Types of Business Valuations
What is your business worth? Unfortunately, there is no simple answer. Different people have different opinions on what defines value, making the question itself a tricky one. After all, how much your business is worth today could be quite different than how much you can actually sell it for at a later date. That’s why regularly reviewing the value of your business is so important.
We’ve outlined the most common methods used to estimate the financial value of a business. While business valuations typically factor in parts of each approach — to ensure they are as accurate and reliable as possible — it’s helpful to understand which valuation types may work best for your business.
It’s important to work with a credentialed business valuation professional who is trained to apply the appropriate methodology.
This type of valuation can be suitable for owners who use their business primarily as an income stream. The method is based on how much income your business is likely to provide and incorporates approaches like discounted cash flow valuation — an analysis that determines current value based on future cash flow projections adjusted over time.
Think about it this way: How much do you need to sell your business for to generate an annual income similar to what you currently enjoy? For example, the income approach may show that your business is valued at $1 million, which will generate roughly $50,000 of income per year. Yet if you’re currently receiving an equivalent of $250,000 per year in income and benefits, you would need to sell your business for much more (say, $10 million) to maintain this lifestyle.
That huge gap in value is worth learning about now so you can make the necessary adjustments to your business — or your other sources of retirement income — before selling.
This type of valuation can be suitable for owners who treat their business as an investment rather than an income stream. It’s a straightforward approach that follows a simple rule: A company should not be worth more than the sum of its parts.
Imagine breaking your business up into the individual assets you own. Add them all up, subtract any liabilities, and you get the business value. Squarely focused on your ledger, this approach incorporates the net book value method, which calculates the cost of an asset minus depreciation.
Something else to keep in mind: Since partial owners typically cannot access the value of assets (unlike income) as they cannot liquidate them, this approach is more appropriate for businesses in mature industries where a lot of capital may be required.
It doesn’t take an MBA to understand this approach. Just let the market be your guide: Take a look at what similar businesses in your community or industry sold for, and you’ll get a good idea of your market value.
This approach can be more appropriate for companies where a lot of comparable transactions can be reviewed, such as some public companies in established industries or small businesses of similar type, size and revenue in the same region.
The liquidation value of a business reflects the amount of money an owner’s estate can expect to receive should it be forced to liquidate the company in the event of the owner’s death. The value generally reflects cash on hand, a percentage of accounts receivable, and the “forced sale” value of assets like equipment and property.
No one wants to think about this possibility, but there’s an old saying about death and taxes that is doubly appropriate here. So let’s boil this down:
- Owner with a company valued at $3 million dies and wills the business to his family.
- Family owes a large percentage of the business value in estate taxes, but has no liquidity to cover estate taxes due.
- Family is forced to sell the business to pay the taxes, including a “forced sale” of assets (equipment, trucks, etc.) at perhaps 30 percent their actual value, and accounts receivable at about 50 percent value.
- Family keeps the cash on hand, minus any liabilities.
What’s left over is called the liquidation value. It’s often not much — and it’s why planning ahead to protect your business and family are so critical.
One Value Matters Most
Of course, when it comes time to sell your business there’s only one value that matters: the amount someone is willing to pay for it. This definition clearly establishes your finish line. However, choosing the right roads to get there — and getting there safely, with the highest value — can in itself present many challenges. Challenges that can only be identified by establishing the value of your business now and throughout the business’s life cycle.
MassMutual does not provide business valuations.
The information provided is not written or intended as specific tax or legal advice. MassMutual, its employees and representatives are not authorized to give tax or legal advice. Individuals are encouraged to seek advice from their own tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel.