The majority of business owners don’t know the true value of their company — whether it’s a C corporation, S corporation, partnership or sole proprietorship.
Often they think their company is worth more than it actually is, which can be problematic if, for instance, they’re trying to sell the company and retire by a certain age.
“If a business owner hears a valuation multiple, he or she may continue to refer to that number without consulting a professional, understanding how a business valuation works and ultimately knowing the true value of their business,” says Holly Taylor, CPA, ABV, ASA, senior manager at Rea & Associates.
It’s a common misperception to say that your company is worth four times EBITDA (earnings before interest, taxes, depreciation and amortization), as that doesn’t take into consideration your industry, business risks, cash flow expectation, debt and more, she says.
Smart Business spoke with Taylor about when you need a business valuation and the importance of it.
Why should a business owner have a business valuation performed?
Some valuations — ‘have-to valuations’ — are required because they are triggered by an event, like:
- The death of a shareholder.
- Gifts of closely held stock.
- Equity compensation valuations.
- Dispute related valuations, such as a shareholder dispute or divorce.
- Forming employee stock ownership plans.
- Converting from a C-corp to S-corp.
- A charitable contribution.
- The allocation of intangible assets.
‘Should’ valuations aren’t driven by a specific event, but are used by owners to make important decisions about their future. You can use them for estate planning, succession planning, selecting the appropriate exit strategy, determining life insurance needs, looking for ways to increase value, setting or updating the value in a buy-sell agreement and/or setting up incentive plans for management.
Before you go into the valuation process, you should already have in mind what you are going to do with the valuation results. In order to get an accurate value, use an experienced, credentialed professional who will take all of the factors and variables into account.
Is there a specific time frame when a business valuation should be performed?
The ‘have-to’ valuations will need to follow set time frames. Depending on the triggering event, the IRS or court sets these dates.
However, it’s always important for an owner to know the value of their business. For example, with succession planning valuations, business owners should start thinking about their business succession plan at least five years before planning to implement it.
In general, it’s a good idea to have a business valuation done every other year, since your business interest is most likely your most valuable asset.
What are ways to grow the business’s value?
Growing your business starts with the mindset that the business is an investment. In fact, it’s typically an owner’s largest investment — 50 percent or more of his or her net worth — and therefore should be treated like any other investment.
The first step to increasing value is understanding what the business is worth. Only then can you set goals for where you’d like the value to be in the future.
The owner should develop a growth plan and have written goals and plans to increase the value. Three key areas to focus on are:
- Increasing cash flow. Investors buy future cash flow; so increased cash flow will increase the business value. You can do that through increased revenue, an improved gross margin such as higher selling price or lower cost of goods sold, or lower operating expenses.
- Decreasing business risks. These are issues like reliance on the owner, key employees, managers, customer concentration, supplier concentration, etc. The more risky an investment, the higher the rate of return is needed to entice a buyer.
Improving growth prospects. The higher the growth rate, the higher the value of the business.
Insights Accounting is brought to you by Rea & Associates