Common Mistakes to Avoid When You Value a Business
US business sales are on the rise. According to the latest statistics, over 10,000 businesses are sold each year. Is your business gearing up to join this exclusive club?
If so, you are probably in the midst of learning how to value a business. Company valuation is always difficult, but it can feel downright impossible when it’s your first time.
Luckily, there are a few tried-and-true methods that can help you out. We created this guide to help you understand different valuation methods and the mistakes to avoid when choosing them.
Do you need help determining the value of your company? Then this article is for you. Keep reading to learn the top mistakes new business owners make when calculating business value.
Not Choosing the Right Valuation Method
There are a handful of different valuation methods suitable for various types of businesses. The valuation method you should choose depends on your goals.
For example, do you want to use the most common or reliable valuation method? Do you want to put your company in the best light or be as truthful and accurate as possible?
Other factors to consider when evaluating the right valuation method for your business include:
- The type of company you own
- The size of your company
- The state of your industry
Regarding company type, there are generally two: asset-light and IP or asset-heavy businesses. These business types would benefit from different valuation methods. More on this in a moment.
Company size doesn’t determine which method to use. Instead, it determines how many valuation methods may be right for your company. Larger companies can benefit from more method types than smaller ones.
Is your industry in decline? If so, you may want to use asset-based or comparable valuation methods over profit-based ones. And companies in poor or healthy industries should stray to the conservative side of things.
Additionally, you may want to consider the type of method potential buyers may prefer. For example, some buyers may want to know the value of your business assets. Others may only care about potential profits.
Considering Sales and Profits Alone
Sales-and-profits-based valuation is also known as the discounted cash flow method. It is the most accurate way to value a business. However, it may not be right for all companies.
Situations requiring other valuation methods include if your business is losing profits but has a lot of valuable assets. Conversely, sales and profits-based valuations are better for cash-rich companies with fewer assets.
To use this method, you must calculate your company’s pre-tax earnings. This is known as the Seller’s Discretionary Cash Flow (SDCF). SCDF considers profits before taking out operational costs, salaries, interest, etc.
Once you determine this figure, you can add in the multiplier. Most businesses are valued at one to three times SCDF. The multiplier you should use depends on owner risk, company size, and more.
Not Determining the Value of Assets
Discounted cash flow valuations may be the most accurate method, but the most common method is assets-based valuation.
Asset-based valuation may not work for software or service companies and businesses in other asset-poor sectors. The types of companies this valuation method is ideal for are those with significant hard or soft assets.
Soft assets are valuable brands or IPs. For example, a new software startup may have valuable code behind its product. This can greatly increase the company’s value even if it isn’t yet turning a profit.
Meanwhile, hard assets are physical assets that hold value. Hard assets include but are not limited to the following:
- Inventory
- Merchandise
- Equipment
- Office furniture and supplies
- Company vehicles
- Machinery
- Real estate
Another asset to consider is goodwill. Goodwill is a non-quantifiable asset that refers to your brand’s reputation in the market. High-quality customer service, strong talent, and consumer loyalty are all examples of goodwill.
Leaving Out Assets and Liabilities When Calculating SDCF
We left out one thing when explaining how to calculate SDCF: assets and liabilities. If you plan to use your business profits in your valuation method, you must also consider these factors.
The SDCF multiplier will take some assets and liabilities into account. However, many multipliers leave out certain hard assets, in particular. Some common ones are inventory, real estate, and cash-on-hand.
It is crucial to add these assets back into your SCDF equation. Additionally, if there are any liabilities your multiplier leaves out, ensure you subtract that from your total valuation as well.
Not Considering Comparables
Has there been a lot of M&A activity in your space of late? If so, using comparable companies (AKA comps) to value your business may be the method for you.
For this method to work, you have to comp your business to others that sold recently. Business sales that occurred too long ago may not account for current factors influencing your industry.
You must also consider factors like size, reputation, and intangible assets. If you don’t, you may try to compare your small business to a Fortune 500 that recently sold in your industry.
Even if you don’t want to use comparables for valuation, consider looking at comps to determine your SCDF multiple. Or you can use comps as just one aspect of your valuation strategy.
Need to Value a Business? Let Fusion Help Sell Your Business in St. Louis
Learning how to value a business is easy when you avoid these mistakes. So instead, use the valuation methods in this guide to get the most out of your sale.
Are you gearing up to sell your business in the Metro East? Fusion is a full-service business brokerage serving small and medium-sized firms. Get in touch with Fusion today to learn more about how we can help you sell your business.