A valuation is based on a hypothetical sale of the company, so two critical issues need to be well defined from the beginning 1) exactly what is being sold (valued), and 2) who is the most likely buyer.
What is Being Valued?
Businesses are generally sold in two types of transactions asset or stock sales. A stock sale involves selling the shares of the stock of a company that operates as a corporation. Most buyers are not interested in a stock sale because it involves acquiring liabilities existing, contingent and potential. An asset sale gives the buyer a clean start. Therefore, stock sales of small businesses are not common. Many valuation methods produce results based on stock sales, so the results must be adjusted accordingly.
Asset sales involve selling the main operating assets of the company. That typically includes inventory; furniture, fixture and equipment (FF & E); leasehold improvements: and all intangible assets, commonly referred to as goodwill. The intangible assets include items like: customer list, trade name, telephone numbers, assembled workforce, etc. These assets are typically sold free and clear of all liabilities. Cash, trade receivables and payables, and miscellaneous assets or liabilities are commonly excluded from the sale. If the owner also owns the company real estate, it may or may not be included in the sale. The sale will also include the assignment of existing leases or contracts, or will be contingent on the buyer obtaining new ones. If the company operates under a franchise agreement or needs a specific type of permit or license like a liquor license, the sale will include the transfer of these items.
Your business is most likely to sell as an asset sale, so determine which specific assets would be included in the sale. That way the results from the valuation methods used can be matched or adjusted to accurately reflect the assets being valued.
Who's Perspective?
One company may have a number of different values. A buyer who will actively operate the company on a daily basis is buying a job as well as a company. So value should be based on earnings before deducting the current owner's compensation. An absentee owner (investor) should base value on earnings after deducting the current owner's compensation since someone would have to be hired to fill those duties. A strategic buyer that wants to plug the business' customer base into their system would place greater value on sales or gross profits rather than earnings.
The majority of small businesses are sold to other owner-operators, so that should be your primary assumption. Only if your company has significant revenues or earnings, should you consider investment and strategic buyers as likely buyers.
Conclusion
It seems like a no-brainer - you need to know exactly what you are valuing and who would be most likely to buy it, before you can value it. Many valuations skip this step and jump right into estimating the value of a company. A valuation missing these critical pieces is like valuing a coin based solely on its face value, even though it may be an extremely rare collector's item.
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This is a pretty good primer. Not nearly enough for someone to do their own valuation (i.e., they still need finance and accounting skills at a minimum), but it's a good overview.
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