As an Accountant and Business Advisory, I get this question very often! But arriving to an answers is very difficult and 90% of the business value comes from qualitative attributes… However the “answer” to this question can go in five different directions:
- Book Value: this will be value on the balance sheet, which the total amount in the Equity section of the balance sheet
- Fair Market Value: this will require to start from Book Value and then add or subtract the Fair Market value of all assets and liabilities in the balance sheet
- Liquidating Value: this will require to start from Book Value and then add or subtract the value you would get from it in a “fire sale” scenario, using the same action systems used by foreclosures and bankruptcies
- Market Capitalization: the fair market value of the outstanding shares of the company owned by investors
- “Going Concern Value”: Generally speaking, is the value that 3rd party investor is willing to pay for the business if it were to exchange hands, also known as Goodwill
This last one, Going Concern Value, is not really a widely use term, and is the most SUBJECTIVE of them all. Book, Fair Market, Liquidating, and Market Cap are “balance sheet methods” and all could be done using quantitative methods; in theory a CPA and/or an Appraiser could calculate the first four. The Going Concern Value assumes that there is “goodwill” added to the market value of your assets and that “goodwill” is 1oo% subjective.
That being said, let’s now ask a better question: “How would a potential successor of my business determine the value of my business?” The answer to that will come from analyzing the areas that affect the companies “Going Concern” (which is the assumption that the business will continue to operate solvently) plus the rate of growth (assumptions about conditions that will change in the future, positively for the business); which I like to call the 11 Components of Business Value:
- Retained Earnings: typically represented in past profits that are accumulated and kept in the business (not distributed), also known as accumulated cash on hand from profits; that are free of debt or other encumbrances. And income growth potential are the most important elements of “quantifiable” value, this is what drives most of the value, but projecting that growth is based on more subjective figures driven by the other ten components of business value.
- Income Generating Assets: Real Estate is the perfect example of this, but there are many type of assets that generate recurring income with very little operation required for them to function
- Infrastructure: these can be tangible assets, systems, and/or technology that give the company the platform from which to serve their customers and generate income. Amazon’s website is a great example of this.
- Customer List: this may be a list of past satisfied customers that are likely to buy from you again or a customer list with recurring income or standard contracts that can reasonably guarantee some sort of income or sales in the near future barring some sort of catastrophe
- Creditworthiness: with banks, investors, private lenders, etc.. Also your vendor relationships, credit limits and credit terms play into this as well.
- Brand: recognition and awareness from customer and potential customer for what you company does. I like to think of “brand” as what the customers think of your business and products BEFORE they buy from you. The perceived quality of your products are services are part of your brand as well
- Intellectual Property: this would be the “knowledge base” of the internal procedures, processes, and know-how that is particular to your business.
- Talent: this has to do with the capabilities of the employees that a new employee would not be able to perform in the short-term. Corporate culture, leadership/bench, employee retention are all important components of this; specially because it permeates to customer service and the quality of the product/service provided.
- Location: this is not only physical location (which is most important for retail and customer-facing type businesses), but in today’s digital world, web presence, search rankings, and/or website traffic plays a big role in here. Also, distribution channels are very important.
- Intangible Rights: some companies have special licensing, permits, contracts, geographic protection, trademarks that are unique and with high barriers of entry from competitors. Enforceable Non-compete agreements are also valuable some times.
- Social Platform: which is the communications platform that the companies enjoys as part of their contact list, social media, and other list of connected people that are also known as the “followers”; which are not necessarily coming from actual customers but are part of a network of potential customers and create word of mouth about your business.
Adding up the tangible value plus the potential value (intangible) of all those will help a small business owner understand where the value of the business comes from. If you own a small business and would like to go through an exercise of value discovery with one of our advisors, contact email@example.com for more information.