If you are considering applying for a SBA loan to buy a business or sell a business, dissolving a business, or adding a partner to a business partnership, you may know that the business needs to be valued. In very generic terms, this means creating a financial model of your business and estimating a value. But how do you know which valuation model is best for your small business? Here are the basics on the 3 primary approaches of business valuation, and which businesses they work best for.
The market approach uses substitution of market sales.
The market approach is the primary way to value small and very small businesses. The valuator will substitute comparable market sales from similar companies that have recently been sold to the company being valued. This calculation includes comparing cash flows and financial information with information about how the company is structured, the industry, and overall economy. For example, if a small government services provider is looking to determine their value for the SBA, a valuator would compare their size, management team, cash flow, and financials to a group similarly sized business in the same industry.
An income approach is based on cash flow.
When valuators use the income approach to find the value of a small business, they focus primarily on cash flow. The income approaches estimate the business value to an investor who could invest in anything from a government bond to a small business. This means looking at how much money a business is making and the business risk compared to other investment risks. Because most people who are buying or selling a business are interested in knowing how this business compares to other businesses this approach is the most used approach. By looking at the historic cash flow and income of a business along with many other business factors, valuators estimate future cash flow and the risk of obtaining the cash flow. From those inputs, they can estimate a value.
The asset approach estimates the business’s value through assets.
For some small businesses, their value may lie in the assets they have. For a construction company, this could include equipment; for a commercial real estate company, it could include their properties; and for a tech company, it could include intellectual property. The asset approach is often used when there is not sufficient cash flow to use the income or market approach and basing the value on cash flow would not adequately estimate the value of a business.
The reality is that a professional valuator looks at your small business and all the available information, and uses the approach (or combination of approaches) best suited for your business. Each of these three models can be useful and each can be used in a misleading way. This is why all the models are helpful but none are perfect. As valuators, we impartially use valuation models to help business owners understand their value, whether it is for an SBA 7(a) loan approval, dissolution of the business, or establishing a partnership.
Valuation is not a strict science, but an art, where we create the best possible comparison for your business to understand it’s value. To find out more which valuation approach is best for your business, contact me to learn more about our business valuation services.