By Kanan Sachdeva
What’s your business worth? The answer is critical as you plan for its future and your own. But valuing your business isn’t a simple task. It would be natural to think that you want the value to be as high as possible. But that’s not always the case.
There are many factors to consider. When you’re valuing your business, here are three considerations to take into account:
- How will you use the valuation? There are a number of reasons you may need a formal valuation for your business. These could include:
- Creating a buy-sell agreement with your partner.
- Transferring your business to a family member.
- Conducting a third-party sale.
- Determining your net worth.
- Obtaining financing or insurance.
- Negotiating a prenuptial agreement or divorce settlement.
- Estate planning.
When valuing your business, you must be realistic to pass Internal Revenue Service standards based on fair market value.
But there is as much art to valuation as there is science. Reasonable people could look at the same business and come up with different values. The question of why you’re valuing your business may impact your valuation approach. For instance, if you’re buying out a business partner, you probably don’t want to pay the highest price possible. Or if you’re transferring your business interest to your kids, you’ll want a low valuation to reduce the gift tax value. If you’re selling to a third party, you likely want the highest valuation possible.
- Evaluate possible methods. Depending on the purpose of the valuation and your business goals, you might consider one of three basic strategies:
- Book value (assets minus liabilities)
- Multiple of earnings
- Comparable sales
Asset-oriented businesses are often valued based on the value of those assets. In manufacturing, for example, the value will include property, machinery and tools. Service-oriented businesses are often valued based on cash flow (present and future) and future profit potential. There may be goodwill value associated with the business based on its reputation, customer relationships and business practices.
Informal valuations based on book value or multiple of earnings may help with certain aspects of financial or estate planning. However, sometimes a formal appraisal is required. If you hire an appraiser, be sure to explain the purpose of the valuation. The formal appraisal will likely be based on a variety of factors, including business assets, operations and cash flow, as well as economic outlook and sales of comparable businesses. Because there is both an art and a science involved with appraising, different appraisers can arrive at different valuations.
- Consider additional factors. Depending on the purpose for your valuation, there might be considerations that influence the overall value of the business. This is where there’s a little more art than science to your valuation.
- Changes in expenses: Don’t take the income statement at face value. For instance, you may be managing the business and taking a $200,000 salary. Another owner may be able to hire someone to manage the business for $100,000. Such a move would immediately increase the net income of the business.
- Depreciating assets: Assets may be depreciated for book purposes, but the fair market value may exceed the book value. Often it is the fair market value rather than the book value that is relevant in valuations.
- Earnout: When there is uncertainty about future cash flows, you and a buyer may negotiate an earnout provision. Part of the purchase price can be fixed, and part can be based on future earnings.
- Intangibles: Your business may have intangible value that isn’t readily apparent on an income statement. For instance, some buyers may be willing to pay a higher price for a business that’s complementary to their own or that opens up new markets.
- Changes in liabilities: In general, business value can be increased as liabilities are transferred or paid down. Value can also be intentionally decreased if unfunded liabilities are put in place, such as deferred compensation arrangements.
- Minority/controlling interests: Businesses that have minority interests may have reduced value due to limited marketability and control.
Once you have a value for your business, remember it’s not a “one and done” exercise. You’ll want to regularly update your business value and update anything that depends on it, such as buy-sell agreements.
It’s also important to make sure that your own personal financial plan fully takes into account your business. After all, the two are inextricably linked. An experienced financial professional can help you integrate your business and personal financial plans to make sure that you’re on track to reach goals for both.
(Article prepared by Northwestern Mutual with the cooperation of Kanan Sachdeva. Kanan Sachdeva is a Financial Advisor with Northwestern Mutual, the marketing name for The Northwestern Mutual Life Insurance Company (NM), Milwaukee, Wisconsin, and its subsidiaries. Kanan Sachdeva is based in Southborough, MA. To contact Kanan Sachdeva, please call (781) 248-8640, e-mail at firstname.lastname@example.org or visit kanansachdeva.com.)