Business Valuation – Owners Need to Get Realistic — and Proactive

For business owners looking to sell in the near future, there is plenty to be optimistic about. 

Buyers have access to capital at low interest rates through banks. Stocks are at all-time highs, driving individual net worth and access to down payments. The Massachusetts economy is vibrant. Most recent reports show GDP growth and unemployment rates outperforming the national average. There is positivity around MGM coming to Springfield, a new GE headquarters moving to Boston, and the potential for business-friendly legislation coming down the pipeline. 

These factors will drive buyers to jump into the market and take the keys to a business, but there is a catch. With more than 1,100 businesses listed for sale across Massachusetts right now, buyers have options and are willing to wait for a value that makes sense. 

When figuring the value of their business, owners can fall into the trap of including sentimental value in their estimation. Some are relying on what a similar business sold for in a different market or, worse, have a target number they drew up without any real anchor to reality. 

For business owners who have dedicated their lives to a business, it can be hard to take a step back and objectively consider what their business is worth. Business owners who are willing to take an objective look at the value of their business can be proactive now instead of reactive when they are ready to retire and list their business for the first time.

The value of a business is dynamic. While there is no way to get a buyer to price sentimental value into a purchase price, there is a potential to make changes to the business that will increase the value over time.

There are three approaches to valuing a business — asset, income, and market approaches. For most privately held companies, valuators rely on either the income approach, market approach, or a combination of the two. The basic formulas for these calculations are widely available online, but what owners can do with this information may be less obvious. 

First, it’s important to know that the years leading up to the valuation or sale are the most important. A long history of profits can show stability for a small business; however, only the most recent three to five years are going to be considered in a calculation. Small-business owners with eyes on an exit have a tendency to disconnect from the business during this most important period when they should be pushing in the opposite direction. 

Flat revenues or increases in expenses during this period have the potential to erase even decades of growth and profitability. Owners should resist the temptation to ‘pull the parachute’ as they get closer to the finish line. Continue to push for revenue growth, and pay close attention to expense control. This is the time to let the numbers showcase the full potential of the business.

Nobody knows the ins and outs of a small business like the owner. Buyers and valuators weigh heavily on the impact the seller’s exit will have on the future of the business. Owners should focus on replacing themselves in the areas in which they are most intertwined in the business to lessen the impact. To identify these high-dependency areas, owners can interview managers and employees, noting issues that cannot be resolved without them. 

Key areas of focus generally depend on the industry or business model but usually include sales generation, relationship management, product development, strategic decision making, or day-to-day business management. If continuity can be achieved through process improvement or process documentation, it should be a key focus. Some results can be found through training current employees and empowering them. Consider restructuring tasks and delegating the current owner’s duties to rising managers.

Finally, clean up the financial statements. For various reasons, including tax motivations, small-business owners have a tendency to let their personal and business lives collide on their company financial statements. Documentation is important for any personal expenses being charged to the business. Owners should be ready to prove which expenses were not necessary for the business so that buyers and valuators exclude the expenses to calculate the value — buyers will not report findings to the IRS. 

Performing a financial analysis can also help owners understand how their business compares to the rest of the industry, making them ready to articulate strengths and defend or improve weaknesses.

Overall, the current market is friendly to someone looking to sell their business. It’s also a great time to be proactive in managing an exit strategy, whether it lies around the corner or several years out. Getting realistic about the value of their business enables owners to take steps to improve it and make informed decisions.