Valuation of Small Businesses

April 13, 2006

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The value of a typical small business should be greater than the total values of its hard assets. For a buyer, the key is that an ongoing business has everything necessary — equipment, location, and inventory if applicable, not to mention experienced employees, suppliers, business processes, and a customer list — all in place, in the right amounts for successful operation of the business.

But how do you put a price on this intangible asset, which is frequently referred to as goodwill or going-concern value? Moreover, how do you determine the true market value of the hard assets used in your business? The answer is that you make a business appraiser a key player on your selling team.

Many business owners don't want to spend the time or money to have an appraisal done. However, the result is often a price that's unrealistically high and turns off many potential buyers, or a price that's unnecessarily low and keeps the owner from cashing out at full value.

Business appraisers are generally CPAs. As a profession, they have established a number of ways to quantify the value of key aspects of your business, and roll them up into an overall figure. As part of the process they will write up a valuation report, which explains in detail how they arrived at their final value. Having a valuation document prepared by an outside expert adds a great deal of credibility to your asking price, because the buyer will be able to see exactly how you arrived at your final figure.

Keep in mind that if you sell out to a larger company, you'll probably be dealing with MBAs who are used to seeing sophisticated financial analyses. They will be much more comfortable going through with the sale (and much more impressed with your management ability) if you have a detailed appraisal prepared.

On the other hand, remember that value is in the mind of the beholder. A professional valuation can tell you the price that an average buyer might pay for your business. However, when it comes to negotiating with an actual buyer, the appraisal is just a starting point. A particular buyer may have a strong strategic reason for acquiring your company, and may be willing to pay a premium over what the average buyer might offer. Another buyer might simply be looking for certain assets to augment his or her own business, and may not be willing to pay for your company's going-concern value at all. It's important that you and your business broker size up the particular buyer's reasons for acquiring your business before naming a price.

Warning

If you do have a professional appraisal prepared for your business, but then decide not to sell, it's a good idea not to keep the appraisal document with the rest of your business documents.

In the event of your death, you won't necessarily want your executor to be tied down by the numbers shown in the appraisal, for estate tax purposes. After all, the appraisal purports to show market value, but if no sale occurred it's hard to know whether that assessment was reasonable. Moreover, any number of things can happen in intervening years to make the appraisal obsolete, but the IRS has been known to dig up old appraisals and assert that they show the true value of the business (after adjustments for inflation, etc.)

You'll often come out better by having your executor do a completely new appraisal for the purpose of computing estate taxes, if and when the time comes.

In placing a price tag on your business, you need to consider:

Key factors: what factors are most important to buyers? What are secondary?
Adding value: How can you boost these important factors before the sale?
Recasting financial statements: How might your accountant adjust your financial statements, before showing them to potential buyers?
Valuation methods: What are some of the methods and formulas that are commonly used to put a price tag on a business?
Partial interests: If you're only selling part of the business, how does that affect the price?

Once your appraiser has come up with an approximate value for your business, you may decide to set the listing price slightly above the top end of the price range, to allow yourself some room to negotiate and still realize the full value of the business (or at least come close to it). Or, you may decide that you want to sell quickly, and you'd prefer to set the listing price close to the actual appraised value or even below it. You should think carefully about this decision and base it on your priorities, and your broker's experience and sense of the current market for businesses like yours. It's much easier to drop your asking price later than to raise it. Of course, your actual selling price will be determined during negotiations with the buyer, preferably after all the other major terms have been worked out.

Some brokers prefer not to set a listing price at all. Instead, they'll hold a controlled auction where a number of potential buyers are contacted and given key information about your business, and bids are solicited. This can be a way to achieve a fairly quick sale at a competitive price, provided the market for your type of business is fairly strong.