The importance of company valuation

Business owners are generally more financially confident than non-business owners, but many still don’t understand the importance of company valuation.¹ In fact, 98% of small business owners didn’t know the value of their own companies.² Determining the true value of a business, a process called company valuation or business valuation, is important during the sale of your company — but can also impact your retirement, legacy, and more.

How a company valuation can help your business and you

Valuation is the foundation of many sound business strategies, as well as many aspects of personal arrangements. An incorrect estimate of your business’s value could negatively impact both your business and personal long-term financial strategies. It can also expose you or your loved ones to an excessive tax burden after the sale of the business or the passing of the owner.

A proper business valuation can help you: 

• Sell the business at a higher price, now or in retirement.

• Ensure buy-sell agreements are properly funded.

• Leave a legacy for your family and loved ones.

Retiring with financial confidence

Since many business owners rely on the sale of their business for retirement income, the effects of a misevaluation can take a toll at this crucial moment. If you plan on retiring, it’s important to understand how much money you can realistically expect to earn for your business if you sell or liquidate it. This may inform appropriate contributions to qualified and non-qualified retirement plans, and help you work towards a healthy income stream for when and how you’d like to retire.

Consider buy-sell agreements with business value

Many closely held business owners execute buy-sell agreements (or rely on the transfer provisions in their business’s governing document) to protect their families, co-owners, and businesses in the event of their disability or death. Having a buy-sell agreement is helpful, but if your agreement relies entirely on business profits or loans, you and your family may not receive maximum value from it. 

To help ensure you or your family get fair value for your business interest if you became disabled or pass away, it may be prudent to fund the agreement with life and disability buyout insurance. But the level of funding is directly related to the value of your business: Without an accurate estimate of your business’s value, you won’t know how much your buy-sell agreement should be funded for.

Estate planning for your loved ones

Understanding what your business is worth can be paramount in making adequate provisions for your loved ones after you pass away. On the one hand, your spouse’s lifetime income needs may or may not be met from the sale or other transference of your business interest. Or, if you anticipate leaving your business to one of your children and handing down other assets to another, knowing the value of your business can be essential so that you can leave each child with assets of equivalent value.

Without an adequate estimate of your business’s value, your estate plan could cause tension within the family and possibly come under IRS scrutiny. What’s more, an accurate estimate of your business’ value allows you to craft an estate strategy with more financial confidence in your intentions being carried out after your death.

So, what is fair market value?

The goal of valuing a business is to arrive at a clear and supportable estimate price. A fair market value of a business is defined as “the price at which the property changes hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having a reasonable knowledge of relevant facts.”³ It is also dependent on variables such as the condition of the economy, if the owner is pressured to sell, and how quickly a qualified buyer can be identified.

The fair market value of your business is likely required if you plan on selling your business to an outside third party, if the purchase price in your buy-sell agreement is tied to fair market value, or for personal purposes (e.g., estate planning).

What is book value?

On an accounting level, a basic measure of worth is book value — balance sheet assets minus liabilities. However, many businesses are sold at prices greater than book value, because the balance sheet shows assets at original cost minus accumulated depreciation instead of fair market value, and book values may not account for the value of customer relationships or future business growth potential. 

An example of book value

Let’s suppose a piece of machinery was purchased for $50,000 five years ago, and the accumulated depreciation is $15,000. As a result, the balance sheet carries this machine at a value of $35,000, even though it could cost substantially more to replace at current prices. Therefore, book value may not provide an accurate indication of fair market value.

Calculation methods for business valuation

Many qualified, independent business appraisers use one of the following business valuation methods:

• Capitalization of earnings: This calculation method divides the annual earnings over one or more years by a “cap rate” that reflects the cost of capital and the risk of the company. For example, suppose a company has average annual earnings of $200,000 and a cap rate of 10%. Under this method, its estimated value would be $200,000/10% = $2 million.⁴

• Discounted cash flow: This method, often used to value new businesses or companies with volatile earnings, begins by forecasting future cash flows over several years, often five to 10. To account for the time value of money, a discount rate is then applied to each year of forecasted flows. The discounted cash flows are then added together to estimate the value of the company.⁵

• Comparable sales and discounts: Some appraisers modify their estimates of value based on recent sales of comparable companies in the same market or industry. So, if a similarly sized competitor recently sold their business for $1 million, your business would be valued around the same amount.⁶

Cost of a business valuation

The cost to conduct a comprehensive business valuation can range from a few thousand dollars to $50,000 or more.⁷ To obtain a business valuation, you may want to contract with a professional appraiser to provide an objective opinion independent from the IRS. A professional business valuation is normally performed by a business valuation firm or certified public accountants who have satisfied professional training and education requirements by earning an Accredited Business Valuator (ABV) or Certified Valuation Analyst (CVA) designation. A financial professional may have an ongoing relationship with a respected valuation specialist and can help you find the appropriate appraiser.

Business valuation is an investment

Although business owners know their priorities, many can only estimate what their companies are worth; over time, such guesswork can prove costly. Not knowing fair market value could cause owners to be underpaid, or for heirs to potentially pay more than their fair share of estate taxes after the owner’s death. Spending the time and money to get your business valuated can be an excellent investment to help ensure you’re accurately funding your retirement and preparing for your legacy.