You've worked hard to get your business to where it is today, but do you know what it's worth?
One of the fundamental measures of success is fair market value. Given its importance to strategic planning, you'd think all owners would know the value of their companies. But that isn't always the case.
Most privately held businesses — a family enterprise, an entrepreneur-owned company or a professional firm — will require an independent valuation at some point. They might be thinking about selling, or maybe there's been a change in personal circumstances, such as a divorce or a retirement. For professional services firms, a partnership structure means business valuation is even more important, especially when partners join or leave.
If a large part of your net worth – and retirement fund – is tied up in the firm, fluctuating or uncertain valuation can be a real problem.
Arriving at business value is as much an art as it is a science, and it takes both reason and instinct to get it right. The value of a business lies in its ability to generate future cash flow. A common place to start is an income-based approach. That involves estimating expected cash flows, then taking a good, hard look at the risks – this is where "instinct" comes into play – to determine an appropriate discount or capitalization rate.
Another method is an asset-based approach, which adds up the values of the underlying assets and liabilities of a business when it's been unable to generate enough cash flow to provide an appropriate rate of return.
A market-based approach, which compares a business with others in the same industry, is also commonly used. The problem for privately held professional services firms is that it can be difficult to apply this approach effectively and find true market comparables because of the uniqueness of their operations and the lack of public information.
Once you've run all these numbers, you have to take into account some of the more intangible factors, such as changing industry and market trends or the impact of management structures (RIM comes to mind). Then, of course, there's brand strength, supplier relationships, name recognition, patents and trademarks, and proprietary technology.
Some firms use a valuation formula to simplify the process, but these can often be inaccurate or too restrictive.
And there is always the issue of cash flow being tied to one person, such as a senior lawyer or an engineer. Imagine if Mad Men's Don Draper left the fictional advertising firm Sterling Cooper Draper Pryce. How would the value of that business change for the remaining partners?
Many owners also attempt to value their business based on "rules of thumb" they have heard of in their industry, which are often incorrectly applied or lead to unrealistic conclusions.
Once you've done all of this, you have the magic number – or do you? While value tends to fall within a range, there is never just one value for a business. Buyers will determine their own value, and it's one of the reasons why there are often differences between the "notional value" and the street value when it's actually put up for sale.
If that magic number is starting to seem elusive, it's important to remember that getting to the value is often not as important as identifying the "value drivers." It's essential for business owners to understand the factors that enhance value. Getting a sense of worth can help firms focus on the metrics that will drive growth. In fact, this can be one of the best reasons to get a valuation in the first place.
Should you try to estimate the value of your business yourself? It can be very difficult for business owners to be objective. It's inevitable that they will link the value of their company to the time and effort it took to build it, but this can often cause them to over-value.
Owner-managers often need an objective assessment to pull them into what's more realistic. They might consider bringing in an independent chartered business valuator, who is trained in valuation and who can look at the business with an unbiased lens, and deliver expert instincts to the job.
Don't wait for a year of super profits, or a year of weak performance, to think about valuation, and don't wait until you're ready to sell. Given current economic realities, privately held businesses in all sectors are looking for ways to strengthen their performance, and a valuation might be the best starting point for growth.
Kelly Kolke is a partner and professional services leader at Grant Thornton LLP.
Special to The Globe and Mail
Join The Globe's Small Business LinkedIn group to network with other entrepreneurs and to discuss topical issues: http://linkd.in/jWWdzT
Our free weekly small-business newsletter is now available. Every Friday a team of editors selects the top picks from our blog posts, features, multimedia and columnists, and delivers them to your inbox. If you have registered for The Globe's website, you can sign up here. Click on the Small Business Briefing checkbox and hit 'save changes.' If you need to register for the site, click here.