Company owners who have no intention to transition their companies to new management any time soon often ask why they need a business valuation.
Business valuation provides the baseline value of a company, the starting point from which you, as a business owner, may build a company with transferable value. Transferable value is what your business is worth to a prospective buyer or investor.
Business valuation is an effective management tool. Getting annual valuations and knowing the accurate value of your company helps you make effective plans to accomplish your objectives.
Reasons for Business Valuations
As your company grows and evolves, capitalize on the benefits of getting business valuations to monitor progress toward achieving your long-term goals. Business owners also need to get business valuations for the following reasons:
To resolve estate and gift tax issues. You need a business valuation to file an estate tax return, plan a gift to minimize estate tax, and guide the representative in fulfilling the terms of the decedent’s will.
Divorce. A business owner getting a divorce requires a business valuation to divide the marital estate and resolve any disputes in the settlement proceedings if the case reaches a court of law.
ESOP. Employee stock ownership plans provide private business owners capital, liquidity, and certain tax advantages. The business must get annual valuations for an ESOP to determine the price per share for its beneficiaries. This valuation is required to comply with IRS and Department of Labor rules. It is significant because the ESOP trustees could be held personally liable if beneficiaries receive less than the stock’s fair market value.
To raise funding. Business owners seeking loans from the SBA and other financial institutions must submit a business valuation. The valuation provides the bank with fair market value amounts that support the loan.
Buy/sell agreement. Business owners need a valuation to develop a buy/sell agreement, which allows a partner/owner to acquire another owner’s interest if that partner decides to retire or exit,s or dies. It includes a price or formula to determine what the remaining partners must pay to acquire the departing partner’s interest.
Insurance. Business owners need to purchase key person insurance to cover their business value if something happens to that person. This requires a business valuation to determine such value. The payout of the key person insurance policy helps the ownerâ€™s family buy themselves out of the owner’s role or continue the owner’s role, depending on the terms of the policy and the buy/sell agreement.
Succession planning. Succession transactions include gifting ownership to family or selling to employees or third parties. Such transactions require a business valuation to determine the value of the company.
Mergers and acquisitions. A business valuation is needed when a company acquires another company, splits up, reorganizes its capital structure, or files for bankruptcy while in liquidation or reorganization. A merger requires both parties to get a business valuation, while an acquisition requires only the selling party.
Key Insights from a Business Valuation
What will you learn about your business following the valuation if you are thinking about getting a business valuation? After a business valuation:
- You will get an understanding of the current market value of your business.
- You will see the value gaps in your business.
Understand the Current Market Value
Current market value is what a buyer would realistically pay for your business if you sold it today. It represents the current worth of your business and reveals your company’s health, strengths, and weaknesses. A business valuation helps you understand the multiple factors affecting your company’s value, such as asset values, income values, and market competition.
See the Value Gaps
For owners expecting to sell their business, a value gap is a difference between the current market value and the sales price they want to get. Similarly, a value gap is a difference between a company’s current market value and business goals.
It is usual for business owners to overestimate the companies’ values due to their attachment to them, but that results in unpleasant surprises when they take their companies to market and find significant differences between the prices they expect and the offers from prospective buyers.
A value gap analysis helps one understand the company’s current situation and indicates if the company’s objectives are realistic. These insights guide owners toward useful remediation strategies or process modifications to protect and enhance value.
Identify the value gap early with a business valuation and take corrective action to safeguard your company against the risk of failure or lower business value.
Value Destroyers in Business
A highly concentrated customer base. If your company depends on a few customers for 50 to 80 percent of its revenue, then you face a customer concentration issue. A concentrated customer base destroys business value due to the risk of a drastic drop in earnings should those customers be lost.
Inconsistent revenue. If your company depends on one-time revenues, it cannot sustain and scale. Instead, focus on smaller, consistent revenue streams. Recurring work and revenue build business value.
Dependency on the owner. Potential buyers see a company’s dependency on its owner as a risk because the company may not perform when the owner leaves. Codified systems, structures, and processes build business value, so focus on them.
Improper or sloppy recordkeeping. Failure to maintain accurate records and documentation reduces business value. You cannot create efficient business plans if the data you base them on is not valid. Prospective buyers gauge a company’s value from its financial statements and accounts. If they are not in order, they see it as a risk.
Begin, Sustain, and Stay on Track
- A business valuation may help you kickstart your value creation process by revealing your company’s current market value, which serves as a baseline value for your business plans.
- The business valuation provides evidence of your enterprise value in a court of law and to taxation authorities.
- Business valuation serves as proof of enterprise value to prospective buyers during negotiation.
- Most importantly, periodic valuations allow you to stay on track in your value creation journey.