I found this valuable post on Diane Kennedy’s Tax Loopholes blog on the topic of business valuation – a process that is as much art as it is a science that you can check here.
How much is your business worth? The answer of course is “It depends.” In this case, it depends on who is asking.
For example, if the IRS is asking how much your business is worth, they’re doing it most likely because they are valuing the business for estate tax purposes. You might also have a lawyer asking because your partner is getting a divorce and they want to know how much it’s worth for a settlement.
Or it could be that you want to know because you want to sell it.
Let’s start off with how the IRS is going to value your business. First, they’re going to look to see what your minutes and agreements say as to valuation. It’s not necessarily a dollar amount, but more of a process that we would want to see. And one thing to remember, if your business hasn’t selected the valuation process, then the IRS is going to select it for you. And chances are the people left paying the taxes are not going to be happy with what they choose.
Some common valuation techniques include looking at the asset value, income stream, cash flow, or gross income.
Generally, asset value will give you a lower value. It’s assuming that there isn’t a viable operating entity. You’ll see this kind of valuation when the business is really just a job. If the chief worker (the entrepreneur) is gone, there really isn’t a business anymore. All that’s left are the assets. In the past decade, though, we’ve seen the rise of intangible valuation. For example, when Google went public there was a revenue model, but massive losses. Using old school valuation, Google wouldn’t have been worth much, if anything. But the stock sold out! Why? it’s because Google had built an intangible asset – traffic and market domination. In this case, the value of the asset is in the hands of the owner. What COULD you do with that asset?
The income stream looks at how much money the venture makes. There is an assumption that if you work in the business that you can be replaced. After you pay the salary to your replacement and possibly adjust benefits to be more in line with a worker, not an owner, how much income is there? A purchaser is looking for ROI in this case. If there is an income stream of $200,000 per year and the purchaser wants a 10% return on his money, then the value would be $2 mill. In real life, though, the expected return is going to be a lot higher because businesses are generally illiquid and riskier than, say, a CD.
Cash flow valuation is a similar process to the income stream. The evaluator is looking for how much value will come from that stream of cash flow. You might also hear the term “discounted” cash flow. That takes into account the discounted value of future dollars. In other words, would you rather I gave you $100 today or $100 a year from now? The $100 a year from now has less value and so it’s been discounted.
Gross income valuation is most often used for professional practices. I’ve seen values of 40% – 75%, for example, on medical practices. That amount represents a percentage of gross income (sales amount) received by the practice. There is usually some kind of guarantee for a year or so that the income will stay at a rate. If it doesn’t, the purchase price is adjusted.
Although no one likes to think about dying or divorce, the reality is that one is certain and the other is more common than we like to imagine. Step one of valuing your business is to memorialize the process you’ll use to determine how much your business is worth, absent a buyer.
Next week I’ll go into some of the techniques for improving value in advance of a sale. There are little simple things you can do to improve the value, but you need to do them years in advance of a possible sale.