Getting a good deal in business sales requires an accurate business valuation.
This important process involves the determination of the economic value of a company and it can be done through a number of different methods.
The Purpose of Business Valuations
Ensuring an accurate business valuation is critical for both the potential seller and the buyer. It ensures that the deal is fair and that the business is worth the amount being paid. There are also tax implications for wanting an accurate business valuation.
For business owners who are new to the process of valuing a company, it can be confusing, complicated or just different.
Understanding the basics of a business valuation can not only ensure a good deal, but it can also help business owners to understand their company’s current state and determine next best steps
How to Value a Business
There are three different ways in which business valuations are conducted.
- Using available assets
- Using the current market
- Using actual income
The reality is that all three valuation approaches offer a unique perspective and insight. One method may be more or less relevant for your specific purposes of business valuation, or you may want to consider taking a hybrid approach in order to achieve as robust and comprehensive an understanding as possible.
Valuation through assets
What is an asset?
An asset is basically an item of value that is owned by the business.
It can be as small as inventory or as large as a warehouse. Assets do not need to be tangible, physical property either. Software, patents, and trademarks can all be potential assets.
Business owners often have assets that they may not know about or understand its potential value.
How are assets used in a valuation?
The asset approach entails looking at a business purely in terms of assets vs liabilities as depicted on a balance sheet. The more assets and less liabilities, the better.
Your assets will also include your Debtors Ledger, which is a record of the money owed to the company. The healthier the ledger, the more money owed and the more valuable the company.
Liabilities are what the company owes, such as outstanding bills, rent, taxes, employee salary and other expenses.
It’s important to note that the balance sheet numbers may not always reflect the intangible assets, however, which may have a much higher monetary value than one realises.
Valuation through the market
Using the market to determine a business valuation is a strong way of indicating whether or not you are getting a good deal.
It’s important to compare the business in question to other similar businesses in the market. What are they being sold for?
Understanding the market context and having comparables is important for making an informed decision. It will help indicate whether you are pricing yourself out of a good deal or selling too low to get your money’s worth.
There are many, many variables that come into play here. The Fair Market Value of a business, i.e., the value that a willing buyer and seller agrees to in the end, is used to ascertain ultimately how a market values a particular business.
Valuation through income
In some ways, this method is the most direct, simplest and easiest to understand. It only considers how much money the business is bringing in, the potential for more income, and the risks that may affect that income.
Both buyers and sellers want to get a good deal so understanding what a business’s ability and potential is to bring in income is important.
Capitalisation vs Discounting
Capitalisation is an approach best suited for businesses with predictable, regular and steady income.
The process takes expected earnings and divides it by the capitalisation rate, i.e., a calculation of net income and current market value of the asset. In other words, if the rate is 44%, you can assume the business is worth four times its annual income.
Due to its complicated nature, we recommend working with experienced accountants and valuation professionals on this process.
Discounting, on the other hand, occurs when you forecast business income over a set period of time, most commonly a few years. The discount rate, i.e., the required rate of return to make the purchase worthwhile, is used in calculation to estimate the risks of not receiving that income.
The last step is calculating what the business is likely going to be worth at the end of this predetermined time. We call this the Terminal or Residual Value. Together with the forecasted earnings, it helps determine what the business is currently worth.
Which method is right for you?
Each method and approach to valuing a business will end up having its own outcome. Different priorities and different calculations will each put a different end value on a business.
For a buyer, risks will be an important factor and their level of risk aversion a determining criterion. Potential for increased income and where they see the business in the future will be significant compared to where they see the business today. To this end, a buyer can be thought of as an investor and therefore their chosen valuation method should and could be based on their individual investment goals.
As a general rule of thumb, here’s a breakdown of each method and when they should be employed:
- Asset-based valuation: Suitable for businesses with a high proportion of physical, tangible assets or during a liquidation of a business.
- Market-based valuation: Suitable for businesses in established industries with lots of comparable sales data.
- Income-based valuation: Suitable for businesses with a strong track record for reliable income and profitability and clear future growth prospects.
Getting a Good Deal as a Seller
How can a business owner maximise their business’s valuation?
- Negotiation strategy – Be prepared to negotiate on the final price based on both your own valuation and the buyer’s diligence findings.
- Consider the market – Take the time to research the market and understand the general sentiment towards similar and comparable businesses.
- Assess your business’s condition – Consider your business’s financial position, growth potential and any risks – hidden or otherwise – so you have an accurate understanding of its condition.
For more information, read our article on Five Ways to Maximise Your Business Valuation.
Position Your Business for Success
ScotPac is the largest non-banking lender in Australia. With over 35 years of experience finding customised finance solutions for our clients, our specialist lenders are more than capable when it comes to finding a Business Finance solution to put your company in an advantageous position. In fact, many businesses and organisations don’t realise the value held in some of their currently owned assets.