Demystifying Business Valuation (Part I): As Simple As 1-2-3

To me, as a numbers person, the worst place for a business owner to be is not to know what you don’t know. Rosy assumptions and optimistic projections, based on nothing but emotion and guesswork, can often hide ugly truths from view. But, on the other hand, overly pessimistic assumptions can lead you to underestimate what your business is worth and miss the truly unique things about your business that make it valuable.

It’s the worst place to be because there’s absolutely no reason why a business owner should be living in the dark. All the data you need to understand what drives value in your business is right at your fingertips. That’s the simplest way to think about a business valuation: it tests what you think you already know and reveals the things you don’t know. That, in turn, helps establish a clear path toward strengthening areas of the business that might be weak and further building value where it currently exists—for a sale now, or a sale down the road.

Simple. The process shouldn’t be intimidating or anxiety-producing. It’s really just a process of discovery based on hard data you already have.

In this piece, let’s take a quick look at what happens on the business owner’s end of the valuation process. There are three simple steps, and while these do require an investment of time and effort on your part, the process is neither onerous nor particularly difficult:

1. Collecting documents: Most of the documents you’ll need are things you already have (e.g., tax returns, financial statements, partnership or stockholder agreements, copies of marketing material, employment contracts, loan agreements, lease agreements, etc.). When you first get it from the valuation company, the document list can seem long, but remember that you’ll rarely be asked to crunch numbers or create anything new.

   The valuator’s goal is simple: to document how you earn money and where you spend money. Their analysis is comprehensive and often complex, requiring many inputs, and the more data they have, the better the analysis will be. But crunching numbers is their job, not yours.

2. Interviewing key employees: Valuators interview people with the most comprehensive knowledge about running the business: the operational leader; the sales & marketing leader; and the finance leader. For smaller businesses that may rely on virtual teams (e.g., an outsourced CFO), whoever runs the relationship internally will likely have sufficient information, but a short interview of the vendor may be necessary to fill in any gaps.

   Expect each interview to last a couple of hours. This is not a days-long investigation into a lot of minutiae. It’s not an adversarial grilling, trying to trip you up or call you out. The goal of the valuator is to grasp, in as much detail as possible, how the business operates and what drives value. Think of it as a conversation: you are educating the valuator on how you run things. And for owners who are not involved—or less involved than they used to be—in the day-to-day operations of the company, these can be eye-opening discussions. So as an owner you may want to sit in on these conversations, as a learning experience of your own.

3. The site visit: The site visit is often done at the same time as the executive interviews, to save time. First, at a very basic level, the valuator must confirm that the business exists where it’s supposed to, that it has the number of employees it claims to, etc.

   Beyond that, the valuator will appraise the physical assets of the business. There will be few hard assets to value for service businesses (e.g., an insurance brokerage). For an asset-intensive business (e.g., manufacturing) or an inventory-heavy business (e.g., retail) the valuator is documenting the age and condition of the equipment or verifying the size/presence of the inventory.

   Finally, the valuator is also learning about the business’s processes: for example, how raw materials move through the system, how that’s captured in the accounting systems, how inventory is stored and logged, and how the final product is shipped out as part of the sales and distribution process.

Collect your documents. Educate the valuator about what you do. Then show them around and give them a hands-on lesson about how you do it. It couldn’t be simpler. And as I have noted in previous articles, the more you do this, the easier it gets because the valuators are working from established knowledge and updating existing data.

Now, what happens to all that data once valuators collect it?

In PART II, we’ll talk about the number-crunching that happens behind the scenes, and how a business valuation can reveal where the value lies in your business.

In the meantime, take heart in the fact that you don’t have to live in the dark, and potentially get blindsided by not knowing what you don’t know. All you need to know about your business is right in front of you. It just takes a trained professional and a simple, systematic process to draw it out.