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As a business owner, one of the most important questions you need to answer is: What is my business worth? However, that question is not necessarily one that you can or should answer by yourself. When contemplating your exit options, you should consider receiving the advice of a professional.

At this point, you may find yourself asking a number of questions, such as: What is a valuation? What are the different types of business appraisals? How much does a business valuation cost? Do I really need a valuation for my business? What is the process of determining the value of my business?

This article addresses these questions, as well as others, and guides you through the critical decisions you need to make when planning to sell your business.

What is a business valuation?

A business valuation is a process used to determine how much a business is worth. The end result can range from a verbal opinion of value to a short written report that estimates the value of your business to highly complex formal reports that exceed 200 pages. These types of appraisals range in price and can cost anywhere from nothing to tens of thousands of dollars.

What is the purpose of a business valuation?

Business valuations are used for many purposes. The value of a business is often required in divorce proceedings, tax planning, bankruptcy proceedings, litigation, buy-sell agreements and strategic planning. An appraisal may also be needed when arranging financing and assessing economic damages for litigation.

Most appraisals are performed for legal purposes, and receiving an appraisal in this format is of limited use to you if your intent is discovering the value of your business to sell it. That is because the appraisal may not reflect the actual market value of your business for the purpose of selling your business.

For whom is a business appraisal written?

Unfortunately, most business appraisals are written for those involved in litigation or other legal matters. Therefore, most use complex language that is difficult to understand and include formulas that are of little use to a business owner wishing to sell.

For example, most appraisals contain an in-depth analysis of national and local economic factors that affect the value of a business, which is required for appraisals intended for legal proceedings. However, most owners are already familiar with the economic factors that affect the value of their business and do not want to pay an expert to prepare a report to discuss these factors.

Appraisals must follow guidelines and standards, and many of these standards require the appraiser to analyze these factors when preparing the report. These guidelines are in place so that appraisals comply with the specific requirements for different types of legal proceedings. For example, an appraisal for a divorce may require a strict definition of value, such as “fair market value,” whereas an appraisal for another purpose may require the standard of “fair value.” Such differences may seem minute, yet appraisals must follow these exacting standards if the purpose is for litigation or other legal matters.

As the business valuation industry has progressed, these standards became more complicated, and thus, the standard business valuation report has lengthened over the years. Following these standards results in more time to prepare a report and therefore an increased price. As a result, most business valuations are of little use to a business owner because they are too esoteric and confusing, and thus have little practical value.

Additionally, many business brokers and mergers and acquisitions (M&A) intermediaries do not have an in-depth working knowledge of these standards, so they decide not to offer business valuations as a service. Subsequently, most of the people offering business valuations are business appraisers and CPAs, many of whom have never sold a business in their life. Few have an understanding of the process of buying and selling a business, and few understand the marketplace for the exchange of companies.

This raises the question: Would you pay an appraiser thousands of dollars to determine the value of your business if that person has never sold a business?

How is a business valuation produced?

As a result of these complicated legal standards, most business valuation report software is specifically designed to produce valuations for legal purposes.

Nearly all appraisers use commercial software when preparing a valuation, while some have produced their own software. You will have difficulty finding an appraiser who uses valuation software designed for the purpose of selling a business. Unfortunately, the reports produced by most valuation software are highly technical and not of much use to you as a business owner.

We recommend seeing a sample report from an appraiser before engaging that appraiser. Read it and see if you can understand it. If you cannot, then you are wasting your money. Remember, the appraisal is designed for you, and if you cannot understand it, then you are throwing your money down the drain.

Fair market value vs. strategic value

  1. Fair market value – Most business appraisals use fair market value (FMV) as the standard of value. Fair market value is the price at which a business would sell between a willing buyer and a willing seller, without taking into account the strategic value to the buyer.
  2. Strategic value – Also called investment value, this is the value of a business to a specific buyer. It can represent the added value to a potential buyer who is in the market for a specific type of business or who is interested in being the owner of a particular brand, patent or other forms of intellectual property. For instance, a buyer who already owns a business in one area of the market may want to buy a similar business to reduce competition. Therefore, similar businesses to that of the buyer will have a higher strategic value to him. Unfortunately, you cannot measure strategic value until you know who the buyer is because every buyer is able to extract a different amount of value from the transaction. For larger companies, a valuation will only serve to establish a floor or a minimum price at which the company may sell. It is possible that your business may sell for more if it is purchased by strategic buyers.

What are the types of business appraisals?

When considering whether you should have your business appraised, you have many options. The various types of business valuations do not have standard definitions, so it can be confusing. You have many choices, and below are descriptions for each option. Most reports fall into three main categories: a verbal opinion, a written report for non-legal purposes (such as a business sale), and a written report for legal purposes.

Verbal opinion of value – A verbal (technically “oral”) opinion of value is recommended for any business owner who does not need a formal report. This style of report usually involves the appraiser, broker or CPA reviewing the owner’s financial statements and then offering an estimate of value. Sometimes business brokers or M&A intermediaries will charge for this opinion, and sometimes they will not.

A verbal opinion of value is appropriate when your financial statements are inaccurate or incomplete, or if you have large amounts of unreported cash in your business. It may also be appropriate when you do not want to invest too much money on a formal report. This type of report is also useful if you are in the planning stages of selling a business and would like a ballpark idea of what your business is worth before committing substantial time, money and effort to the process.

It is common for us to provide a verbal opinion of value to a client without preparing a formal report. We ordinarily have a 30- to 60-minute conversation with a client before advising the client on what type of report we believe is necessary. A formal report is not necessary for most small businesses valued at less than $500,000. In some cases, however, a formal report may be required.

Written report, not complying with appraisal standards (Restricted Appraisal Report or Calculation of Value) – These reports do not comply with appraisal standards and cannot be used for legal purposes. We generally refer to these reports as a “business valuation, not for legal purposes.” The format of these reports varies tremendously. Some are simple and straightforward, and others are long, formal and confusing. Categorizing the types of reports found in this category is nearly impossible.

A “calculation of value” is the industry’s attempt to offer a simplified report for business owners. Pricing can range from free to tens of thousands of dollars. These reports are useful for business owners who are looking to sell a business, and may not be used for legal purposes, such as a partner dispute, bankruptcy, or divorce. These reports are strictly advisory in nature and are not intended to be used for legal purposes.

Formal appraisal (Self-Contained Report) – This type of report is necessary for any legal purpose, such as a divorce, tax matter or bankruptcy. These reports are often hundreds of pages in length and are of little use to a business owner who is looking to sell a business. The format of these reports tends to be more consistent than the other formats because they comply with the appraisal standards. These reports usually cost $5,000 or more.

In conclusion, there is more to a business appraisal than affixing a number on your business. Before you determine how much your business is worth, you need to first identify what exactly is a business valuation, what is its purpose, for whom is it written, how is it produced, what type of business appraisal is appropriate for your business, and should you use fair market value or strategic value. Being equipped with this knowledge can help not only in saving you hundreds of dollars by choosing the right individual or company to prepare your business valuation but also in obtaining the maximum sale price for your business. Learn more about the process of valuing a business for sale from my latest book, The Complete Guide to Selling a Business.