We know that successful transactions begin with fully informed sellers and buyers; it is essential that the parties understand how the value of a small business is determined. Below is an outline of methods and rationale necessary to get a fundamental understanding of valuing a small business.
IMPORTANT The information on valuation presented here is sizespecific. If the business net income is approaching or exceeds $1 million, substantially different methods of valuation are likely appropriate.
The valuation methods and rationale presented yield fair market value of the business assets transferred free and clear of debt. Market value being the amount a buyer could reasonably be expected to pay and a seller could reasonably be expected to accept inan arms length transaction and within a reasonable period of time on the market, buyer and seller both being fully informed and neither being under any compulsion to act.
If the transaction includes the sale of real estate, both the real estate and the business should be viewed as separate transactions and the valuations of each must stand on there own merit. The real estate appraisal willestablish a reasonable rent factor that will be used in determining the recast business earnings.
Hiring a professional to perform the valuation
What is the business worth and what will the business sell for, are very different questions. In over 20 years, we have collected countless $2,000 to $8,000 appraisals provided by “professionals”. All of these reports may answer the question what is thebusiness worth but few are even close to identifying what it would sell for. There are many reasons why a “professional” valuation may be desirable including; determining minority shareholder interests, issuing stock options, ESOP creation and upkeep, estate tax assessment or tax returns, charitable contributions, trusts, family partnerships, insurance, private equity, initial public offering, SBAloan requirement, divorce, bankruptcy, and more.
There are an extensive number of methods acceptable to the IRS to calculate the value of a business, the values these methods generated may or may not reflect the reality of the market place. The professional evaluator must make many subjective assumptions to complete the evaluation, as such; experience shows the value reported is likely to confirmthe viewpoint of the party requesting the report. The buyer’s evaluator will report a low value to please the client and the reverse is true of seller’s evaluator. We do some expert testimony work and find it amazing when the “professional evaluator” for one party in a divorce case can justify a value of $4.5 million and the “professional evaluator” for the other party can justify a value of$500,000. Fact is both may have used sound reasoning and acceptable methodology but both were wrong. If you have a valuation performed, be certain the evaluator is using real world “business sales” experience, and can demonstrate to an informed buyer a justification of market value.
The basic valuation methods and challenges they present
Asset Based Valuations: An asset-based valuation requires us toestablish the “fair market value” of the assets of a business. Inventory value at cost can generally be determined relatively easily. The balance of the hard assets including furniture, fixtures, equipment, machinery, and leasehold improvements, are a challenge. The book value reflected on the financial statements of a business is not a realistic indication of current market value. Commonly wefind a substantial number of the business assets never appear on the balance sheet.
The value of used business "assets" is highly subjective and it is unlikely the buyer and seller will agree on fair market asset value; both will have a defendable but different perception of value. A four year old computer used in the business for instance, the seller cannot do business without the computer and...