Perhaps your small business is ready to expand, and you’re thinking the best way to do that is by purchasing another small business. How can you determine a fair price?
Valuation is difficult in all kinds of purchases, but can be especially tricky in the purchase of a business.
When valuing a home, experts generally compare the home to similarly-sized homes that have sold recently in the neighborhood. With that information, they can estimate the fair market value. This method doesn’t work as well for businesses. There are just too many variables involved.
Instead, valuation experts rely on several methods.
The assets-based approach
One method is based on adding up the business’ assets and subtracting its liabilities. This is sometimes known as the book value approach or the balance sheet method.
While this method can be very helpful, it requires some finesse. Businesses typically mark down the value of their assets because of depreciation. This means the valuation experts have to assess whether the business has calculated the depreciation accurately. They also must determine how easy it would be to convert assets into cash if necessary.
The earnings-based approach
Of course, one does not typically purchase a business just for its assets. One also wants to make sure the business they’re buying has the potential to earn money.
Another common valuation method is based on determining the business’ potential for earnings and judging that against the amount of money the buyer will likely end up paying. The result can be an estimated return on investment.
This method relies to some extent on predicting the business’ future earnings, and that can be a risky endeavor. Valuation experts must work that risk into their calculations.
Valuation experts often use a combination of approaches to determine the fair market value, but the ultimate purchasing price is usually the product of negotiation. The valuation estimate helps the buyer and seller alike to have a ballpark figure they can negotiate around.
Attorneys help buyers and sellers to find the valuation professionals they need, and work as skilled negotiators to help them arrive at a price that works for them.