How often should business owners get a valuation for their companies? Frequency depends on factors, including their unique business model, industry, market conditions, competition, and most importantly, the purpose or reason for valuation.
Certain events make business valuation necessary: ownership transition, tax purposes, valuation housekeeping, admitting or buying out a partner or shareholder, estate planning, succession planning, etc.
3 Top Reasons for a Business Valuation
- Exit planning
- Tax purposes
- Valuation housekeeping
Business owners often ask if they need to invest in preliminary business valuation at the start of the exit planning process. The answer is YES!
Get accurate answers to the below questions before you start planning your exit. Your answers should not come from your gut but a precise analysis of your business’s current value.
The questions include but are limited to:
- How will your business move from its current state to meet your financial needs?
- What are your company’s potential cash flows and growth prospects?
- Which areas should you focus on to enhance your business value?
If you are planning your exit strategy, a preliminary business valuation is essential to get started. During the exit planning process—usually a long one—we advise an annual valuation, although it’s wise to get one every couple of years regardless.
The annual valuation helps you stay on track and know that your company has not off-course but is heading straight towards your exit goals. The yearly valuation measures the progress of value creation.
A 409A valuation is an appraisal of the fair market value of the common stock of your startup.
If you do not price your stock options, the IRS assumes you are giving away something valuable. That causes significant tax issues.
Option holders found in violation of 409A have to pay taxes and a 20 percent federal penalty, state penalties (if applicable), an IRS tax underpayment penalty, and interest on unpaid taxes (if any).
Most startups will likely not face a 409A audit. However, for successful startups, an expensive and time-consuming IRS audit becomes a greater possibility. Also, the Securities and Exchange Commission (SEC) looking closely at pre-IPO stock awards poses serious questions.
Getting a 409A valuation to protect your company and employees is essential. You must obtain a 409A valuation twice if you are planning to offer standard stock options:
- Every 12 months.
- After the close of a new funding round by your company.
Factors that influence 409A valuation include:
- Market approach: This includes an analysis of the transactions of comparable companies.
- Income approach: This helps determine your business projections for the next five years by analyzing your company’s free cash flows.
- Asset approach: This includes an analysis of the company’s assets (both tangible and intangible).
Many companies complete a valuation as part of housekeeping or on an as-needed basis. It may occur annually, quarterly, every couple of years, etc.
Annual Business Valuation
Life is unpredictable, and an opportunity to liquidate your interest in the business could suddenly arise. If that happens, you will need the valuation as part of due diligence for the transaction. The same applies in case of an ownership transition, be it selling your company or an M&A transaction. And if your family needs to dissolve your business after something happens to you, then the yearly business valuation will be helpful to them.
Quarterly Business Valuation
Usually, only public companies must do a business valuation in one form or another every quarter as per SEC regulations. As a small business owner, you need not do this; but, we recommend quarterly business valuations if your business is strongly seasonal.
For example, a company providing a swimming pool maintenance service will have profitable business during the summer and fall seasons but the rest of the year.
By getting frequent business valuations, such companies may tap into opportunities to merge with other companies with longer seasons or purchase from an adjacent or complementary industry. In both cases, the business valuations would ease the transactions.
Ad-hoc Business Valuation
Partnership businesses in which partners come and go for several reasons should opt for ad-hoc valuations. This gives the partners a better idea of the fair price to buy out a partner. We strongly recommend performing an ad-hoc business valuation when an indication that a partner might be planning to exit.
Ad-hoc valuation is also conducive is when you are considering an IPO. It will help determine the company’s opening stock price.
Factors Influencing Business Valuation Frequency
The frequency of business valuation, beyond that required by law for public companies, depends on your company’s situation. Substantial changes in the business, industry, and economy justify performing a business valuation.
As a business valuation makes assumptions and calculations on the facts available at that particular time, it remains valid until the underlying factors change. Changes or unforeseen events justify another business valuation.
Cash flow impacts business value. If your company produces significant cash flow, you want to measure it more frequently and also be able to afford the costs for it. Making measurement a part of your business strategy will help you with growth planning and value creation by identifying key risks and value drivers.
If your company operates in a stable industry like utilities or has a diverse customer base, business valuation need not be frequent. Volatility, however, mandates greater frequency in business valuation because volatility comes with price risk. An industry seeing constant change and large swings in value, a small number of customers, limited geographical location, or a static number of services or products make companies more volatile.
Connect with our experts to get in-depth information as to how often you should value your unique business and the most suitable method to do it.