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Understanding Your Company's Valuation for Effective Business Succession Planning

Posted by Clay Baker on Thursday, June 13, 2024

Accurate valuation is crucial for effective business succession planning. Learn more.

A Small Business Owner Creating An Accurate Company Valuation for Business Succession Planning

Having a business succession plan in place is critical to give you better peace of mind about the company you’ve worked hard to build. And at the heart of an effective succession plan is an accurate business valuation, which provides a clear, objective picture of your business’s value. But it’s not just about numbers; it’s about setting realistic expectations and creating a solid foundation for the future of your company. In this article, we’ll discuss the importance of having a clear valuation and how to ensure that your hard-earned success is passed on.

The Importance of A Business Valuation

A business valuation is unique to each company. It provides a clear understanding of your small business's value for yourself and your successors in planning for your financial future. Here are a few key benefits:

Facilitate Financial Planning

Proper financial planning provides a robust framework for making informed decisions, enhancing efficiency, ensuring stability and increasing growth. By evaluating key metrics like earnings before interest, taxes, depreciation and amortization (EBITDA), and financial statements like cash flow analysis and a balance sheet, you can be better equipped for financial planning.

EBITDA is a widely used measure of your company’s financial health and ability to generate cash. It helps you understand operational efficiency and profitability to guide performance improvements and investment decisions.

Cash flow analysis is equally critical. It evaluates your business's liquidity and ability to meet financial obligations. Profit margins, including gross, operating and net profit, are important indicators of cost management. These ratios reveal how well your business converts revenue into profit.

Additionally, a balance sheet provides insights into your company’s financial stability. It includes assets, liabilities and equity, which provides a snapshot of your business net worth and finances.

Ensure Fairness for Successors

An accurate and objective business value helps with the fair distribution of your business's assets among your successors. Whether you’re passing on your business to family or selling to a third-party, it helps prevent disputes. It also helps your successors understand the financial commitments they will be taking on so they can plan for necessary investments or loans.

Improve Retirement Planning

Knowing your business's value helps you plan for retirement. A fair sale price provides the financial foundation for your retirement, ensuring you have sufficient funds to support yourself. It also allows you to set realistic goals. Then you can plan for the lifestyle you desire, whether that involves traveling or simply maintaining your current standard of living post-transition.

Minimize Tax Liabilities

Transferring ownership of your business can have significant tax implications, including estate taxes, gift taxes and capital gains taxes. A thorough business valuation can help in strategic tax planning and minimize tax liabilities. By knowing your business's value, you can work with financial advisors to structure the sale in a tax-efficient manner. This might involve timing the sale to take advantage of lower tax rates or using tax deferral strategies.

Attracting Investors or Buyers

Investors and buyers need reliable information to make informed decisions regarding your business. A well-documented business valuation can enhance your business's appeal to your successor. It may also identify opportunities for future growth that you may implement before handing your business over.

How To Determine the Value of Your Business

Determining the value of your business takes into account various financial, operational and market factors. Here are the primary methods and steps involved in a business valuation:

1. Meet With Business Appraisers

A good place to get started when growing the value of your company is to meet with your trusted advisors, including CPA, attorney and commercial banker. They can help you dig deeper into your finances and provide tips on how to help you grow the value of your business. Formal valuations are usually carried out by a business appraiser who is accredited in business valuation.

2. Determine Your Approach

Next, your advisors will help determine your valuation approach. There are three methods generally used: asset-based, income-based and market-based. Here is a brief breakdown of each:

  • Asset-Based: This method calculates the value of your business by adding your assets and subtracting liabilities. There are two main types:
    • Book value: Based on the balance sheet, this approach uses the historical cost of assets minus depreciation and liabilities.
    • Liquidation value: Estimates the amount that would be received if all assets were sold and liabilities paid off, often at a discount.
  • Income-Based: Using a discounted cash flow analysis, this method projects future cash flows and discounts them back to their present value using a discount rate.
  • Market-Based: Determines the value based on the sale price of comparable businesses in the same industry. This method often uses valuation multiples. Those multiples are then multiplied by financial metrics such as EBITDA or revenue.

Business Valuation Resources

Your CPA, attorney and commercial banker can help connect you with additional resources, including the U.S. Small Business Administration (SBA). The SBA sets guidelines for small business loans and offers resources to help your company. While the SBA doesn't directly lend money, it provides guarantees to approved lenders like your local community bank, making it more attractive for them to extend SBA loans to your small business.

To learn more about how Northwest Bank can help you in the succession planning or business valuation process, contact one of our commercial bankers today.

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The Author

Clay Baker

Clay Baker

Regional Bank President

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