We have all heard the stories of rags to riches success in business. The tales always seem to have some commonality in the story-line; started in the garage, by a starving but determined character; while waiting tables or digging ditches to make ends meet. The result, of many hours, months and even years of hard work, failure and small success, the product finally goes to market in the face of unimaginable odds for success but succeeds beyond even the budding entrepreneur’s wildest dream. The stories prodigy sells the successful business for an unbelievable valuation and lives on – wealthy forever after. While some creative literary license is obvious in the stories telling the basis for the scenario is experienced and repeated many times over every day, with various points of difference and similarity, throughout America. The life and times of every of business, like every story, has a beginning, a middle and an end with each transition punctuated with hard work, risk and adversity. So in the end, what is the real value of all the effort?
Business valuation, the process and a set of procedures used to estimate the economic value of an owner’s interest in a business is used by financial market participants to determine the price they are willing to pay or receive to affect a sale of a business. The process encompasses a wide array of fields and methods that include review of financial statements, discounting cash flow models, and similar company comparisons. Regardless of the methods employed in evaluating the worth of a business and the timing of the divestiture, the most successful plan to getting out of a business begins at the beginning. Employing an effective, well-formed exit strategy should be an integral part of the every business plan.
The most common valuation methods include three basic approaches:
- Asset-based approach – This business valuation approach totals up all the investments in the business and lists the business net balance sheet value of its assets and subtracts the value of its liabilities.
- Earning value approach – This method is based on the idea that a business’s true value lies in its ability to produce wealth in the future. The most common earning value approach is Capitalizing Past Earning. With this approach, a valuator determines an expected level of cash flow for the company using a company’s record of past earnings, normalizes them for unusual revenue or expenses, and multiplies the expected normalized cash flows by a capitalization factor. The capitalization factor is a reflection of what rate of return a reasonable purchaser would expect on the investment, as well as a measure of the risk that the expected earnings will not be achieved.
- Market value approach – The market value approach to business valuation attempts to establish the value of a business by comparing the business to similar businesses that have recently sold and most often works well when there are a sufficient number of similar businesses to compare.
Although the Earning Value Approach is the most popular business valuation method, for most businesses, some combination of business valuation methods will be the fairest way to set a selling price and while the science is important, the ultimate determination of value is dependent on some other important factors including: The life cycle position of the business, the customer base, existing supplier chains, product and service exclusivity, uniqueness, competition and potential for growth.
It is important to understand that real value is rarely as high as the seller’s perception or as low as a buyer’s expectations. While many tech start-ups have shown that valuation can be based on the number of users or followers, the majority of businesses must develop and exit strategy with a clear understanding of valuation.