Small business valuations: What you need to know
Educate yourself on appraisals before you sell your company.
You may think you know the value of your business after years of paying bills and tracking bank statements, but even the savviest entrepreneurs should get a professional appraisal before selling.
"Most business owners don't have the expertise to do it on their own," says Tim Morrison, CFA, ASA,and senior business appraiser at Wells Fargo.1 "It's easy to measure hard assets, but an appraiser can understand the intangible assets: the value of your workforce, patents, customer lists, and procedures."
Before you put your small business on the market, enlist a reputable appraiser and learn about valuation methods.
Use an experienced specialist for a business valuation
Certified appraisers, such as professionals affiliated with the American Society of Appraisers, will assess a business' value for a fixed fee, the amount of which depends on the complexity of the engagement.2 Ask appraisers for references and check certifications to ensure the candidate has the appropriate experience.
"How long have they been doing valuations? If the appraiser does not perform business valuations on a regular basis, he or she may not be up-to-date on current valuation approaches and methods," says Morrison.
Start your business valuation early on
Don't be afraid of getting valuations too early. Typically, the business is the owner's most significant financial asset, and understanding its value is critical for proper planning. "There could be a disconnect between what the owner thinks the business is worth and how the market values it," says Morrison. "If [the owner] know[s] there's a disconnect earlier, that will help with the owner's retirement and estate planning." An appraiser can always update his or her valuation later. If the value isn't what you expect, you'll want time to adjust, especially if the sale of your business is intended to help fund your retirement. The cost for an updated valuation is typically a fraction of the original cost. By hiring the same appraiser to do annual valuations — often at a discount because of the frequency — business owners can track over time how much their business may be worth.
Understand business valuation methods
The three approaches to business valuations are:
Asset approach. This approach is based upon the concept that the value of the company is equal to the value of its tangible assets — including receivables, inventory, machinery, equipment, and real estate — and subtracts liabilities. It is generally appropriate if the value of the business is closely tied to the value of the assets – such as a real estate holding company. However, this approach could undervalue a company with significant intangible assets, such as trade name, customer lists, internally developed technology and processes, and workforce in place. The intangible assets are generally captured under the two remaining valuation approaches.
Market approach. This approach values a company by applying observable market data to metrics of the subject company. Typically, market data will consist of valuation multiples, such as a price-to-earnings multiple, for publicly traded firms in the same industry as the company being valued. In another method, the appraiser may obtain data on transactions for companies in the same industry. These multiples are then applied to the metrics of the subject company to determine the value. The market approach is best-suited for situations in which the company operates in an industry with several publicly traded firms or where transactions involving similar companies can be identified.
Income approach. For any investment, the ultimate question is what is the return on the investment? The income approach works well for helping to determine the return on investment since it relies upon the expected net cash flow – gross cash flow minus expenses – that a company is expected to generate. "Because of this 'cash is king' maxim," says Morrison, "the income approach is almost always an appropriate valuation method."
Your appraiser should consider all of these methods when doing your valuation, but he or she may not use every one. "A tech company, for example, probably wouldn't use the asset approach because that type of business doesn't have a lot of tangible assets," Morrison says. "And with the market method, sometimes you just can't find companies that are comparable to the one you are valuing. But a good appraiser will tell you why he or she didn't use a certain approach."
1 Tim Morrison has Certified Financial Analyst (CFA) and Accredited Senior Appraiser (ASA) designation.
Wells Fargo Private Bank and Wells Fargo Wealth Management provide products and services through Wells Fargo Bank, N.A. and its various affiliates and subsidiaries.
Wells Fargo & Company and its affiliates do not provide legal advice. Please consult with your tax and legal advisors to determine how this information may impact your own situation.
This information is provided for educational and illustrative purposes only.