How to value a business for investment

If buying and selling businesses is a new frontier for you, you can consult any number of online resources to help you determine the value of a business for investment. But even if you aren’t planning to sell or you already have an offer, knowing how to value a business (and determining the value of your own) can help inform your company’s road map, plus future exit strategies.

What is a business valuation?

Valuing a business is a complex discipline as you might expect when billions of pounds are bet on the stock markets every day on the basis of companies’ valuations. But it doesn’t have to be rocket science. 

A business valuation is a general process of determining the economic value of a whole business or company unit. Business valuation can be used to determine the fair value of a business for a variety of reasons, including sale value, establishing partner ownership, taxation, and even divorce proceedings. 

The basics of business valuation

The topic of business valuation is frequently discussed in corporate finance. Business valuation is typically conducted when a company is looking to sell all or a portion of its operations or looking to merge with or acquire another company. The valuation of a business is the process of determining the current worth of a business, using objective measures, and evaluating all aspects of the business.

A business valuation might include an analysis of the company’s management, its capital structure, its future earnings prospects or the market value of its assets. The tools used for valuation can vary among evaluators, businesses, and industries. Common approaches to business valuation include a review of financial statements, discounting cash flow models and similar company comparisons.

Valuation is also important for tax reporting. The Internal Revenue Service (IRS) requires that a business is valued based on its fair market value. Some tax-related events such as sale, purchase or gifting of shares of a company will be taxed depending on valuation.

Important: Estimating the fair value of a business is an art and a science. There are several formal models that can be used, but choosing the right one and then the appropriate inputs can be somewhat subjective.

Why would you value a business?

Outside of buying or selling an entire business, here are some other common reasons for valuing a business:

• For investment purposes: valuation can help with settling on a price for issuing new shares
• To develop an internal market for shares: valuation can help to trade shares in a business at a reasonable price
• To stimulate management: valuation can focus the attention and efforts of under-performing management, or reward those who go above and beyond

Lots of variables affect the value of a business, such as brand reputation, competitors and the wider economy, but the following factors pack the biggest punch:

• The circumstances surrounding the valuation (compare a voluntary sale and a forced one)
• The tangibility of the business assets (contrast physical assets with future profitability)
• The age of the business (an established company’s profit versus an emerging company’s negative asset value)

But by far the weightiest factor that affects the value of a business is how much a buyer is willing to pay for it. 

How much is a business worth?

Valuing a business can help you focus on areas for improvement. There are lots of things you can do to help secure a good valuation, including:

• Planning ahead: have a solid business plan, with a focus on how you’re going to achieve both short-term and long-term results
• Reducing risk: for instance, if you rely on a particular group of customers, consider diversifying
• Putting great processes in place: think about how you store information, whether it’s financial records or simply how the business works. Often, the more you can show, the higher the confidence in the business

Keep in mind that what works for one business won’t always work for another. 

5 steps to obtain a proper valuation of your business

Step 1: Forget about capital assets when valuing your business.

Unless you’re a qualified chartered accountant or a financial wizard, you may have made the common mistake of associating asset value with business value. In fact, these two entities are completely separate.

 

 

Step 2: Work out profitability by being aware of gross income and all outgoing payments.

If the value of your business isn’t measured in capital assets, then what is it measured in? Profits.

A valuation of your company is all about the money you are making and the money you are likely to make in the future. A buyer wants to know how much they can expect to make if they take over your company.

With gross income and outgoing payments, your own salary is included in that. However, we aren’t talking about every cent you earn from the business, just your base operating wage. Net profit is what we are aiming for.

But that isn’t all we need. A business is not valued based on its income for a single year. We also need to consider two more important aspects for valuing your company: longevity and profitability adjustments. 

Step 3: Calculate the value.

This is the step that everyone dreads: the actual mathematics required to calculate the value of your small business.

• First, establish your net income.

• Second, look at multiples.

Looking at your variables, you must decide based on what you think your multiple should be. Here’s a basic guide:

• A business run by a single worker will be unlikely to sell for a multiple above three.
• Businesses with revenue below $500,000 often max out at five.
• Only larger companies earning more than $500,000 in net profits can expect to reach a double-digit multiple.

• Third, figure out your market.

Your market significantly affects your profitability in future years to come.

• Fourth, determine your potential market growth rate.

• Finally, add growth projections.

Step 4: Factor in your market valuation.

Your valuation is a guide. You’ve created a valuation you can present to investors and buyers, providing them with a reasonable and respectable answer to the questions of «What is your business worth?» But that doesn’t mean your business is actually worth the value you’ve put on it.

In the end, your business is worth what the market says it’s worth. 

Even though you’ve done all the proper calculations, your business’s value ultimately lies with the people investing in or buying your business to determine what they think it’s worth.

 

 

Step 5: Accept the will of the market.

You may need to compromise on your figures if the market doesn’t support them. If you need investment to survive or you can’t wait to sell, then you cannot afford to be stubborn with your numbers.

Know your worth

We know you’ve put bucketloads of hard work, grit and determination into making your business what it is today. But although there’s not just one sure-fire way to get an accurate understanding of the value of your business, it’s important to know your worth while leaving emotions out of the equation.

You want things to add up on their own merits, and remaining impartial could help prevent you from over or underestimating your business’ worth. 

Remember, if you’re unsure of how to go about valuing your business, the best step you can take is to reach out for professional help. We would happily schedule a meeting!