Business valuations are used to help small business owners determine the value of their shares of stock or membership units. They’re helpful in that they can indicate the value of the equity of a company without there being an active market price readily available, such as for investments like Apple or Amazon.
Many small business owners are unaware of the value of their businesses and may incorrectly assume that certain characteristics of the business increase or decrease its value.
The three approaches to business valuations
Business valuations are conducted under three separate approaches: income, market and cost.
- The income approach attempts to determine the present value of a business’s future cash flows through the application of a discount or capitalization rate.
- The market approach applies transaction multiples of similar companies in similar industries to the business’s ongoing earnings. (Similar to how your realtor values your home by researching sale prices of similar homes.)
- The cost approach assigns a value based on what it would take to replace the business with one of equal utility.
One of the primary benefits of having a business valuation performed is to learn the key factors that an analyst considers when determining an appropriate value for your business — many of which are not financial metrics. Knowing what an analyst looks at when valuing a business can allow you time to transition or improve various aspects of your business to increase its value.
Business valuators give consideration to a range of factors: interest rates; local, state and national economies; industry information; financial data; and, very importantly, company-specific characteristics.
The goal of considering all these factors is to understand the risk and potential reward of an investment in your company. Risk and reward are opposites when considering the value of a business. The more risk the business has, the less value it has.
8 key company characteristics
Company-specific characteristics can have a major impact on the valuation of a small business. Many of these factors are not financial factors, and some may be misunderstood by business owners as either increasing or decreasing value.
1. Debt levels
Higher-than-industry-standard debt levels may indicate that a business is having difficulty funding itself from operating cash flows and is relying on too much leverage to achieve its mission. This puts the business at risk of excessive interest expense and may result in less, or no, cash available to be returned to investors in the business. Items that negatively impact cash available to be returned to investors represent a major risk to the business and may decrease value.
2. Customer pool
Concentrations of sales to a limited number of customers, in some cases a single customer, may reduce the value of the business. If a major customer doesn’t continue doing business with a company, that can have a significant impact on the ability of the company to generate a return for investors, thus increasing risk.
Many business owners incorrectly think that having fewer customers that generate significant return is a positive for their business, when in fact it is likely viewed as a major risk to the future of the business if the relationships or contracts were to terminate.
3. Heavy reliance on key individuals
Many small businesses can end up relying on a few or even a single individual to achieve many of their operational goals. Sales, purchasing, accounting, human resources and other major areas of a business may be concentrated with a few or even a single individual.
This presents a risk to the company if the individual(s) were to leave, as their functions may need to be replaced with multiple people or, in the case of sales, operating results may suffer.
Many small businesses also heavily rely on their founders, who take on many of the operational tasks of the business. This increases the risk, and thus reduces the value, of the business, as a founder may seek to transition out of their business at retirement or pass the business to another generation of their family. “Keeping it in the family” may in fact reduce the value of the business, not increase it.
4. Reliance on key suppliers
Businesses may rely on a few key suppliers to obtain the raw materials they use in production or products that they resell to the public. Relying on a few key suppliers increases the risk of the business. Any disruption in one of those supplier relationships may reduce a company’s ability to fulfill orders, stock inventory, etc.
Significant competition for a business increases the risk a business will be able to generate a return for investors into the future.
6. Geographic location
Certain businesses may focus on a single or small number of geographic areas for their business. However, limited regions of operation increases the risk the business has for future operations. If a particular region were to shrink, in terms of population or economic growth, the business would be at risk of being able to generate less return for a given investor.
7. Earnings volatility
Investors seek a steady stream of positive returns on a given investment. Volatility in the earnings of a business may be a sign to an investor that there is less certainty to continued returns. Often, business owners will point to banner or record years as benchmarks of what they can do.
While exhibiting positive historical patterns is excellent, the value of the business is based on the forward-looking returns an investor can expect to receive. Often, a business with steady earnings may be valued higher than a business that had higher, but erratic, earnings patterns.
8. Product diversification
Diversification of products is important for reducing the risk to an investment. “Viral” or fad products may lose market share rapidly and reduce the potential for future returns. Similarly, offering too many products, for which the company can’t provide adequate support, may also increase the risk of future returns and decrease the value of the business.
How Wipfli can help
A valuation engagement allows a business owner the opportunity to discuss these characteristics and how they can impact the value of their company.
Often, business owners are so focused on the bottom line that they can miss other factors that impact value. Many of these factors can’t be fixed or changed overnight. Sometimes you need years to implement changes, such as hiring the correct management team, expanding product offerings or exploring new geographic markets.
Having a conversation with a Wipfli valuation specialist can help business owners understand some of the key company characteristics that can impact the value of their business. Contact us to learn more, or continue reading on:
The top reasons why you need to know the value of your business
What you need to know about valuing your business in a divorce
5 ways to build value and sell your business for more