KEY ARTICLE TAKEAWAYS
Learn the different reasons a business owner may need to determine their company’s worth and how it can impact valuation
Explore some of the most common valuation methodologies
Discover how market value is determined and steps an owner can take to increase valuation
It is an important question, but you might be surprised that the answer will be different depending on why you are asking.
You might need to know this answer for several different potential reasons:
Personal financial planning:
You want to know what a buyer in the market might pay to help you plan your financial future
You want to find the lowest value that will withstand IRS scrutiny so you can transfer more to your heirs
Buy/sell agreement or value stock for an option/equity plan for employees:
You might rely on simple formulas to reduce complexity and make it easy to understand
In each of these cases, the valuation for your company could be quite different. Same company, different valuations. In other words, there is no precise way to answer this question without knowing a lot more.
Want to get a sense for what it takes to sell your company? Start with this exit checklist.
Company valuation methods
For this post, let’s assume the purpose for your question is to determine how much a third party buyer might pay for your company – how much could you expect to get if you took your business out to market and sold it?
is based on data from similar transactions in the private market to determine approximate market value.
is simply the net asset value of a company based on an assessment of its tangible and intangible assets less its liabilities – this can be useful to establish a baseline value for a business.
Discounted cash flow
(or capitalization of earnings), probably the most widely used methodology, attempts to estimate the future free cash flow a company will generate, and using an appropriate discount rate, calculate the present value of these future cash flow streams.
For businesses that are less asset-intensive, the market value or DCF methodology will figure more prominently than the asset value methodology. Conversely, for businesses like heavy construction companies, asset value will be more important.
In all cases, however, a reliable valuation will have two components:
- An estimate of the future cash flows of a business
- An assessment of market, industry, and specific company risk – the higher the perceived level of risk in a company, the lower the resulting valuation. In other words, perceived risk is inversely related to valuation.
How to calculate market value?
It is important to remember that a company valuation is simply an estimate of what the market would pay for the company if it were to go to market and engage with several different bidders. In our experience, these estimates are almost always wrong. Why?
Value is in the eye of the beholder. Different buyers will come up with different estimates of the future cash flows in a particular business. Some buyers might have components in their own business, or have prior experiences with a specific business model, that cause them to over- or under-estimate the future cash flows of the target company.
Likewise, different buyers will have different perceptions of the level of company, industry, or market risk in a particular company, based on their prior experiences and overall judgment.
Finally, the specific price that a specific buyer will bid will be influenced by the negotiating dynamics involved in the transaction. If the buyer is competing with several other buyers, the price which they might bid will likely be higher than if they were the only bidder.
As a result, when presented with the exact same materials about a target company, buyers can come to dramatically different conclusions about the value of the business. The chart below shows five deals we have worked on over the years. For each deal, each dot represents a unique bid, and how much higher that bid was of the lowest bid we received.
How can you increase your company’s valuation?
To come up with their valuation, buyers estimate future cash flows, and then assess the level of risk in the target company. Knowing this, what can you do today to increase the expected price you would get in the market for your company?
Given the importance of future revenue and earnings growth, the first thing you can do is:
- Build (and execute on) a supportable, detailed growth plan. To do this, you need to think about the drivers for growth across sales channels, salespeople, products and service lines, and geographies, and then how that growth can be supported operationally. We have developed a template that can help you work on an effective growth plan.
- Identify the risks in your business that professional investors will perceive, and develop plans to eliminate or mitigate those risks prior to going to market to sell your company. It is important to understand that you will see risks in your business differently from a professional investor. Why? Because you manage these risks every day and are likely comfortable with them, but for an outsider, these risks will diminish value.
Our CoPilot assessment can help you identify different risks in your business, and prioritize the work you will need to do to eliminate or mitigate those risks. It gives you an investor’s view of your business prior to going to market (sort of like getting the test ahead of time), allowing you to address risks that would otherwise prevent a transaction or reduce your company’s value.
Ideally, you would start this work two to three years ahead of when you intend to sell your company. This gives you plenty of time to identify and resolve the different perceived risks in your business and to build a credible growth plan.
Online valuation tools
When you Google “How much is my business worth?” you will likely be directed to several online valuation tool sites. You enter in some financial information and identify your industry, and voila, it spits out a valuation for your company.
While it is kind of fun to go through these exercises, these valuations are at best, inconclusive and at worst, dangerous. Relying on something as crude as one of these tools can lead you to make critical decisions about selling your company based on faulty information, which can be expensive and a waste of time.
Instead of trying to predict the unpredictable, focus your energies instead on understanding what you can do to increase the value of your company. Build a believable, supportable growth plan and identify and fix the risks in your business. While it might not be as fun as playing with an online valuation tool, it will help you sell your business for more money and with less headache.
As an Associate at Class VI, John is responsible for deal execution and board advisory services for clients in several industries including business services, food and beverage, distribution, consumer products, and energy. John also assists in Class VI’s marketing efforts through content development.