A common myth is that selling price equals business value. As Warren Buffett has famously quoted, “Price is what you pay; value is what you get.”
What Is Business Value?
Value is fundamental. The theoretical or notional value is also called fair market value. It represents the highest amount a willing and able buyer will pay to a seller, assuming:
- The market is open and unrestricted;
- The buyer and seller have similar levels of detailed information regarding the company, its market niche, and knowledge of the business’s financial and operational details. etc.; and
- They willingly enter into a transaction.
To calculate the fair market value, a valuator makes several assumptions, such as the reaction of the open market, the type or identity of potential buyers, the length of business continuity, etc. However, such assumptions may influence the actual sales transaction and lead to differences between value and price.
To find a business’s value, obtain a business valuation from an impartial, experienced third party to calculate a current market value.
Business Valuation and Calculating Value
To calculate the business value of a company, a professional valuator or business valuation advisor must consider diverse factors, including the operations of the business, the industry niche, market dynamics, etc., and incorporate them into one or more of the three primary business valuation approaches: the income approach, asset approach, market approach.
Also called a cash flow approach or an earnings approach, the income approach considers future cash flows to determine a company’s current market value. The valuation advisor projects the business’s future cash flows and then examines the company’s probability of achieving them.
This business valuation method works incredibly well with companies with considerable intellectual property value because advisors can often only estimate them by their potential future performance. For instance, software companies have more intellectual property than physical assets.
Under the asset-based approach, advisors use the net asset value of the business to determine its current market value. The net asset value of the company equals total assets less total liabilities.
This method works on the assumption that if the owner sells all assets today at fair market value and uses the proceeds to pay off all debts, liabilities, and taxes, what remains will be the net asset value.
The asset approach best serves businesses rich in physical, tangible assets, such as construction or real estate holding companies.
The market approach of business valuation uses metrics from comparable companies and recent transactions to determine the target company’s value. The quality of the business valuation process depends on the similarity of selected market metrics to the company under review. The availability or lack of public information on the selected companies and transactions impacts the quality of this business valuation process; therefore, valuation advisors prefer to use the market approach in conjunction with the income approach to determine the value of a business.
Irrespective of the approach used to determine business value. Based on certain assumptions, the business valuation process results from the theoretical or speculative value (current market value). The price is determined after a business goes to the market and the sales process begins.
What Is Selling Price?
Price is arbitrary. It is the amount a potential buyer is ready to pay for your business. It may be less or more than the calculated business value. Many factors influence why a buyer does not match the selling price with your business value.
Buyers are different. One assumption is that the potential buyers have similar skill sets when making value calculations. In reality, prospective buyers are diverse. They have different knowledge levels, negotiating abilities, and financial strengths, leading to differences between business value and selling price.
Emotions affect decision-making. The business valuation process assumes that the rational investor seeks to maximize returns. However, as both buyers and sellers are human, emotions influence decision-making. They often overlook the objective analysis results and allow their emotions to overpower evidence.
Strategic buyers can pay more. A strategic buyer purchases a business to integrate it into their existing operation. That acquisition generates more value for them than acquiring it and keeping its operations separate. Therefore, they are often willing to pay more than other buyers, resulting in the selling price exceeding the business value.
The selling price is not paid entirely in cash. Sales proceeds do not necessarily come in 100 percent cash. Depending on the terms agreed between the buyer and the seller, the transaction may include the exchange of shares, vendor notes, or any other structures to bridge the price gap.
Even when the selling price is not equal to the business value, it reflects the value of the business. This is why savvy business owners get valuations!
Business Valuation Does Not Equal Selling Price
As a business owner, you must know that business value does not equal selling price. However, if you want to sell your company, a business valuation will help you understand what your business is worth in the market. This information will guide you through the negotiation process. The actual selling price is determined when you engage in selling your business.
By knowing your company’s business value, its key value drivers, your exit goals, and the value of your intellectual property, you can make an informed decision as to what price you will accept for your business and what you must do to build value if the price you need exceeds the current market value of your business.
Business valuation is a complex process. Determination of business value varies depending on your business’ unique situations and needs. Expert business valuation or exit planning advisors will give you the most accurate calculations. They will also prepare you and your company for the sales process and ensure that you get your desired exit.