Valuations Explained

From Investopedia:

“[A business valuation is] The process of determining the economic value of a business or company. Business valuation can be used to determine the fair value of a business for a variety of reasons, including sale value, establishing partner ownership and divorce proceedings. Often times, owners will turn to professional business valuators for an objective estimate of the business value.”

Business valuations (and appraisals) are rendered by certified and accredited professionals, affiliated with one or more nationally-recognized associations (see our Valuation Links for a list of organizations.) They are regulated professionals disassociated with the mechanics of a transaction and charge an up-front fee for their services.

Sunbelt brokers maintain relationships with national business valuation firms, in order to provide this service to clients who need or desire it. Your dedicated Sunbelt business broker will advise you on the different types of valuation services available, the associated costs, and provide you his/her professional advice on the necessity of such reports.

What Determines Value?

While there are many areas that a business appraiser will evaluate, cash flow and risk are the two important factors.

Fundamentally, a buyer purchases a business for income. Cash flow can be expressed in many ways, typically either as Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) or Seller’s Discretionary Earnings (SDE). In small business transactions, SDE or EBITDA is the most common basis for establishing a selling price.

Bottom line, the more cash flow there is, the more a buyer will be likely to pay to get it.

All cash flow comes with a degree of risk. Risk may be present in customer concentration, reliance on vendor relationships, macro economic trends, competitive forces, key employees, legal exposures and more. A formal business valuation will include an analysis of the company’s risk and quantify that risk into a percentage known as a Discount Rate or Capitalization Rate.

What About Goodwill?

Goodwill is not a random figure – it is calculated by subtracting tangible value from total value. The residual is considered goodwill or intangible value. Business sellers often over estimate the value of goodwill, assuming that things such as technology and an established brand adds “goodwill” value that should be featured into the asking price – it doesn’t, unless those items improve cash flow.

Be sure to also read our Broker Opinion of Value summary to understand how that is different from a business valuation.

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