When business owners are interested in selling their company, how does the owner know how much their company is worth? While business owners often have a sense of what they think the company is worth, their analysis is often limited solely to intuition. Without a properly conducted valuation analysis, business owners may not realize the full value of their company when selling to an employee stock ownership plan or a third party buyer.

How is value determined?

In general, value is primarily derived from the cash flows generated by the business. Ultimately, the question is how much is someone willing to pay to receive those cash flows? Receiving a formalized valuation from a qualified financial advisor will give a business owner invaluable information in supporting the price at which their company should be sold. Valuations are typically performed using multiple forms of methodology, which usually involves a review of factors pertaining to the company’s historical and projected financial performance, competitive landscape, as well as company strengths and weaknesses. Risks inherent to a company’s operations, industry, and cash flows will be scrutinized. A preemptive understanding and management of these risks can help a business owner ultimately achieve maximum value.

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Valuation Methods

Business owners are often familiar with the concept of a pricing multiple. Pricing multiples are generally used in market approaches that consider comparable companies or precedent transactions. Many business owners often have an intuition for pricing multiples paid by buyers of businesses similar to theirs. Of course, the devil is in the details and it’s important to understand the many facets of a business considered when reaching a particular pricing multiple. Valuation multiples can vary materially across types of buyers, industries, company sizes, differences in profitability and risk, as well as the particular financial metric to which the multiple is applied. Sophisticated buyers will understand the differences and will advantageously cite rationale in support of a lower purchase price.

Buyers of companies are paying for future cash flows, rather than historical cash flows. As such, an income approach that considers a company’s projected earnings potential is also commonly used. Projected earnings are an estimate, and will be scrutinized by a buyer. As a result, it is important for any earnings forecast to be rooted in supportable assumptions. Forecasted earnings will be analyzed in the context of historical performance, industry outlook, and perceived risk. Sophisticated buyers will use a seller’s inability to formulate and articulate a supportable rationale for forecasted performance as an opportunity to offer a lower purchase price.

Valuation Benefits

Selling a company is a once-in-a-lifetime event, and it is an emotional event that impacts legacy, as well as the financial well-being of an owner and their family. Receiving a formal valuation from a qualified financial advisor at the time of considering a sale can assure business owners that they are receiving fair compensation. Of course, business owners may also choose to receive a valuation in advance of considering a sale to ensure maximum value is received.

Buyers of businesses will scrutinize financial performance and risk and advantageously cite reasons to lower a purchase price. At the same time, buyers of businesses are looking for ways that they can maximize their investment through changes in the business in order to realize “trapped value.”Unfortunately for the current owners, this “trapped value” is then subsequently received by the future buyer rather than by the current business owner. Receiving a formal valuation well in advance of a sale transaction can provide the business owner with the chance to realize the “trapped value” through the proactive identification, management and reduction of perceived risk.