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How to Understand Key Factors Used in Business Valuation
Posted by Sylvia Lagerquist, CPA
To many business owners, the practice of business valuation seems almost like an alchemist’s art. After all, when you’ve spent years (and likely decades) in the midst of managing and growing a company brick-by-brick, it can seem random and irrational for a business valuation firm to suddenly tell you how much (or how little) your company appears to be worth.
The reality, however, is that business valuation is the most critical step that will ultimately stand between most business owners and retirement. After all, chances are you chose to invest most of your time, money and effort into building the business, which means that it is now your most critical asset.
Considering the outsized importance of this asset and its value to the future of most private company owners, you need to understand business valuation. In fact, the sooner you become conversant with the essentials of business valuation strategy, the sooner you will come to a more realistic understanding of how others will view your business.
The following are some (and by no means all) of the key factors that a business valuation team will likely examine as they seek to establish a fair market value for your business:
1. Forecasting future performance and cash flows.
While this is can be quite variable depending upon the buyer’s intended goals for the acquisition, some key elements being examined can include:
- cash flow
- forecasted growth within the company’s industry
In addition, a critical area to be examined may be the impact of intangible assets such as:
- the concentration and loyalty of customers
- the company’s dependence upon certain accounts
- current contracts
- trade secrets
- market position
- distribution channels
- proprietary products
- intellectual property (IP) such as patents and trademarks
- growth capacity with current facilities and personnel
2. Examining financial leverage.
This focuses on the company’s ability to leverage assets and wide borrowing capacity or its lack of available assets and limited borrowing capacity.
For example, a company that possesses outstanding credit; a collection of high-value production machines that are now fully owned; and a long-term supplier contract that locks in competitive pricing, demonstrates very strong financial leverage.
Where this causes frustration for many small business owners is that in some cases, the owner may be selling the business in part to get out from under a high mountain of debt or to avoid having to dig deeper to finance new equipment or other major changes.
Nonetheless, passing these challenges to a buyer doesn’t reduce their significance, and a business valuation expert will zero in on them quickly.
3. Establishing expectations for financial return.
Consistency is the goal for any acquirer. The reason most investors or companies acquire other businesses is to take advantage of a reliable source of cash or market positioning or customer relationships. This is why it is essential to examine expectations for financial return early in the valuation.
In order for a company to be highly valued when compared to its peers, the business should possess:
- high-quality, well-managed financials
- streamlined and fully documented business processes and procedures
- a management team that is incentivized (or possibly contractually obligated) to stay in place following an ownership transition
- a consistent history of sales performance
- clearly defined profit margins
That is why it is essential for business owners to understand that the value of a business is a factor of timing as well as figures.
It’s smarter in most cases to put a company on the market when it’s had 3-5 years of consistent growth and proven profit margins, than it is to drive toward a sale before that time (say, when there are only 1-2 years of consistent performance) or even after it (when 3 years of consistent results are followed by 1-2 years of lower performance).
As you can see, business valuation is a demanding process because it looks at the business not only as it is today, but also as it has been in the past and as it might become in the future.
As a business owner, your strategic imperative is to build your business in a manner that gets you ever-closer to creating a framework for successful business valuation — while also examining the market and economy yourself to stay informed on when the ideal time for exit might arrive (which could be before, or after, you would personally prefer).
To learn more about how you can optimize your business for a successful valuation or future exit strategy, contact your CPA today.
- Keys to a Successful Business Valuation
- Key factors Influencing Small Business Valuation
- Seven Things That Determine the Value of a Business
Image Credit: ter-burg (Flickr @ Creative Commons)
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