Determining accurate small business valuations is important for getting a fair price when you sell your company, or when you are trying to attract investors who give you capitol in exchange for a certain amount of equity in your business. However, the process of calculating small business valuations is not a hard and fast science, there are a lot of assumptions in the process that impact the end result. If you are looking at small business valuations calculated for your company (or one that you are considering investing in or acquiring) and they do not seem to add up to you, a wrong turn could have been taken in the process of calculating it. Here are a few common mistakes that create inaccurate small business valuations:
- Using the wrong valuation market approach.
Business valuation reports are based on one of several value metrics. It is common for business valuation tools to use “fair market value” when putting a price tag on a company; however because this method is common, it often incorrectly assumed that that was how the valuation was developed. When a company is looking to increase their valuation in order to draw more investors, or get the greatest amount in an acquisition, they may use a valuation called the “investment standard of value.” This value method typically leads to greater ultimate valuation than the fair market value, while the circumstances behind the valuation is the same for both. Understanding the method used to determine the valuation you are looking at will help you get a sense of what the number means.
- Using the profits instead of cash flow to determine the business valuation.
As you would probably assume, the primary factor when determining the valuation given to a business is its ability to generate income. The most accurate way to factor in a business’s ability to generate income is with the cash flow of the business, not the profit (although the profit seems like the most direct indicator of income power). If the business has the earning power to generate an enormous amount of profit, but the cost of doing so ties up all of their assets (or more than the available assets), it will create a tremendous stumbling block in actually meeting that earning power. For this reason, the most accurate business valuations come from calculating the cash flow from the business’s income statement and balance sheet that show they have enough money to run like a well oil machine.
- Incorrectly calculating the business valuation multiples.
Using the wrong business valuation multiples is a simple mistake that people make while creating a business valuation, and is the most common reason that a business valuation goes wrong. There are several valuation multiples that can be used to calculate the business’s worth, and each use different metrics that should not be confused with each other. For example, if the net cash flow is used in the multiple equation, you should not calculate the net profit instead; this will result in an inaccurate business valuation. Make sure the numbers used in the business valuation calculation are accurate if you feel like the end result seems unreliable.
- Forgetting any assets or the liabilities in the business valuation.
In most cases, when the small business is sold, it is the assets that are actually transferred. This means that the value of the sale pays off any liabilities the seller has, and the buyer takes ownership of the assets. However, in some cases, the business valuation involves retaining some liabilities, or adding in additional assets. If this is the case, the additional assets should increase the value of the business, while liabilities decrease it.
- Miscalculating the value of the business goodwill.
The goodwill of a business is difficult to measure. For example, the owner of the business might perform the jobs of four or five employees, and the purchaser will have new labor costs to cover those functions. This “sweat equity” should impact the total business valuation being considered when the business is being sold, but it is easy to overlook. The goodwill of a business should be closely evaluated to ensure that it is accurate.
Do you know of any other reasons a business valuation might be inaccurate? Please share in the comment section below.