As it usually happens, some event will likely occur during the time you own your business that will trigger the need for a valuation. A valuation is a process that, based on several factors, will generate the economic value of your interest in the business you own. Once you determine that you need a valuation, there are three very important questions you will need to ask yourself: what is being valued, why is this being valued, and when do I need it valued?
These three questions will be discussed in turn; but first, it is crucial to understand the two types of valuations you can obtain and, then, by answering the questions above, you will be able to determine which type you need. The first type is a formal business appraisal. This appraisal is an opinion of the value of your business that is certified by a licensed appraiser. This appraisal can be used in court. In order to generate this formal appraisal, a licensed professional will need to undergo a rigorous analysis of every part of your business, including the economic condition of the business, the financials, the future prospects of the business, other interests in the business, and all of the business assets.
However, if, after assessing the above questions, you realize a formal evaluation is not what you need, your second option is to obtain an informal valuation. An informal valuation is, as the name implies, a much more casual opinion of the value of your business. These valuations are ideal for those interested in getting an idea of what their business is worth, and those who do not need to use the valuation for any kind of legal matter or any other matter involving third parties.
As stated above, the first question you should ask yourself is what exactly are you valuing? You should have a clear understanding of what needs to be valued – what asset, property or business interest is to be valued? Once you determine what needs to be valued, you can then decide whether you need a formal appraisal or an informal valuation.
The next logical question that follows is: What are the different interests and/or items that can be valued?
1. Assets - Most small businesses are sold on an asset basis, rather than a stock sale. If you are selling your business as an asset sale, then you will need to determine what specific assets you will include in the sale and, therefore, will be valued. Also, intellectual property can, and should, be valued as an asset. Another determining factor will be whether any of the hard assets leased. Following are the assets that business owners commonly include as part of the valuation if the sale is structured as an asset sale:
2. Stock - If stock is being valued, you will need to see if there are any restrictions on transfer that would impact the value of the stock. If a partial ownership is being valued, then the relationship to the entire ownership is important to understand. There are other variables that will also need to be considered that will potentially increase the value of the business, such as tax advantages.
3.Non-compete or employment agreements - You will need to determine whether these will be valued separately or if they will be included in the business valuation. These will often be valued with the business, as many professional practices would be nearly worthless without such agreements in place.
4. Real Estate - If you are obtaining a valuation as you prepare to sell your business, you will need to determine whether the real estate will be included in your sale. Real estate is often valued separately, by a special appraiser. However, most businesses only lease space and therefore real estate is typically not included in the sale of a business.
5. Debts and Liabilities - When obtaining a formal appraisal, you will be asked whether the buyer is assuming any debt or other liabilities. This will, most likely, affect the value of the business and the overall opinion on valuation.
6. Contracts - Contracts are at the heart of almost every business. You will need to assess what contracts you have, such as employment contracts, customer contracts, equipment contracts, leases, etc. Another factor in the outcome of the valuation is whether these contracts are assignable.
The next step is to determine why you need a valuation for your business. As we discussed earlier, business appraisals and valuations differ greatly depending on the purpose of the valuation. The answer to this question will ultimately establish whether you need a formal appraisal or an informal valuation. For example, a business owner going through a divorce and who needs a valuation to determine alimony will require a different standard of value than business owners seeking a valuation for the purpose of a shareholder dispute. Further, state laws vary greatly for certain types of business appraisals, such as for divorce, which will have a large impact on the type of valuation you need. Valuations prepared specifically for legal purposes, such as taxes, legal disputes, damage cases, and so on are affected by a complex array of federal and state laws and precedents.
Determining the purpose of the valuation will also assist you in selecting the standard of value that will be used when valuing the business. “Fair Market Value,” which is the price at which the property would be bought and sold when neither the buyer or the seller are under compulsion to buy and when both parties have reasonable knowledge of relevant facts concerning the business, is the most common standard; however, it does not apply in many cases. Another standard is “Investment Value,” which is the value of a business to a specific or expected buyer. This type of standard will often yield a higher value on the business.
The purpose of the valuation is an important component of the valuation process and must be carefully considered. Business appraisals are usually not applicable for multiple purposes. If you had your business valued for the purpose of a divorce, the final value may not be relevant if you are then looking to establish a price to sell your business or price your stock. It is important to understand the different elements of a valuation so that you can ensure that the right valuation is performed, based on the exact purpose you have. This is especially true now that the internet in riddled with DIY valuation sites. It would be a huge mistake to obtain a value thorough an online software program and then use that for, say, tax purposes or for other legal matters. You need to know what is being valued and why in order to obtain a proper valuation.
The final question you must ask yourself is: When do I need my business appraised? Believe it or not, the date of the valuation is crucial because certain circumstances can cause major differences in the outcome of the valuation. It is easiest to value a business at the end of its fiscal year. This is because adjustments often have to be made depending on the date of the appraisal – different accounts receivable, different level of inventory, varying sales volume and cash flow.
However, it is not always possible for a business owner to wait for the end of the fiscal year to obtain the valuation. For this reason, especially when selling a business, metrics can often be established, such as 4.0 times EBITDA, which would allow the parties to account for differences in the valuation over time. If the parties agree on the metric, then they can apply it (multiple of EBITDA, SDE, etc.) to the base value (revenue, EBITDA, cash flow, etc.) to establish a value for the business and make adjustments to the price accordingly.
When seeking a valuation for legal purposes, the date is critically important and is usually subject to intense negotiation, except for cases in which it is outside of the parties’ decision (i.e. taxes). Changes or inaccurate dates can be costly, and can require a new business appraisal to be performed.
When having your business valued, you also need to consider how long it will take the business appraiser to prepare the valuation. A lead time of 30-60 days is often healthy for a thoroughly prepared, written appraisal for a small or medium-sized company. For companies in the process of selling, a lead time of 2-4 weeks is often sufficient. Knowing how long it will take an appraiser to value your business beforehand will give you time to plan and make all necessary arrangements.
The most important thing to remember when you are seeking a valuation is that they are very subjective. There is no exact mathematical equation that will yield an exact number for every single business. There are too many factors to consider and every single business is unique. Keeping that in the forefront of your mind will help you navigate the waters more efficiently and, hopefully, remind you that the most important things to consider are what you are valuing, why it is being valued, and the timing of the valuation.
Before approaching a business appraiser, make sure you have a clearly defined purpose and know exactly when you need the appraisal completed. While a business appraiser can help you determine these, it will save you time, and money, if you have a good understanding of the types of valuations and the process before beginning the process.