Business Valuation: Importance, Formula and Examples

Knowing the true market value of your business can be useful for many reasons, not just for selling it or raising investment. Putting a price on the company may be the first time a business owner – especially one with a small, entrepreneurial, founder-based, or family-owned business – comes to fully understand how outsiders view their business and the main factors that drive the business’s market value.

Better understanding of the factors that drive value can help owners prepare for a sale, today or in the future. But according to an article in Knowledge at Wharton, a business journal from the Wharton School of the University of Pennsylvania, business owners don't always have an accurate view when it comes to valuing their business.

"Business owners have unrealistic ideas of what their business is worth," the article notes. "This is the most common reason that merger deals fail." 

The Importance of Understanding Your Business’s Value

Many business owners feel a valuation has two purposes: to help the company raise investment or to help in selling the company. But Mark Holdreith, co-founding partner of Media Advisory Partners, a New York City boutique investment banking firm, sees the additional importance of business valuation. 

“Even if I’m thinking a sale is three or five years down the road, the discipline of evaluating what’s driving my business’s value today will pay benefits," he says. "Considering these value factors in your strategic planning and budgeting process will also improve operational and financial performance of the business – adding value when you do sell."

Of course, he notes, having a clear idea of your value means you can go into merger and acquisition (M&A) negotiations better informed, but it’s the preparation and paying attention to factors that build value in advance of a sale and helps boost a business’s valuation.

“Preparing your business for sale is critical,” says Holdreith. “The more comfortable buyers are that your business is well run and buttoned down, that your business is what you’re representing it to be, the less risk they will associate with the transaction.”

Buyers can mitigate risk in a number of ways, including lower valuations and less favorable deal structures (meaning the amount of cash at close versus future, performance-based or “contingent consideration” payouts). Having your financial, legal, and commercial issues in order can maximize valuation and speed time to a successful close.

"The ultimate sale of the business is a highly emotional event for a founder and the process is a distraction," Holdreith adds. "The better prepared a founder is, the better they can manage through the negotiations and sale.”

Having a clear picture of what you want your life to be like post-transaction can also be important. Whether you prefer to stay with the business or stop operating immediately will affect the possible deal structures, as well as the pool and type of potential buyers.

Whoever is valuing your business may want to have full access to your accounts, so it’s important to have all your numbers in order, including credible forecasts, says Holdreith. Ideally, businesses looking for the highest valuations should have accrual-based financial statements compliant with U.S. Generally Accepted Accounting Principles (GAAP).

“To a buyer, the most important considerations are historical financial performance and your forecast going forward – so you need to credibly back up that history and forecast,” he says.

What Affects the Value of a Business? 

There are many factors that can impact a business’s value. Here are some of the most important: 

Profitability 

Valuations are generally expressed as a multiple times EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). For example, a business with EBITDA of $1 million and a multiple of 3 is valued at $3 million. A business’s multiple (and, therefore, valuation) will be greater if revenue and EBITDA has increased for several years. The multiple will be lower if profits are decreasing or erratic.

 Forecasts 

Investors don’t just want to know how much money you’re making now. They also want to see forecasts and an evidence-based rationale for your projected revenues and profits. Do you have a strong business development approach and dependable forecasting methodology? What are the key market dynamics impacting future performance? Is the competitive environment favorable? Are there regulatory or technology issues that can enable growth or challenge the business?  

People: management team and succession planning

Having a strong management team can be crucial. Who are the key people in your business, and how likely are they to stick around?

“If the business, especially its revenue, is highly dependent on the owner, and the owner wants to step away, having a successor in place is critical,” explains Holdreith. In this situation, having a succession plan may increase the universe of potential buyers and adds value to the business.

“While strategic buyers may have operators who can take over running the business, financial buyers, like private equity firms, may not," Holdreith says. "Without a successor in place to take over from a valuable owner they may decline to make an offer or adjust the offer lower to account for the situation.”

Business momentum

As mentioned above, revenue and profit momentum can be a key component of any potential buyer’s assessment of your business. However, momentum is not limited to financial performance. Momentum can also come from new partnerships, product launches, joint ventures, or any truly significant positive development, notes Holdreith.

Client concentration and retention

Small businesses sometimes rely heavily on one or a handful of clients for a large portion of revenue, which is typically seen as risky by most buyers.

“When buyers see risk, they mitigate that risk by lowering the sale price,” says Holdreith.

Reducing dependency on key clients is important for mitigating risk so the business’ valuation remains strong. Hand in hand with low concentration is client retention and longevity. Long-term, stable client relationships can give confidence for the future.

Assets 

In many cases, a bigger company can buy a small business to acquire its specific assets. Your business valuation can be higher if you own buildings or machinery, for example, but can also be helped by intellectual property (IP), especially if the IP has proper legal protection.

Contract management

If possible, try to make sure all your clients are contracted. The longer the term of the contract the better. Also consider including language in contracts that ensures they are assignable without consent. This can reduce uncertainty and risk for potential buyers. You can also make sure there are no liens on the business.

Strategic value to the buyer

Buyers are more likely to pay a premium if the business or assets are of high strategic value to them. For example, adding a capability, expertise, IP, or important geographic presence that accelerates the execution of a buyer’s overall strategy can make a buyer more aggressively interested.

Business resilience

Businesses that continue to perform well during challenging economic times such as recessions generally get an uplift in their multiples. The sector your business serves and the impact of future market, competitive, technology, and regulatory changes willlikely be considered.

How to Value a Business 

While business owners often ask for valuations from the accountants they’ve worked with and have built trusted relationships with, Holdreith insists the best outcomes come from M&A advisors dedicated to your business’ industry.

“In the marketing services industry, for example, we know the range of multiples firms are selling for and what factors are driving their valuations up and down,” says Holdreith. “Business owners are best served by finding the right expert for the industry they’re in.”

However, in the end, the only way to get beyond an estimate to true value is to put the business in the market for sale.

Here are some ways experts calculate business valuation when valuing a business for sale or investment: 

Discounted cash flow value 

This valuation method is based on future business performance. It estimates a company’s future cash flow and expresses that as net present value (NPV). It is used to calculate the value an investor should be willing to pay for an investment, given a required rate of return on that investment. The discounted cash flow formula is complicated, but with the right data it is possible to come up with an acceptable estimate of the following year’s cash flow. Each additional year becomes more difficult to estimate with an acceptable degree of accuracy. 

Revenue/earnings multiple 

A more common – and simpler – method of valuing small- and medium-sized businesses uses a multiple of revenue or earnings/EBITDA. This calculation involves taking a company’s earnings after all business expenses are paid and using a current industry multiplier to generate a value. 

Different industries have different multiples, and each business within that industry may have higher or lower multipliers depending on many factors. For example, high-growth technology, tech-enabled, or larger businesses with recurring revenue streams and low client concentration can typically be valued much higher than a smaller, low-growth company whose revenue is primarily project-based. An M&A specialist in your industry may be able to advise on the most appropriate multiplier for your business.

All these various factors combine to determine a company’s multiple. Given that complexity, until an individual business is analyzed in detail it can be difficult to estimate its multiple. However, business size can provide an illustration of a range of multiples – yet even this simple generalization should be taken with caution. Generally speaking, the larger the business, the greater the multiple.

Assuming the financial performance and future growth opportunity for a business is trending positive:

• Businesses with EBITDA under $1 million are likely to have multiples from 3x to 4x.
• With EBITDA from $1 million to $3 million, 4x to 6x.
• From $3 million to $5 million, 6x to 8x.
• Above $5 million, 8x to 10x.

High-growth, technology or tech-enabled businesses with recurring revenue business models and longer-term contracts can likely trade above these multiples. It all depends on the needs of the buyer and the attractiveness of the assets.

"Better understanding of the factors that drive value can help owners prepare for a sale, today or in the future, and improve business operations and performance in the meantime." 

Other Considerations When Valuing a Business

A business valuation formula can rarely capture the full value of your business.Additional factors beyond a formula contribute to a comprehensive assessment. In some cases, a business might receive a higher-than-expected valuation because the purchaser is prepared to pay a premium for specific knowledge, equipment, or simply to remove a competitor.

“Talking through how you address risks, long before you put your business on the market, is how you prepare for a successful outcome,” says Holdreith. “The more prepared you are, the less risk is perceived by a buyer, and the less risk, the better the value and the better the deal structure – better everything. By prepared, I mean pay attention to the factors that truly drive value, maximize their positive impact, and mitigate any risks that arise.”

The Takeaway

Preparation far in advance of a sale – including knowing what you, as the owner, want in terms of your post-sale future with the business – can be the most important thing a business owner can do to maximize their business’s valuation. Furthermore, working with an M&A advisor or investment banker that you have good chemistry with and trust can pay dividends. The right advisor can lead the process, negotiations, and coordination with the other professionals necessary to transact successfully. They can also handle the difficult discussions that may arise, keeping your potential future relationship with the buyer positive.

A version of this article was originally published on September 16, 2022.

Photo: Getty Images