How to Calculate Your Business Valuation?
Business valuation calculations can be tricky. It is best entrusted with professional business appraisers.
Business valuation calculations are fundamental to every business. Be it to re-strategize existing operations or to consider a sale, these numbers are used as a reference to the overall worth of your company.
Business valuation is a process of determining the total worth of a business in economic terms. Small companies and publicly traded ones alike use various business valuation methods to arrive at the best possible valuation for their company. Founders pitch for the maximum possible value, whereas investors look for opportunities for the best ROI.
Either way, the importance of a valuation process cannot be ignored. Valuation figures on the one hand act as a benchmark for companies to revisit their operational strategies to maximize profits. On the other hand, investors and money lenders refer to valuation numbers while vetting funding proposals. In the following section, we discuss some specific reasons that reiterate the importance of business valuation calculations.
Why is company valuation important?
A successful business operation relies heavily on all aspects of cash flow into and out of the company. Sales revenue apart, founders are required to raise funds either from investors or other money lending institutions. Alternatively, the company might be structured in a way that eventually leads it towards an acquisition or an IPO. A reliable business valuation forms the basis of all these activities. Without valuation numbers, none of these economic transactions are possible, as the interested parties will not have any reference point to initiate discussions.
The flip side of this is a scenario where interests in the company are disputed. There could be a fall out among partners. One of the partners might face a personal situation in need of him to share assets with a third party. Or the company could be facing bankruptcy, in desperate need of a bailout. In these dire circumstances, business valuation calculations become the benchmark towards an amicable settlement.
A proper business valuation can be carried out only when accounting records of a company adhere to US GAAP regulations. This affiliation indicates the authenticity of all financial records. It is seen that valuation numbers of businesses that do not follow US GAAP regulations can vary by a multiple of 1x or by a value of 20-30%. Without clean financial records based on US GAAP regulations, professional evaluators will not have confidence in the company’s recorded EBITDA or the net income despite using the best business valuation methods.
Before entering the valuation process, the founders must have clarity about the purpose of it. Why are they evaluating the business? And what are they trying to accomplish with this valuation? These two basic questions set a context for the valuation exercise. Let us look into scenarios that affect the business valuation formula.
- Valuation for mergers and acquisitions – Business valuations with the intention of mergers and acquisitions focus on obtaining the best fair market value price of the company. The bottom line here for the benefactors is the return on investment. Those business valuation formulas that focus on these aspects are chosen while evaluating businesses on the verge of a merger or acquisition.
- Valuation for estate and gifting – Business valuation calculations in this case are focused on an owner-centric approach. It is best advised to prepare for such valuations before estate planning. Similarly, in the case of ‘gifting’ scenarios or ailing health of the business owner that might lead to death, business valuation preps have to start well in advance. The IRS suggests such valuation methods for charitable donations as well.
- Valuation for disputes – Disputes in business can happen either in case of conflicting interests of shareholders or in case of a business partner’s liability towards a personal asset sharing scenario (Eg. Divorce). In such cases, the company might need to be fragmented to work towards settlements. Business valuation methods in such cases have to account for the withdrawal or transfer of shares among beneficiaries.
- Valuation for financing – To attract investors to fund a company requires a business valuation formula that maximizes the company’s future profit potential. If a company plans to approach investors or banks for funding, they must start preparing for the valuation exercise well in advance so that all the necessary metrics are in line with this approach.
How to calculate your business valuation?
Now that we have discussed the various scenarios for business valuation, let us explore different ways of approaching business valuation calculations. The methods used vary with each particular approach. Here are the three basic ones:
Present value vs. book value vs. fair market value
- Present value – This approach takes into account the current and future cash flows of a business. It applies to a ‘going concern’, that is, assuming the business will continue to operate and grow in the future. It is also known as the ‘income approach’. The business valuation methods used in this approach focuses on the company’s income. Some examples are: capitalization of earnings methods, discounted flow method, formula method.
- Book value – Also called the ‘liquidation value’ or the ‘asset-based approach’ is the simplest one. It indicates the net worth of a company by subtracting all the liabilities of the company from the assets to arrive at this value. But assets must be valued based on market value. Only then, the business valuation calculations can indicate the company’s worth of liquidation.
- Fair Market value – Business valuation methods used in this approach focus on the value of the business based on the market. This accounts for a scenario where the company might be sold. Thus it involves comparing valuations with similar companies in the industry. It is easy to perform such valuations for publicly traded companies where financial information is easily available.
Business Valuation formulas & SDE
There are various forms of business valuation formula. The simplest among them is the Seller’s Discretionary Earnings or SDE. This is best suited for valuations of small businesses. However, the structure, size, industry, and complexity of the business will matter in the outcome. Here is a brief of how SDE based calculations work:
SDE is typically calculated from the previous financial year. Valuation analysts typically begin by noting the pre-tax net earnings of the target company for the given year. To this is added the owner’s draw from the business. Next, all the one-time expenses are added to this value except the cost of goods sold. From this value, all liabilities are deducted. Liabilities include debt, unpaid bills, and the likes. The final value derived from this calculation is the SDE.
SDE is a good measure to calculate how much money a business brings to the owner after all deductions. This business valuation calculation is a good indicator of the profit potential for a new buyer.
Industry multiplier or SDE multiple
SDE value is a good starting point. However, it is a measure only of the present. The ‘industry multiplier’ or SDE multiple is the value that when multiplied with SDE indicates the future possibilities of the company. Professional valuation firms publish guides with industry-based multiple values.
SDE multiple varies with industry. This is the differentiating factor. For eg, the SDE value might be the same for an AI and fashion business. But it is the SDE multiple, based on industry trends that will make a difference in the business valuation calculations. This approach ensures that every business is valued for their true worth and not as a run-of-the-mill exercise.
Add Business Assets & Subtract Business Liabilities
The last step in to add the business assets and subtract the business liabilities those of which were not already included in the SDE. An interested buyer is more likely to consider the legal structure of a business as a whole. This includes all the tangible as well as the intangible assets of the company. In practice, the seller takes responsibility for all the liabilities. But based on the business valuation calculations agreed upon, terms of the sale might differ. Here is how this works:
- Tangible assets are those that have a physical value. Aspects like real estate, accounts receivables, and cash on hand are all tangible assets that otherwise are not included in the SDE multiple. But they must be considered if the buyer plans to purchase all tangible assets.
- Intangible assets on the other hand are aspects like trademarks, patents, customer base, goodwill, and others. These are always part of SDE multiple as they have a major role to play in determining the true valuation of a company. Also, if the tangible assets are sold, these intangible assets go along with it.
- Liabilities are outstanding debt. They could be in the form of current loans, outstanding payments for suppliers, or past debts in the business. Usually, the business seller takes responsibility for all liabilities. The practice is to pay off debts using the money made from the sale. However, it finally boils down to the terms of the sale agreement between two parties.
Considering all of the above the final business valuation formula looks like this:
Now that we have a fair idea of business valuation calculation in theory, let us look at an example. In the next section, we consider a hypothetical situation and compare two businesses in different formats to see how business valuation works.
Example of Business Valuation
Let’s consider two businesses in the software industry. One, a software company in Louisiana, and another software firm in Delaware. We are using this comparison between two geographically different companies of the same industry to indicate the effect of risk factors on business valuation calculations, in this case, the state of incorporation. Higher the risk, lower the valuation.
In this example, let’s assume the average multiplier for the software industry to be 2. Here are some basic statistics of the two companies:
Company ABC located in Louisiana
- Annual revenue: $630,686
- Annual SDE:$90,534
- Other assets: $343,050
- Liabilities: $65,000
Company XYZ located in Delaware
- Annual revenue: $455,980
- Annual SDE: $75,898
- Other assets: $252,050
- Liabilities: $35,000
Using the formula for Business estimated value from the previous section, the valuation stands like this:
- Company ABC estimated value = ($90,534*2) = $181,068
- Company XYZ estimated value = ($75,898*2) = $151,796
By the looks of it, Company ABC in Louisiana seems to have a higher valuation than Company XYZ in Delaware. But there are many variables in this which will affect the multiplier. Of the many, in this example we will consider the effect of geography on the software industry. Though we have considered the average multiplier for the software industry as 2, based on multiple factors, this value can vary anywhere between 1 and 4.
Business in Delaware
Delaware is reputed to have the most conducive business environment in America. As compared to Louisiana, which is more dependent on the energy industry, Delaware offers a good location for corporations of almost all industries. Almost half of America’s publicly traded companies, including giants like Apple, Google, etc., are incorporated in Delaware. Here are the other top reasons for business valuation to be higher in Delaware:
- Delaware’s Court of Chancery – Delaware has a long history of corporation friendly laws. Unlike other states, they have a special Court of Chancery that presides only over cases involving corporate law. The judges have a lot of expertise in handling complicated cases involving corporate law. Thus, if a business gets into litigation troubles or is considering complicated mergers, the best counsel is available for the company in Delaware.
- Flexibility of Company structure – Unlike other states, Delaware allows a single member board of directors. Also, shareholders and directors of the company need not be residents of Delaware. This flexibility heavily contributes to increasing the business valuation of a company
- Investor preference – Delaware does not require to publicly disclose the names of company’s directors and shareholders. Thus investors and VCs prefer to fund companies based in Delaware. There is also an added layer of reliability.
- Tax benefits – Delaware is tax friendly for companies. It does not collect taxes from Delaware corporations that do not do business there. In addition, stock owned by people not residing in Delaware are not subject to Delaware taxes. Neither does it tax ‘intangible assets’. All these factors add to a lot of tax savings for companies in Delaware.
Considering all these reasons, let us assign a multiplier for the businesses in Louisiana and Delaware. Since the software industry average is 2, let us assume Louisiana is at 2.2 and Delaware is at 3.5 Based on these considerations, here is how the final values look like.
Company ABC : 2.2 multiplier (Owing to Louisiana’s limiting business climate)
- Estimated business value: Annual SDE $90,534 * 2.2 = $199,175
- Total estimated value: (Estimated business value $199,175) + (Estimated value of other assets $343,050) – (Liabilities $65,000) = $477,225
Company XYZ: 3.5 multiplier (owning to Delaware’s favorable business climate )
- Estimated business value: Annual SDE $75,898* 3.5 = $265,643
- Total estimated value: (Estimated business value $265,643) + (Estimated value of other assets $252,050) – (Liabilities $35,000) = $482,693
As is clear from this example, the estimated business value of Company XYZ in Delaware is much higher than Company ABC in Louisiana.
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