One of the most common questions business owners ask me is to explain the different business valuation types and to guide them to the one that’s right for their situation. While there is a broad range of business valuation methodologies, there are essentially two types of valuations — estimates and appraisals.
Business valuation estimates
The first type of valuation is an estimate of value. This is simply a calculation of business value using basic financial information and multipliers. It’s less precise than an appraisal but may be the perfect solution in the right situation.
For example, owners at an early stage of business succession often only need an estimate of value to assist them in their financial and strategic planning.
Often, these owners are discovering for the first time what their business is roughly worth and what factors would make their businesses more attractive to potential buyers. As such, they are usually more interested in learning about value drivers to strategically increase their business’ value. The precise value of their business at this early stage is less important because they expect it to change dramatically in future years.
Having an estimate provides these owners with a baseline. With an understanding of what their business is worth and what it could be worth, they can embark on strategic business planning initiatives to close what is commonly referred to as the value gap.
In addition, these owners are often beginning to learn about their readiness to exit, business succession components and exit options. However, their main focus in the near term is on value-building.
The benefit of an estimate is that it’s inexpensive and easy to calculate. Armed with some financial history and an understanding of market demand, an estimate may be calculated within minutes because the process is mechanical and doesn’t require much analysis or judgment.
Business appraisals
The second type of valuation is a business appraisal, also referred to as a certified valuation. Business owners who have advanced from the discovery phase and are preparing for succession often require a more accurate business valuation than what an estimate provides.
A formal business appraisal also affords an owner a more defensible valuation due to the appraiser’s expertise, objectivity and credibility (assuming your appraiser is objective, credible and an expert). Plus, a formal business appraisal process may ensure that legal and reporting compliance requirements are met.
For example, a business owner preparing wealth transfer or estate planning strategies may require a formal business appraisal to satisfy IRS rules regarding valuation methodology, professional judgment, discounts, premiums, documentation and independence. Alternatively, an owner planning to transfer the business to a family member, key employee(s) or a third party may also be best served by a formal business appraisal. Each situation is unique, and qualified valuation experts will assess the circumstances and employ one or more valuation methodologies, depending on the type of transfer and level of detail required by the buyer.
As expected, a formal business appraisal requires a more in-depth analysis. The appraiser will need to understand the nature of the business, its history and its management. A financial analysis will need to be performed based on balance sheets, income statements and cash flow statements. An analysis of industry and market trends, the regulatory environment and economic factors will be conducted. Tangible and intangible assets will be evaluated. A risk assessment will be performed, and complete explanations and documentation will be provided.
Considerations
When deciding what type of business valuation best meets your needs, consider the following factors:
- Purpose of the valuation — Is the valuation for your own understanding, to provide you with a baseline for value-building or in preparation for your succession?
- Stage of your business — Are you at the learning and discovery stage or preparing for a transaction?
- The audience — Is the valuation for you, a family member, a key employee or a third party?
- Precision required — Is an estimate sufficient for your needs, or do you need a more precise valuation to meet the requirements of your audience?
If you’re interested in learning more, please email me at Phil.Harwood@TamariskAdvisors.com to receive a complimentary copy of “Valuation Guide from Discovery to Exit,” a 15-page white paper that expands on this article. Now go forth.
