Most business owners only think about getting a formal valuation done on their company when they are considering selling it and need to evaluate offers.
But the disciplined process of determining your company's monetary value can give you insight when facing other types of questions — such as how best to grow your company, where you are weak or strong in industry terms, and how to track progress on your strategic goals.
Everyone understands the concept that if I have more sales and income, I'm probably worth more money. That's not incorrect. But in determining the worth of a company, other factors also drive the number.
For example, let's say you have two companies with $10 million each in sales. One company has 10 customers at $1 million apiece. The other has two customers at $5 million each. Which do you think is more valuable?
In addition to customer concentration risk, other factors influence value, such as age of equipment, management depth, systems in place, capacity and technology.
A valuation informs you from a market perspective the important drivers of the business, and help you know how you would be evaluated. Some companies may not be looking to sell, but they want to study how they are operating and what their value range would be based on multiples being paid, and factors being valued. This allows a company to pinpoint in real dollar terms where they have needs.
There are four specific points during the process of a company's growth that a business might want a formal valuation, in addition to when they plan to sell.
1. When a company sets a goal to grow organically, and wants to measure that growth for accountability. As part of strategic planning, companies establish what they want to accomplish and when. A valuation gives you metrics to establish where you are today, and equally important, to measure where you are a year out.
It's easy to say our revenue was "x," and now it is "2x." But rather than looking at one line item, quantifying other value-drivers allows you to understand where you are succeeding and where you are weak.
2. When a company needs a baseline to incentivize its team before an acquisition. From a structure standpoint, a valuation can provide a way to compensate or incentivize the people who have been part of your team before an acquisition. Companies will structure stock options or profits interests so that team members benefit from the increased value that is expected after the event they are about to undertake.
3. Understanding the value of the company you want to acquire. If you are in the process of making an acquisition, you are probably evaluating the target company from a qualitative standpoint. A valuation can help you with your negotiations so that you don't pay too much. The business selling will already have a valuation, but buyers need one as well, or, at the least, an independent assessment of the seller's numbers.
4. Accountability after an acquisition. If you've made an acquisition, having a valuation done right at or after allows you to check in two or three years later from a tracking standpoint. Was this a success? Did we pay a fair price for it? Are we moving toward the goals that we set out to do? If this is a first acquisition in a line of several, it gives you a way to evaluate your purchase in a way that could impact how you do later deals.
While a valuation at the end of the day provides a single number of the worth of a business, the biggest benefit from the process for owners is learning the components that underlie that number. This information provides a basis for concrete analysis and decision-making on many fronts.
Scott Womack is a partner in the Business Valuation and Litigation Support Practice at LBMC, the largest regional accounting and financial services family of companies based in Tennessee. He specializes in assisting small and medium-sized businesses in the potential sale of their businesses. He can be reached at 615-309-2301 or email@example.com.