Toronto business and technology lawyer, Sukhi Hansra, discusses what is a business valuation and what are the key considerations when valuing your business during uncertain times.
As a business owner or entrepreneur, there are many reasons why you would want to know what your company is worth. You may want to offer shares to an employee, seek investments, or buy out a partner. You could be interested in buying or selling your business. You might need a business valuation for tax or succession planning purposes.
What is a Business Valuation?
A business valuation is the general process of estimating the realistic fair market value of a business. Determining a business’ value is a complex process – part art, part science. Complicating matters is the fact that many business owners and entrepreneurs are overly optimistic about how much their business is worth.
An accurate business valuation relies on the unbiased judgement of the valuator. Business valuators weigh several factors to accurately estimate the value of a business, including the type of business, its financial performance, local and national market trends, the value of assets and liabilities, and any unique or proprietary technology.
Other considerations include the current capital gains tax rate (50%), interest rates on business acquisition loans and current economic conditions (i.e. COVID-19 has negatively impacted retail more than the restaurant industry).
Do I Need a Business Valuation?
A solid business valuation establishes a realistic and fair dollar picture of your business. This can help you increase the value of your business and negotiate better deals. You may notice that your business loans far exceed your assets, or your large marketing spend is eating away at your monthly revenue. It is generally good practice for any growing business to value their business at least once a year.
Choosing a Valuation Method
Several valuation methods are commonly used. Each has different drawbacks and levels of assurance that the result will accurately reflect your company’s worth. The most suitable choice depends on the purpose of the valuation and the company’s characteristics, such as profitability, future outlook and asset mix. The following are common valuations methods from least complex to most complex.
- Times Revenue Method. Multiply actual revenues over a certain period of time by an industry multiple to quickly and easily determine the “ceiling price” or maximum value for a business. Choosing an industry multiple depends on the rate of growth in the industry. For example, technology companies may have a 3x multiple, whereas service businesses may have a 0.5x multiple. This method is ideal for younger companies or companies poised for rapid growth, such as software as a service (SaaS) companies. Drawbacks to this method are that revenues do not equate to profits and choosing an accurate multiple may be difficult.
- Asset-Based Value or Book Value. A company’s book value often results in the lowest value and is commonly used to set a “floor price” or lowest value for a business. It is often used when a company hasn’t issued shares or to assess liquidation events. The Book Value is calculated by determining the fair market value of a company’s assets and then deducting liabilities. For example, if a business owns $120,000 worth of inventory and equipment, but owes $70,000 on a bank loan, the Book Value would be $50,000. If the company were to shut down, the shareholders would receive this Book Value upon liquidation.
- Precedent Transactions Analysis. Precedent Transactions Analysis is a valuation method in which the price paid for similar companies in the past is considered an indicator of a company’s value today. Similar to the real estate market, if the neighboring restaurant sold for $800,000, that’s an indicator that your restaurant might be worth around $800,000 as well. While the method is relatively straightforward, a key drawback is the availability of accurate and trustworthy information sources. Private businesses often do not fully disclose the amount that they sold for. Also, differences between businesses and market conditions can also impact your estimated valuation. This can make drawing conclusions difficult.
- Earnings Multiplier. The Earnings Multiplier is useful tool to value whether to invest in a company. It determines how expensive a share is in relation to how much money the company is making. A high earnings multiplier may mean that the shares are overvalued (for example, because profits are lower than expected). The earnings multiplier is calculated by dividing the current price per share by the company’s earnings (revenues – costs) per share. For example, if you sold your shares at $50.00 per share and your profits equate to $5.00 per share, 50 dollars / 5 dollars per year = 10 years. This is often stated at “Company X is selling at 10 times earnings”. Comparing Earnings Multipliers against competitors is another way to use this tool.
- Discounted Cash Flow Method. A very popular but somewhat complex tool for business valuations and investment decisions. The Discounted Cash Flow (DCF) Method estimates the value of a business/investment today based on projections of how much money the business will generate in the future. The idea is that money today is worth more than money tomorrow. The main drawback is the ability to accurately predict future cash flows. The following is an example of how it works. if you are buying a business that makes $100,000 profit every year, the value of those profits must be discounted by the interest rate (let’s say 5%, or 1.05). This means, the value of the profits for year 1 are worth 100,000 dollars / 1.05 = $95,238.10. The value of the profits for year 2 are $95,238.10 / 1.05 = $90,702.95. Year 3 profits are worth $86,383.76. Therefore, a 3-year valuation of the business’ worth today is approximately $272.324.81. If a business owner is selling for less than the valuation figure, the buyer is getting a good deal and will make some profit.
Whether you’re passing the company onto a family member or selling it to outside purchasers, you will need a solid business valuation that establish a realistic and fair dollar picture for your business. An experienced Business Lawyer or a business broker who is a Chartered Business Valuator will be able to help you determine the proper value of your business.