Getting Your Money's Worth
Those who are considering a loan for buying a business should understand SBA business valuation requirements. Valuations are to ensure the business is honestly reporting their assets, liabilities and business potential. It also helps the potential business owner ensure they are getting their money’s worth. However, not everyone understands all of the different formulas that must be taken into consideration when setting the value of a business.
Publicly traded companies like Microsoft have a set value based on how their stock is trading and what assets they hold. Smaller business valuations are more challenging to determine since they typically do not issue stock. This does not mean that a privately owned business has less value; it merely means the interest in the business is slightly different.
There is no single formula that is used to set a firm value for a business. The Internal Revenue Service (IRS) defines the fair market value of a company as the price a willing buyer who has no stake in the outcome is willing to pay for the business.There may be tax reasons, estate planning reasons and other reasons why a family member would purchase a business but this practice is carefully monitored by both lenders and the Internal Revenue Service.
The Small Business Administration (SBA) requires businesses sold to family members have a business valuation completed regardless of the size of the loan. All other businesses are required to have a certified valuation if the loan amount exceeds $350,000. The reason family member loans face greater scrutiny is because they are not “arms length" transactions and the sale price may not reflect an accurate price.
Cash flow, equipment on hand, inventory and brand name recognition are all factors used to determine the final value of a company. When these factors are combined by someone who is certified to conduct an audit of the condition of a business, they are able to determine the fair market value of a business. Businesses that have limited or no cash flow are not necessarily worthless, although they may be valuated lower.
There are three primary methods of coming up with an accurate valuation. They are an asset-based valuation, income-based valuation and market based valuation. Each uses a slightly different model and the SBA may require the use of multiple methods depending on the loan size and the industry.