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Knowing your company's worth and why it's important
Valuing a private company before a sale, or as a precursor to raising debt or equity funding, is an inexact science. In fact, the lack of a standard approach that everyone readily accepts often means that buyers and sellers of small businesses come to the negotiation table with widely different estimates.
However, if you need to establish the value of your company, there are many approaches available to help you do so. Here's an overview of the most commonly used techniques.
Many sides of the same coin
The options to value a business range from surprisingly simple to incredibly complex. Determining the most appropriate method to value your business involves a process of trial and error, while not losing focus on your end goal. For example, if you intend to apply for a bank loan, the valuation method you select must meet the expectations of the loan officer. Alternatively, if you wish to value your business out of curiosity, you might choose the most straightforward approach to provide a "back of the envelope" valuation. Here are some options:
1. A multiple of revenues
On the simplest end of the spectrum, you could calculate the value of your business by applying a multiple to its revenue. Keep in mind that the multiple varies by industry and nature of the company. For example, an accounting firm might sell for as much as one time its revenue, whereas a dog-walking business might command a price equal to 50 percent of its income.
2. Sales of other companies
Similar to one of the methods used to value real estate, this approach uses sales of comparable businesses to determine value. However, it presents several challenges. The details pertaining to the sales of most private companies remain confidential. Additionally, while a business may appear on the surface to share similarities with your company, in reality, it may bear little resemblance to your business, and therefore provide a poor comparison.
3. Asset-based valuations
This method includes two options: valuing the business as a going concern or valuing it for its liquidation value. The former requires subtracting a company's liabilities from its assets and adding an amount representing "goodwill," which is the value of intangibles, such as the company's reputation to arrive at its value as a going concern. Alternatively, calculating the liquidation value requires identifying how much the company's assets might sell for on the open market and then subtracting the firm's liabilities. This calculation produces the net amount the business might realize from its liquidation.
4. A discounted cash flow
This approach to business valuation involves forecasting a company's cash flows, typically for five years, as well as a calculating the firm's terminal value, which is the value of the company as a going concern. Since operating a business comes with risk, the value of the business must reflect that uncertainty. Simply put, there is no guarantee of generating the cash flows included in the projection and realizing the company's sale in the future.
Therefore, when valuing a private company, you must apply a discount rate, expressed as a percentage, to the projected cash flows and the terminal value. The higher the discount rate, the greater the risk of earning future cash flows, which translates into a lower present value and a decreased valuation. Adding the discount cash flows and terminal value together produces the value of the firm's cash flows and the future value of the business itself in today's dollars.
Know your worth
Regardless of the method you select, keep in mind that if your business experienced a rough patch recently that impacted its financial performance, the value of the company would likely fall short of your expectations. Therefore, before investing the time, effort and expense associated with the more involved methods, make sure the company's recent performance is representative of the firm's health and therefore its worth.
And while some business owners rarely calculate the value of their business, doing so on an annual basis provides a health check of sorts. For example, if the valuation drops from year to year, you may find the root cause stems from an operational problem that requires your immediate attention. In fact, given the visibility it provides into a company's overall health, even a business owner with fewer than 12 months of operating experience can benefit from conducting a valuation.
Whether you plan to sell your business, raise debt or equity funding to fuel expansion, or merely want to determine its value for your own gratification, either by yourself or with the help of a valuation expert, you can put a number on your company's value.