Business valuation can be important, the key factors that affect business valuations, and how to best estimate valuations.

Knowing the true market value of your business can be useful for many reasons, not just for selling it or raising investment. Putting a price on the company may be the first time a business owner – especially one with a small, entrepreneurial, founder-based, or family-owned business – comes to fully understand how outsiders view their business and the main factors that drive the business’s market value.

Better understanding of the factors that drive value can help owners prepare for a sale, today or in the future. But according to an article in Knowledge at Wharton, a business journal from the Wharton School of the University of Pennsylvania, business owners don’t always have an accurate view when it comes to valuing their business.

“Business owners have unrealistic ideas of what their business is worth,” the article notes. “This is the most common reason that merger deals fail.”

The Importance of Understanding Your Business’s Value
Many business owners feel a valuation has two purposes: to help the company raise investment or to help in selling the company.

Even if I’m thinking a sale is three or five years down the road, the discipline of evaluating what’s driving my business’s value today will pay benefits,” he says. “Considering these value factors in your strategic planning and budgeting process will also improve operational and financial performance of the business – adding value when you do sell.

Of course,  having a clear idea of your value means you can go into merger and acquisition (M&A) negotiations better informed, but it’s the preparation and paying attention to factors that build value in advance of a sale and helps boost a business’s valuation.

Preparing your business for sale is critical. “The more comfortable buyers are that your business is well run and buttoned down, that your business is what you’re representing it to be, the less risk they will associate with the transaction.

Buyers can mitigate risk in a number of ways, including lower valuations and less favorable deal structures (meaning the amount of cash at close versus future, performance-based or “contingent consideration” payouts). Having your financial, legal, and commercial issues in order can maximize valuation and speed time to a successful close.  The ultimate sale of the business is a highly emotional event for a founder and the process is a distraction. “The better prepared a founder is, the better they can manage through the negotiations and sale.

Having a clear picture of what you want your life to be like post-transaction can also be important. Whether you prefer to stay with the business or stop operating immediately will affect the possible deal structures, as well as the pool and type of potential buyers.

Whoever is valuing your business may want to have full access to your accounts, so it’s important to have all your numbers in order, including credible forecasts. Ideally, businesses looking for the highest valuations should have accrual-based financial statements compliant with U.S. Generally Accepted Accounting Principles (GAAP).“To a buyer, the most important considerations are historical financial performance and your forecast going forward – so you need to credibly back up that history and forecast.

What Affects the Value of a Business?
There are many factors that can impact a business’s value. Here are some of the most important:

Valuations are generally expressed as a multiple times EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). For example, a business with EBITDA of $1 million and a multiple of 3 is valued at $3 million. A business’s multiple (and, therefore, valuation) will be greater if revenue and EBITDA has increased for several years. The multiple will be lower if profits are decreasing or erratic.

Investors don’t just want to know how much money you’re making now. They also want to see forecasts and an evidence-based rationale for your projected revenues and profits. Do you have a strong business development approach and dependable forecasting methodology? What are the key market dynamics impacting future performance? Is the competitive environment favorable? Are there regulatory or technology issues that can enable growth or challenge the business?