what situations it may or may not apply. However, the appraisal you receive and work from is only as good as the appraiser who calculates it and prepares the report. Make sure that the appraiser you use has a solid certification in business appraisal as well as experience in your industry before hiring them for the job.