As nouns, the difference between valuation and evaluation is that valuation is an estimation of an object’s worth, while an evaluation is an assessment, such as an annual personnel performance review used as the basis for a salary increase or bonus, or a summary of a particular situation. A business evaluation is often the nomenclature of management consultants and has to do with assessing the entire business organization and its relative operating effectiveness.
The terms business valuation and a business appraisal are synonymous. In the recent past, business valuation has become the most accepted term representing placing a reasonable market value on a going concern business or the value of a planned start-up company. Let’s discuss appraising (valuing) a business, the steps to obtain a professional business valuation, and the evaluation of a company’s worth.
Do You Know the True Value of a Business Appraisal?
If you are a homeowner and a business owner, then you have likely heard the term real estate appraisal before. A real estate appraisal is part of the buying and selling process where the value of a property is determined before the transfer of ownership.
With a business, appraisals and valuations may be more complicated, but the concept is the same. A business appraisal or valuation is the equivalent of an economic analysis that helps to determine the actual worth of any business or professional practice. Anytime there is a potential change in the ownership of a business, the value of that business needs to be determined.
What is the target use of a Business Appraisal or Valuation?
A business owner may need to know the true value of his or her assets for any number of reasons. Business appraisals are a common part of securing a business loan. For instance, particularly if the lender is a traditional bank. The valuation of a business is also necessary for partnerships if they are moving to separate ownership, settle partnership disputes, or trying to bring in another party. If you are gifting a part or all of your business for estate planning reasons, you must first obtain an appraisal for tax purposes, similar to knowing your home’s value before taking it to market.
The owner does not always order business appraisals. A commercial lender, business investors, legal professionals, tax authorities, and even courts can demand a business valuation depending on the circumstance. For whom the appraisal is for, and its purpose will make a difference in the method used to obtain its value.
Understanding the Main Differences in Business Valuation Approaches
To estimate the value of a company, a professional appraiser will use three techniques: the market approach, the income approach, and the asset approach. Each approach will give you an idea of the value of the business but from a different viewpoint. Then once the results of all three are analyzed and combined, do you get a comprehensive business valuation.
- Market Approach – Competition is the driving force behind a market approach to setting the value of your company. The evaluator will look at similar businesses’ selling prices and use that data to estimate what your company is worth. This approach is very similar to the technique used in a home’s value appraisal.
- Income Approach – The income approach of a business valuation can be achieved through several methods. At its core, it’s the expected economic benefit and level of risk that would come from an investment in the business. Depending on the method used, the current cash flow will be capitalized, discounted, or multiplied to help determine the future financial value of the company.
- Asset Approach – This is easiest explained as being the sum of all of the tangible parts that make a business. What the asset approach does is hypothetically take all of the equipment, stock, and supplies and sell them separately to see what they would be worth. This dollar amount becomes a part of the business’ overall value to potential buyers or shareholders.
The Documentation Needed For an Accurate Business Valuation
For a professional appraiser to be able to conduct their research, a business owner will need to provide a certain amount of data, paperwork, and financial information. The more current and up to date documentation you can offer, the more accurate the business valuation. The quality and timeliness of the data are critical when trying to ensure that you are getting a defendable valuation number for the time, money, and effort you have put into building a business.
A list of the basic documentation you should be able to provide includes:
- Your current capital structure
- Your financial statements over the last three years
- Tax returns from the last three years
- The current year to date financial statements
- The profit and loss summaries from the last three years – quarterly if available
- A full list is provided here: Data needed for a Business Valuation
The appraiser will also ask you key questions about your business, such as your major product or service category, the sales process, customer profile, customer concentration, vendor concentration, and any major competitors. The number of full and part-time employees is needed along with a short description of those employees you rely on the most. Do you have key employees under non-compete agreements? You should be completely honest, open with your professional evaluator, and provide them with all the information requested to get a report that accurately represents your company’s worth.
What Should a Business Valuation Report Contain?
When a professional appraisal is completed for your business, an extensive report is delivered that consists of much more than just numbers and financial data. A correctly executed business valuation will start with a summary of the purpose of the appraisal and its scope along with the expected recipient and the date.
After the summary, you should find a description of the current economic conditions concerning your industry on different levels. What follows are various analysis reports, including the financial statement, which provides the reader with an understanding of where the business stands economically in comparison to similar enterprises.
Who is qualified to appraise A Business?
For a business valuation to be considered valid, it must be performed by an uninterested third party. These valuation analysts are experts in interpreting data and trends to make a fair conclusion about the worth of a company or business. The results that the qualified appraiser provides you with should be both prompt and accurate so that you can proceed promptly with the transaction that initiated the business valuation in the first place.
Is a Business Valuation the Same as a Business Evaluation?
The primary purpose of a business appraisal is to determine a company’s financial value in the marketplace. A business valuation is looking at all assets concerning all risks and liabilities. An evaluation of a business measures the intangible, as it is assessing the operations of the business to see how effectively and consistently it generates cash flow. This type of business tool is typically utilized when an owner or management is trying to improve on cash flow or profits by improving productivity.
When Should a Business be Appraised?
A new business can typically wait about two years before having their first business valuation report executed unless they are venture or angel capital-backed or are in hyper-growth mode. Having the first appraisal done at two years is a good idea, especially if competitors have been showing an interest in buying your company. Knowing the true value of your enterprise early on will also be helpful if you have expansion plans but need help in funding your growth. An accurate business appraisal can be used to help you get funding from a bank or other type of business lender.
Established businesses should have a professional business appraisal done every five to ten years or sooner if you are executing your exit strategy or approaching retirement age. Keep in mind that any time a vested partner opts to leave a business, a valuation will be needed to determine their fair share of the company. If you intend on “gifting” shares to family members as a part of their inheritance, the IRS will want an arm’s length appraisal.
Whether looking for financing to expand your operations or to hand your legacy over to your heirs, an accurate business valuation is invaluable. Arm yourself with the full economic knowledge of your business now, and you will be in a better position to negotiate your price later. Call 561-325-9777 or email to find what your company is worth through our professional valuation services.