Business valuation can be crucial in the context of divorce, tax-planning, succession planning and sales and purchases of businesses. There are numerous, legitimate ways to value a business. However, there are three approaches to business valuation that are most commonly used, either purely or with some variation.
Certain valuation approaches are more or less common depending upon the type of business being valued (manufacturing, retail, service, etc.). Certain approaches are more or less common based upon the purpose for the valuation (divorce, succession planning, tax planning, etc.).
The “asset approach” simply accumulates the appraised monetary value of each asset of the business and subtracts the debt of the business. The asset approach can be the easiest way to value a business, but it also can miss some important considerations. The asset approach usually does not include consideration of the cashflow of the business. For example, a business may look valuable under the asset approach, but may only be comprised of financially expensive assets (like historic buildings) that cannot produce much money.
The “income approach” values the business based upon estimates of the amount of money that the business is expected to produce for a future period of time (with the duration depending upon business type). Actuarial formulas are then used to discount that future flow of money to its present-day value. The income approach is often considered the most mathematically accurate approach to business valuation. However, it is difficult to confidently forecast future revenue of a business, even with detailed reports of that business’s past revenue.
The “market approach” uses the purchase prices for comparable businesses that recently sold to determine what a reasonable buyer and seller should agree upon. The market approach is like a real estate appraisal that values a house based upon recent sales in the neighborhood. This approach is often difficult to administer because comparable business sale prices (particularly for small businesses) are not always readily available.
Sometimes, if a small business is being sold from one individual to another, the parties will rely on the income approach to valuation. If the business only owns expensive assets (such as real estate) that are likely to retain value over the long-term without a need for big returns, the asset approach is sometimes most easily used. If a business is being purchased by an investment group (think Berkshire Hathaway or Bain Capital), the market approach is often relied upon to determine valuation.
If someone is selling or purchasing a portion (not all) of a business, the value for that portion is usually going to be significantly discounted (no matter the valuation approach) by between 10 and 40 percent. This discount reflects the lack of marketability and lack of control that necessarily is a part of owning only a portion of a business instead of the entirety of the business.
In the context of taxes, the IRS usually dictates the business valuation approach to be used. Professional business appraisers can and should be hired to at least assist in valuing businesses.