Clients often ask how to determine the fair market value (FMV) of a small business. On one level, the goal is to establish a price that a willing buyer and a willing seller would agree to in an open and unrestricted market. There are a variety of ways to establish FMV, and the choice of valuation method depends on the business and the reason for the valuation.
For example, let’s say you’re in a two person company and your partner wants to leave. They’ve offered to let you buy them out of their share, with the price being based on the FMV. But what value are we talking about – the value of the business today, with both partners working in the business? Or the value after the sale, when the size of the workforce has gone down by 50%? This is just one example of the complicated nature of what seems like a simple question.
That said, here are some common methods of determining the FMV of a small business, along with some of the pros and cons of each approach:
- Asset-Based Valuation: This method looks at the business’ tangible and intangible assets. It calculates the cost it would take to replace all physical assets (like real estate, equipment, inventory) and intangible assets (like brand value, patents, copyrights, and good customer relations). Liabilities are subtracted from this sum to find the asset-based value. This method is best used when a business has significant tangible assets, so it’s a commonly used method in industries like manufacturing or retail. It may be less useful in, for example, a two-person consulting business.
- Income Valuation: This method uses the company’s financial prospects to determine the business value. The Discounted Cash Flow (DCF) is a commonly used income valuation method that estimates the value of an investment based on its future cash flows. DCF analysis finds the present value of expected future cash flows using a discount rate. A higher discount rate indicates a higher amount of risk associated with an investment. This method is often used for businesses with strong predictable cash flow, such as service businesses.
- Market-Based Valuation: This method estimates business value based on what similar companies sell for. The problem with this method is that it can be hard to find comparable sales data for a small business, making this method more appropriate in an industry with lots of transaction activity.
- Earnings Multiplier: This method is often used for businesses that have a solid history of earnings. It’s based on the principle that a business’s value is worth a multiple of its profit. This multiple can depend on the industry, economic environment, and other factors. And it may not be workable in a new business, or one where future earnings are hard to predict or depend on the specific people working for the business.
Each method has its strengths and weaknesses and they often produce different results. Therefore, it might be advisable to use several methods to reach a more comprehensive understanding of a business’s FMV. Employing a professional business appraiser is another option – they can provide a detailed analysis that can be presented to potential buyers or lenders, adding credibility to the stated business value.