Business valuation for privately held companies can be a highly technical process, considering company assets, historic and projected financial performance, comparable transactions, general economic indicators, and rules of thumb.
Most valuation methods are simply guides to negotiations, except under either of two circumstances:
- legal disputes where a court may require a professional valuation report prepared by a Chartered Business Valuator, or
- private sales where the buyer and seller have agreed to use a specific valuation method in lieu of price negotiations.
Four main types of valuation method are generally recognized:
Asset-based valuation. Using this approach, assets and liabilities on the balance sheet are adjusted to reflect market values rather than book values. The resulting difference, less cash required for ongoing company operations, is the company's adjusted asset value.This method ignores earnings and cash flow and so typically results in a conservative value, unless the company has been losing money in which case it may over-state what an informed buyer is prepared to pay. This method can be used when a business is simply shutting down and liquidating. Assets are sold, liabilities are paid off, and the net remainder is the company's liquidation value.
Industry rules of thumb. Value may be estimated as a multiple of revenue, pre-tax income, free cash flow (also known as EBITDA: Earnings Before Interest, Taxes, Depreciation, and Amortization), or other measure, sometimes in combination with net asset value. These methods provide a quick estimate of market value. Some examples are "Three Times EBITDA" and "One Times Revenue". These blunt tools are often used to establish approximate values, in support of detailed negotiations.
Discounted cash flow. Here, historic and/or projected future earnings are discounted to determine a net present value, which becomes the estimate of fair market value. Discount rates used for small, privately held firms can often be in the range 25% to 35%, reflecting perceived risk relative to other investments. Mathematically, a 25% discount rate on EBITDA gives the same value estimate as using the rule "Four Times EBITDA". Variants of this method are generally accepted as the preferred method of company valuation, used by accountants, bankers, and brokers.
Comparable transactions. This involves comparing company size and profitability to recent transactions involving other companies. Subjective adjustments to value are made based on relative comparisons and a resulting estimate of company value is derived. Because sales of private companies are often secretive, finding comparable data for this approach can be difficult. Business brokers often have the best access to comparable sales data.
Choosing the right valuation method should depend on the valuation purpose. For litigation support, a Chartered Business Valuator may be required to produce a valuation that is acceptable in court.
For share issues within an employee-owned company, a fair market value of the company as a going concern is needed. This is typically set by the company's Board of Directors, based on objective third-party advice such as from a Chartered Business Valuator, Certified Professional Accountant, or similar professional.
For privately negotiated sales (with or without broker involvement), rules of thumb and discounted cash flow can be used to set approximate values, followed by detailed negotiations.
Ultimately, your business is worth what somebody is willing to pay for it. Properly preparing your business for sale will help ensure prospective buyers conclude it is highly valuable.
Thinking of selling your business? Contact us to start the conversation.