The vast majority of small business owners have worked extremely hard to build up their business. And as the saying goes, when it comes time to move on (be it for retirement, a change of plans, or an untimely death), there are really only three options: sell, pass it on to a family member or employee, or shut it down.
Given the inevitability of a transition, its more important than ever to understand what your business is worth. Let’s take a look at how to get your arms wrapped around a value.
First things first, let’s go through some definitions. Our concern is in this article on business worth is largely “Fair Market Value” or FMV. The IRS has definined FMV as
“The price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.”
In simple terms, a business is worth what someone is willing to pay for it. FMV also presumes that you are not under duress to sell (i.e. in a situation such as an untimely death, a bankruptcy, etc). If you are trying to understand value under duress that is an entirely different article.
You can download a copy of IRS 59-60 here.
When we try to understand what a small business is worth, we are really trying to determine what a willing buyer would pay for it. When we put our “buyers hat” on, there are three many methods that we use to ascertain value:
- Asset Based Approach – What is the net worth of the physical assets of the business?
- Market Approach – How does entity compare to peers that have sold?
- Income Approach – What is the value of the ongoing “benefit stream” of the company?
When using the above approaches one of the most important steps – regardless of the technique used- is to “normalize” the financial statements. With regards to the P&L statement, many small businesses work to minimize their tax bill. While this is perfectly legitimate from an owner’s perspective, from a valuation perspective a buyer would want to understand the complete economic benefit available from the business. The balance sheet requires similar adjustments – ranging from adjusting depreciated equipment to current FMV or adjusting for excess / non-operating assets. Ultimately, these normalizing adjustments are a critical component of understand what a small business is worth.
Beyond these quantitative adjustments, a valuation analyst also looks at the qualitative factors present in your company. This helps the analyst understand how your business performs compared to peers, how productive the assets are, and the likelihood it will continue to perform at a given level. Items that might be analyzed include:
- Are revenues increasing, decreasing, or stable?
- How strong is the management team?
- What barriers to entry are their for new entrants into the market?
- Does the company have a strong, defensible market niche?
- Is there re-occuring, contractual revenue? Or are all sales “one off?”
- Are any clients large enough to present a risk to the business should they depart?
- Are any vendor relationships overly critical to the business
Thoughts on Increasing Business Worth
Beyond the nuts and bolts of valuation, buyers in the real world concern themselves with one primary consideration: risk. As much as the “numbers” drive valuation, buyers are probably most concerned with reducing percieved risk. The more red flags that a business presents, the less likely that a sale will occur. That’s right: perceived risk can through valuation out the door and actually prevent a business from transacting. Here are some of the biggest risk factors that we see buyers concerned with:
- How stable are the revenues and earnings? (Are they declining? If so, why?)
- Are their a material amount of adjustments to the financial statements? (buyers prefer that there are fewer)
- How much risk is their in “client concentration? (If one large client departs, what happens to my earnings?)
- How dependent is the business on the seller? (If the seller walks, will the revenue dry up?)
If you are intent on moving from the subject of small business worth to actually selling a small business, then put your “buyer’s hat” on and try to view the business from their point of view. (Investment bankers and M&A advisors often call this a “pre-diligence.”). Before you try to extract the value from the business you’ve built up, understand the issues that might impair value during a sale process.
Understanding the worth of a small business is a blend of qualitative and quantitative factors. An experiences analyst uses both to understand how a “notional buyer” would likely view your company. You can do the same on an “unofficial” basis with a few rules of thumb, but for an expert’s touch contact a certified valuation analyst.