Knowing the value of your business can improve decision-making

It’s not uncommon for business owners to know or have an estimate of the value of their business. What’s more common, however, is not being able to fully justify how that value was reached.

“Business owners have their finger on the pulse of their business, but they don’t always understand valuation metrics,” says Courtney Sparks White, J.D., LL.M., ASA, CVA, partner, business valuation and forensic accounting, at Clarus Partners. “There is a tendency to overvalue a closely held business, which is understandable as it’s often the largest asset the person owns.”

She says understanding a business’s value and the metrics that drive that valuation are essential to many decisions business owners make. Putting all the valuation elements together within a framework can help business owners be better decision-makers.

Smart Business spoke with White about business valuations and their usefulness.

Why should business owners understand the value of their companies?

Fundamentally, business owners who understand the value of their company are in a position to make better decisions. It allows owners to make plans based on facts and it can be beneficial to risk assessment — discovering, for instance, that having only three large customers is a risk that decreases the company’s value.

Many business owners think value is determined by revenue and top-line growth, but that doesn’t always directly translate to value. There are other, unique factors that contribute.

A valuation can be required in some situations — upon an owner’s death, when making a gift, during a litigation proceeding such as shareholder disputes or divorce. In those situations, people often just want a number. But as a planning tool, a valuation can be a strategic asset as owners work to grow their business. It can help business owners understand the key metrics that drive value for their companies.

How does a business owner determine the value of his or her business?

The easiest way to determine a company’s value is to work with a professional who’s skilled in business valuation. But to explain the process with a little more specificity, there are three main approaches to valuation: asset, income and market. Within each are various methodologies that are applied, not all of which are relevant for every business in every situation.

Many business owners talk about multiples of revenue or earnings as the central components that determine a business’s value. That approach can lead to inflated valuations that obscure a company’s actual value because the multiple may not be relevant for that business, or it’s the wrong multiplier or base to use.

The three main valuation approaches are considered a staple regardless of industry, but the choice of which to use hinges on the company’s industry, life cycle and asset-intensity. That’s why working with an experienced adviser is the best approach.

How often should valuations take place?

Valuations that are used as planning tools to make better decisions should be conducted every two to three years. In a rapidly changing market, valuations may be conducted more often, but annual valuations aren’t often necessary.

Conducting a valuation at the startup and exit phase of a business’s life cycle is standard. A lot is in flux with a company at the outset, so valuations should be performed relatively frequently. For owners of startups, it’s good to understand how the business is valued as it progresses.

At the opposite end of the spectrum, a business owner planning his or her exit should keep the valuation updated. Businesses in the middle of their life cycle should have valuations conducted based on what’s happening in the market or with the company.

Valuations are a valuable tool for business owners at any stage of a company’s life cycle because it can be the basis of a conversation about the business that uses very finite terms. When considering a valuation, speak with a skilled valuation professional to understand the process and ensure that the valuation can be an effective tool.

Insights Accounting is brought to you by Clarus Partners