There are a lot of reasons a business owner would need small business valuations. Perhaps they are closing down their business and need to analyze their debt to assets to pay off their creditors. Perhaps they are selling the business to someone else and need to determine the business’s ability to generate income. Perhaps they are generating capital to start or grow their business and need to represent how much money a business like theirs tends to make. Each of these scenarios requires small business valuations, but each of them involves a totally different calculation, which produces a totally different (yet still accurate) number. Sometimes, the best small business valuations are a compilation of several valuation approaches. Let’s consider the three most common approaches for small business valuations, and how they’re used:
Three Common Business Valuation Approaches
- Valuation Asset Approach
Let’s say that you are shutting down your business and need to liquidate your assets to pay your debts. In some cases, if you’re filing bankruptcy, you won’t have enough to cover the cost of your debts. Your debtors will want to see what you will be able to convert to cash, and then prioritize how much you pay back to each debtor. In this case, the market value of your assets will be compared to your debts to determine your business’s valuation.
Risk: All valuations involve assumptions in their calculations. Sometimes those assumptions aren’t accurate, which impacts the accuracy of the complete valuation. In the case of the valuation asset approach, the market value of the asset has to be estimated. You can’t just use the amount that you paid for the asset to determine how much you could liquidate it for. You can’t even really determine that amount by the depreciated value of the asset, since factors such as market fluctuations would impact how much you could actually sell the asset for; just because an asset has half of its usable life left, it might not be worth half the value that you paid for it. Determining the market value of your assets is a risk that you take with a valuation asset approach. However, the business valuation services who performs your valuation takes this into consideratio while creating your value.
- Valuation Income Approach
Let’s say you’re selling your business to someone else who will continue to operate it and make money from it. It doesn’t matter that you don’t have a ton of assets if the assets that you do have can bring in the big bucks. If this is your situation, you’d use financial statements over the last several years to estimate the amount of money that your business could generate over the next several years, in order to determine the price tag that the person who is purchasing your business should pay.
Risk: The valuation income approach assumes that the business will make X amount of dollars if it is operated the same. There are a lot of soft costs or assets that can’t be calculated but would change the income of the business if it changed ownership. For example, perhaps the original owner did the work of several employees, additional manpower costs would arise if he left. Perhaps much of the income was generated through customer loyalty to the owner, not the business itself. Perhaps the relationship the owner had with suppliers afforded him discounts that a new owner wouldn’t get. These are risks that have to be factored into the small business valuation tools.
- Valuation Market Approach
Let’s say you’re a new business but need to generate capital from investors to start or grow your operation. You don’t have any income history to use the valuation income approach. You probably have a lot more debt than assets, so the valuation asset approach is useless. In this case, you could compare the financial reports that are produced by similar-sized companies in the same industry to estimate your valuation.
Risk: Some businesses are so unique there really isn’t any comparable business to use for the valuation market approach. Also, just because a business is in the same industry and is the same size doesn’t mean it is operated the same and would create the results in the future.
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