Welcome back – in our last article, we explored how partners should – or could – split equity in a business and the example we used was that one partner brought a half million in assets and the other brought a half million in capital. That adds up to one million, right? Yep. The business is worth one million, right?
Nope. Not so fast. The business has one million in assets and liquidity, but it may not be worth one million. There are three basic ways to value a business, and that is only one of them.
The first, of course, is the asset approach – we just used it. Assuming that those two partners ceded ownership or responsibility of those assets and capital to the business, yes, the business would have a value of one million dollars. This is a traditional corporate view of a business – simply put, what could the stakeholders sell in the event of a failure that would recoup their investment.
Next, though, is called the market approach, and that value is arrived at from what the market would actually pay for a business in that particular environment at that particular time. Our example may be worth a great deal more if they can consistently show that one million dollars in assets operates as effectively as other businesses in the same type of market that are valued at five million. This is a near constant comparison for small businesses or those that deal in the realm of services and inte3lectual property.
Most well-known for those who invest in small businesses at the next level would be the income approach. Here, the value of a business is based on the actual cash flow through the business, contracts, and other yearly income statistics. If our “million dollar” company can only muster 100,000 annually, then the value may be much closer to 100,000 than one million.
So how can a small business actually grow their value? There are a myriad of ways, and the first is to systemize everything. Playing fast and loose with a company is only fun for a little while, then realizing that you are only decreasing profitability usually makes entrepreneurs get smart and start to set up routines and processes to make the company more efficient. Of course, this efficiency drives profitability, so no matter the valuation method, the value of the business grows.
Ultimately, even though you may not have any reason at this point to arrive at a value for your small business, having one and understanding how your owner’s equity is growing – even if the business isn’t for sale – helps to make you a smarter owner and when the time comes for the next stage of capital funding, those habits will help to provide a real-world value of your company to investors or the next round of owners.