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Selling or Buying a Business? Valuation Methods

When you want to sell your San Diego small business or professional practice, or if you are in the market to purchase, at some point, everyone will have to decide how much the business is worth. This is obviously important for the seller and buyer, but will be equally as important to the banks, lenders and/or investors. Here is a quick guide with respect to business valuation methods.

Selling/Buying a San Diego Business: Three Generally Accepted Valuation Methods

In general, there are three generally accepted approaches to business valuation.

Income method
Asset method
Market method

Selling/Buying a San Diego Business: What is the Income Method?

As the name implies, the income method of business valuation uses the income generated by the business as the basis of determining value. Obviously, under this method, the business being sold or purchased is an ongoing business and the buyer is expecting to keep the business running.

To use an oversimplified example, imagine that you are selling a small apartment building — say six apartments. In this example, the income method of valuation uses the monthly rental income as the basis for valuation. Expenses are factored in and various customary industry standard discounts and multipliers are added. In general, the focus is on net cash flow and expected rates of return based on the level of investment. If you are paying $100,000 for the apartment building, but it only generates $1,000 a year in discretionary cash flow, that is not a good rate of return on your investment. However, $20,000 a year in discretionary cash flow is a different story. Again, this example is oversimplified since, in practice, the income method takes into account historic track record, growth prospects in the industry, size of market, number of competitors, location and facilities, and many other factors. Further, rate of return is not necessarily the key variable. A lot depends on the type of business and industry.

Selling/Buying a San Diego Business: What is the Asset Valuation Method?

The asset valuation method essentially asks “how much would it cost to create this business from scratch?” Conversely, the question can be phrased: “if I liquidate the business and sell each piece, how much money do I recover?” Obviously, this is not a method well suited for a business that is expected to continue operating, but might be better suited for buying a business that is now or soon to be defunct. Continuing our apartment building example, this valuation method is similar to a “cost-to-rebuild” valuation.

Selling/Buying a San Diego Business: What is the Market-Based Valuation Method?

In general, the market-based valuation method establishes value based on the actual sales in the market of comparable businesses in the comparable area during the relevant time frame. This is the most common method used in real estate transactions. With our hypothetical apartment building, the appraiser will search records of recent sales of six-unit apartment buildings in the general neighborhood over the last months or years.

The same method is used with respect to business valuations. To value a hypothetical comic book store, the appraiser will compare the existing business to the sale of other comic book stores, if available. Attention will be paid to size and volume and location. Even businesses that resemble the business being valued can be used — so, maybe, a regular book store with appropriate adjustments and qualifiers.

Selling/Buying a San Diego Business: All Valuation Methods are Typically Used

In general, when trying to value a business, a business appraiser will use one method as a primary method, but will likely reference all three methods. Thus, with an ongoing business, an income method is likely to be the primary valuation tool. Some effort will be made to look at the asset method and the market method. Exploring and examining all the methods provides a “check” on the primary method being used.

For those interested, there are some less common methods of valuing a business including something called the “social value method.” See article here. That might be useful for valuations and appraisals of social purpose corporations.

Contact San Diego Corporate Law

For more information, contact Michael Leonard, Esq. of San Diego Corporate Law by email or by calling (858) 483-9200. Mr. Leonard has the experience to help with the sale or purchase of a San Diego business.