Business Valuation and Common Misconceptions and Associated Risks

Maneuvering through the intricate landscape of business valuation can be as challenging as it is critical for owners looking to sell their business – their life’s work. The valuation process is not merely an academic exercise but a practical one that can significantly influence the final sale price of a business. 

It’s essential for business owners to understand that an early, independent valuation serves a dual purpose: it provides a snapshot of the current worth and highlights potential value increases through operational improvements. This article delves into the complexities of business valuation, exploring common misconceptions and strategic considerations to ensure that entrepreneurs maximize their wealth when the time comes to sell.

Understanding Different Business Valuation Methods

1. Market Comparison Valuation Approach

Also known as the Market Approach, the Market Comparison Valuation Approach, is a method for valuing a business by comparing it to similar businesses that have been sold recently. This approach assumes that the value of a business can be determined by looking at the sale prices of comparable companies in the same industry or sector. 

2. Asset-based Approach to Business Valuation

This method calculates the valuation based on the total net asset value of the company. The value is derived from the company’s balance sheet:  the fair market value of its total assets minus the total liabilities. Total assets include:

• Tangible or real assets: such as real estate, equipment, inventory, and receivables.

• Intangible Assets: such as intellectual property, patents, trademarks, goodwill, and brand recognition.

3. Adjusted Net Asset Value Method

This valuation method is a specific application within the Asset-based approach to business valuation. It adjusts the assets and liabilities on a company’s balance sheet to their fair market values, as opposed to their historical cost or book value. It provides a snapshot of the company’s value at a point in time by reflecting what the assets and liabilities would actually be worth if they were to be sold or settled. 

4. Earnings-based Valuation Method

Here, the focus is on the earning potential of the business, using an analysis of past earnings performance to establish a pattern or trend and forecasting future earnings based on historical data, industry trends, and the economic outlook. It looks at the net present value (NPV) or after-tax cash flows:  how much money a firm is making when it is all said and done.  To find this value, you can use any of the following approaches, or a combination to drive a value.  

• Earnings Multiplier Valuation Approach: The multiples approach a streamlined method of earnings-based valuation that determines a business’s value by applying a multiple to its earnings. This multiple is derived from comparable companies in the same industry and reflects the market’s assessment of the future growth and risk associated with the business. One common multiplier used is a multiple of EBITDA (earnings before interest, taxes, depreciation, and amortization)

• Market Capitalization Valuation Method: This straightforward approach is used primarily for valuing publicly traded companies. It calculates a company’s total value by multiplying its current stock price by the total number of outstanding shares. This figure represents the aggregate value that the market believes the company is worth at a specific point in time. Market capitalization reflects the public market’s perception of a company’s future prospects and earning power, encompassing factors such as market conditions, investor sentiment, and economic forecasts.

• Discounted Cash Flow Method: This method calculates the present value of a company’s expected future cash flows. By forecasting the business’s free cash flow over a certain period and then discounting it back to today’s value using a required rate of return (which reflects the riskiness of the investment), the discounted cash flow (DCF) method aims to determine the intrinsic value of a business. This approach takes into account the time value of money, recognizing that future cash flows are worth less today due to the potential earning capacity of money over time.

Pros and cons of business valuation methods

Each of these methods can yield different results, and choosing the right one depends on the nature of the business and the purpose of the valuation.

The Market Comparison Valuation Approach is useful for investors and buyers as it provides a reality check against other valuation methods by anchoring the business’s value to actual market transactions. However, it’s important to remember that this method provides a range of values rather than a precise figure, and it should be used in conjunction with other valuation approaches for the best results.

The Asset-based Approach is a straightforward method of valuation that can provide a clear picture of a company’s value based on its substance. However, it may not fully capture the value of future earnings potential and can undervalue companies with significant intangible assets such as company culture or intellectual property or those whose primary value lies in their earning power rather than their net assets.

The Adjusted Net Asset Value Method is particularly suited to businesses with significant tangible assets or where the business is not a going concern. It’s often used in situations such as liquidation analysis, merger and acquisition transactions, or for businesses that may be winding down operations.  While it  adjusts assets and liabilities to current market values, it may struggle with intangibles.

Using an Earnings-based Valuation Method is often favored for its forward-looking perspective and its ability to accommodate different business sizes and types. It is particularly relevant for valuing profitable, going-concern businesses where the primary value driver is the generation of earnings or cash flow rather than the possession of assets.

Ultimately, valuations gravitate towards the net present value of after-tax cash flows, capitalizing on earnings, using discounted cash flow, or applying industry ratio multipliers like EBITDA multiples. An accurate valuation often requires a combination of these methodologies to capture all elements affecting a business’s worth.

Business Valuation Misconceptions and Risk

When it comes to valuing a business, one of the most prevalent missteps is the owner’s overestimation of its worth. This miscalculation often stems from an emotional attachment and the sweat equity that cannot be quantified on financial statements. It’s vital to acknowledge that potential buyers will scrutinize profitability and risk, not the years you’ve invested. 

Along with the owner’s bias for valuation, there are a number of other aspects of your business that may also affect the value.

Factors Affecting Business Valuation

If you choose to get a preliminary valuation of your business as part of compiling Part I of your Deal Book, you will have the insight into improvements or changes you may want to make in your business before you actively pursue selling.  Any combination of the following factors  may affect your business valuation:  

• Client list concentration: Reliance on a few clients can elevate risk and lower valuation. buyers generally seek a diverse customer base to ensure stability.

• Annual performance: Cherry-picking the year for performance will likely put buyers on edge since it does not show a history of performance. 

• Leasehold Interests: A leasehold interest refers to a structure where an entity leases the land and/or buildings for an extended period of time. If you do not account properly for leasehold interests, your business may be valued too low. Separating land and buildings in a different entity with some kind of a leaseback is usually best practice.

• Working capital calculations: You need to know how changes in working capital affect your valuation. Buyers often require a certain level of working capital to be maintained to ensure a smooth transition and continuity of operations. Working capital calculations will be included in the Letter of Intent, and need to be clear, with examples, and easily reverse-engineered. They should relate directly to the representations and warranties provisions.

• Business organizational structure: The organizational structure of a business significantly influences its valuation at sale. S corporations, LLCs, and partnerships often command a pass-through valuation premium because they are not subject to the double taxation faced by C corporations. For a consistent and equitable valuation, it’s recommended to apply C corporation tax rates (approximately 21%) to pass-through entities during NPV cash-flow calculations. This standardization ensures that valuations are comparable across different entity types. Additionally, many deal comparison databases predominantly feature S corporations or LLCs.

• Goodwill: The difference between the purchase price and the appraised value of assets is called goodwill.  As an intangible asset, goodwill is amortized differently than assets which are depreciated. It may not be in the best interest of the buyer to recognize substantial goodwill, so the buyer may want to allocate some or all of the purchase price to different assets in an effort to minimize goodwill on the books.

Those are the biggest factors to consider when coming to your final valuation, and each one is as important as the other in their own way. Understanding where you business is now, with a preliminary valuation will allow you to make adjustments to the factors that are negatively affecting your current valuation.  

Importance of Professional Guidance

With years of experience working with business owners, the Certified Financial Planners™ at Avion Wealth are here to help guide you through this process.  If you’re curious about the next steps toward your business exit, reach out for a complementary conversation.  We can answer your questions and connect you with the resources to start your journey the right way.

To learn more, request a complimentary copy of Paul Carroll’s book Tips & Traps: Selling Your Business While Maximizing Your Wealth.