What’s in This Article:
Valuation is Only Needed When You Want to Sell
Value Depends on the Purpose of the Calculation
A Business in the Red Isn’t Worth Much
Owning a business is hard work, and it’s common for business owners to wonder how much their company is worth. Whether you are thinking about selling your business or not, have an offer on the table, or are merely curious, there are quite a few business value myths out there. Here are five.
Myth 1: Valuation is Only Needed When You Want to Sell
A common business value myth is that valuation should only be determined when a business is getting ready to be sold. Knowing how much your business is worth is good information to have on hand, even when a sale isn’t being considered.
This information can be helpful for business and estate planning, particularly when planning the future ownership or transition of the company. It can also support succession planning, financing decisions, and long-term business goals.
Of equal importance is keeping this information up to date for planning purposes. The value of a business today may not be the same as it was a year ago.
Myth 2: The “Rules of Thumb” Myth
Contrary to what you may hear in casual conversation, there are too many variables to consider in valuing a business to rely solely on a “rule of thumb” calculation.
A business is not necessarily worth two or three times annual revenue, as other factors need to be taken into account. Likewise, valuing a business based on past transactions, known as precedent transactions analysis, requires considering differences between the businesses and changes in market conditions.
The idea that financial statements are all that are needed to determine business value is another common misconception.
While rules of thumb can be useful as a general comparison after a more detailed assessment, they don’t fully account for factors such as goodwill, future earnings, customer relationships, or the regional economic outlook.
The IRS Business Valuation Guidelines also recognize that valuations require consideration of the business, its financial condition, and relevant economic factors.
Myth 3: The Comparison Myth
We all love to compare ourselves to others, but this can be a mistake when it comes to business valuations because no two companies are exactly the same.
Even if you are comparing your business to a local competitor that recently sold, the circumstances surrounding that transaction may be different from yours.
Changing interest rates and economic conditions, along with differences in customers, contracts, cash flows, and expected growth, can all affect business value.
For example, a business with recurring customers and consistent cash flow may be valued differently from a competitor with similar revenue but less predictable earnings.
Comparable transactions can be helpful, but they should be evaluated alongside other relevant financial and business information.
Myth 4: Value Depends on the Purpose of the Calculation
The purpose of a business valuation matters, but that doesn’t mean the results can be adjusted simply to produce a preferred outcome.
For certain tax-related valuations, the Internal Revenue Service uses the concept of Fair Market Value (FMV). Generally, FMV reflects the price at which property would change hands between a willing buyer and a willing seller, neither being under compulsion and both having reasonable knowledge of the relevant facts.
However, not every business valuation uses the same standard of value. Depending on the circumstances, a valuation may be prepared for a sale, estate planning, financial reporting, litigation, or another purpose. The applicable standard, valuation date, and assumptions can affect the result.
For example, a business owner cannot simply assign a $5 million value when selling to an outside buyer and a $1 million value when transferring the same business to a family member without appropriate support for the difference.
A qualified valuation professional should identify the purpose of the valuation, apply the appropriate standards, and support the conclusion with relevant financial information and analysis.
Myth 5: A Business in the Red Isn’t Worth Much
In smaller, privately owned businesses, the distinction between ownership and management is often blurred. Companies that have valuable assets or strong earning potential may not appear particularly profitable at first glance.
Owner compensation, discretionary expenses, depreciation, and other accounting adjustments may affect reported earnings. A valuation professional may need to review these items to better understand the company’s financial performance.
A business may also have valuable customer relationships, contracts, equipment, intellectual property, or other assets that contribute to its overall value.
This is why it’s important that more than just business tax returns are analyzed and that the right questions are asked about cash flow, assets, liabilities, and future earning potential.
For example, “losing money” does not always mean a business has little value. Likewise, a sudden increase in revenue does not necessarily mean the company’s value has increased by the same amount.
Understanding the complete financial picture is essential when evaluating a business.
In the end, there are many important reasons why business owners should understand the value of their business, even when they aren’t planning to sell.
The American Institute of CPAs (AICPA) provides a Statement on Standards for Valuation Services (VS Section 100) to guide applicable valuation engagements performed by its members.
Having accurate financial information and understanding these common misconceptions can help you work with a qualified valuation specialist to make informed decisions about your business.
At Cheryl Jefferson & Associates, we help business owners understand their financial performance and plan for the future. Learn more about our Subscription Services or contact CJA to discuss your business’s financial needs.
Frequently Asked Questions
How often should a business valuation be updated?
There is no single schedule that applies to every business. An updated valuation may be appropriate when significant financial, operational, or market changes occur or when a new valuation is needed for a particular purpose.
Can I determine my business’s value using annual revenue?
Revenue multiples can provide a general comparison, but they don’t account for all the factors that influence value, including profitability, cash flow, risk, assets, and future growth.
Can a business that is losing money still have value?
Yes. A business may have valuable assets, customer relationships, contracts, or future earning potential even when its current financial statements show a loss.
